Private equity investments from the investor’s and the issuing companies’ point of view

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List of abbreviations

1 Introduction
1.1 Objective of the paper
1.2 Methodology

2 Fundamentals of PE investments
2.1 Definition of the term private equity investments
2.2 Participants on the PE market
2.3 Process of PE investments and negotiation criteria
2.4 Application of PE investments in the company life cycle

3 Benefits and risks in PE investments
3.1 Breaking down the critical points between the investors: LP and GP
3.2 Breaking down the critical points between investor and target
3.3 Weighting the power between investor and issuer

4 Conclusion

List of literature

Integral Total Management (ITM)

List of figures

Figure 1: PE market structure and participants

Figure 2: PE investments in different business stages

List of tables

Table 1: Relationship factors between investors and PE firms

Table 2: Relationship factors between PE firms and target companies

List of abbreviations

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1 Introduction

The European private equity and venture capital association, abbreviated EVCA, regularly stresses the importance of private equity for economy and society in Europe. Since 2007 investments up to 233 billion Euros have been made through private equity and venture capital deals. Especially patent filings are driven by these investments (EVCA, 2013). Simultaneously private equity investments between 1980 and 2004 generated annual net returns of forty percent. Comparing with twelve percent performance of the Standard & Poor's 500 over the same period, private equity becomes a preferred asset class to investors (Private Equity Council, 2004).

The consulting group Roland Berger yearly provides an outlook for private equity transactions. The financial crisis and a general slowdown in the European economy have impacted investment behavior negatively. For 2013 though positive trends are estimated, especially for the Scandinavian and German market. Important target industries will be pharmaceuticals, commerce and energy suppliers. Roland Berger also observed that the model of private equity financing should be reworked and adapted according to the new market environment (2013).

1.1 Objective of the paper

The paper on hand aims at analyzing the financial model private equity from participants’ point of view. The introduction has shown the importance for the overall economy. Questions of the paper are: what are the criteria for successful investments for both parties; what are the advantages respectively difficulties from the perspectives of investors and issuers of private equity?

1.2 Methodology

In order to systematically approach the questions the author first provides the fundamentals of the concept. In a second step benefits and risks for the participants in private equity investments will be described. A simultaneous assessment of these will result in an overview reflecting potential profits and losses.

The analysis focusses on theoretical descriptions; practical applications will not be considered. Information and data gathering is based on secondary literature.

2 Fundamentals of PE investments

This chapter sets the fundamental understanding of the model. In first instance the term is defined. Secondly participants of this transaction will be identified and described. Thereafter the transaction process and negotiation criteria are pointed out. Motivation for PE requirements in different business stages will conclude the basics.

2.1 Definition of the term private equity investments

A very comprehensive definition of private equity, abbreviated PE, investments has been provided by Fraser-Sampson: “any equity investment in a company which is not quoted on a stock exchange” (2010, p. 2). Concomitantly he refers to PE investments in publicly listed companies aiming at becoming private and examples of publicly listed companies with additional PE financing instruments (2010). Strictly differentiating the term PE it is any “equity capital that is not quoted on a public exchange” (Investopedia US, 2013 a). Consequently PE is one external financing instrument next to loans, bonds, debts and public equity (Gleißner & Schaller, 2008). On the other hand the attributes of equity capital fully apply: presentation of ownership in an asset and participation of retained earnings respectively losses as well as bearing the risk of business over a long time span without demanding guarantees. In contrast to equity from stock markets PE is less vulnerable to external factors due to the creation of a conscious partnership between investor and capital seeker (EVCA, 2007).

According to Kasener et al. the term is being used differently in the United States and Europe, separating venture capital from the concept PE (2007). Venture capital, abbreviated VC, is equity capital given to early stages of business developments (Jesch, 2004). The European approach to PE includes VC as a subset of PE with the remarks that VC focuses on “entrepreneurial undertakings rather than on mature business” (EVCA, 2007, p. 6).

PE investments in further context of this paper will be defined as ”the [negotiated] provision of [equity] capital [...] with the aim of developing the business and creating value” (EVCA, 2007, p. 6). There is no demarcation of certain stages of business development.

2.2 Participants on the PE market

Concluded from the definition there are at least two participants on the PE market: firstly, there are investors that provide equity capital and secondly, there are companies seeking for equity capital. Figure 1 summarizes the PE market structure. The direction of arrows specifies the flow of capital and services in the investment. When divesting, the arrows will reverse (Prowse, 1998). Moreover the figure shows that there are further participants. PE firms bring investors and seekers together. Additionally investment advisors, placement agents and investment brokers support the transaction. Latter will not be further detailed.

Figure 1: PE market structure and participants

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Source: adapted from Prowse, 1998, p. 23

The group of investors is built upon the participation of wealthy individuals and families, institutional organizations, industrial investors and others. Private investors and families mainly provide capital to businesses in pioneering stages. The Anglo­Saxon literature calls these “business angels” as they further offer entrepreneurial knowledge and experience (Kasener et al., 2007). Institutional investors are banks, insurance companies, pension funds, and public institutions. This group represented the largest investing source of PE in the past twenty years according to Prowse (1998) and EVCA (2013). Their main target is the strict realization of returns above public equity market opportunities. Public institutions and business companies in contrast also strive for strategic partnership and creation of synergy effects according to de Zwart et al. (2012).

Role of PE firms is the pooling of capital from investors and creation of funds that will invest in publicly and privately held companies. They serve as intermediaries for raising and investing capital (Prowse, 1998), thereby diversifying the risk through creation of portfolio investments (Kürsten & Nietert, 2006). Additionally they use their own equity and funds borrowed from banks and other lenders to drive business (Private Equity Council, 2004).

PE firms are general partners (abbreviated GP): they will negotiate with, consult and support the capital seekers and targeting companies in accordance with their own positioning. Sonndorfer (2012) points out the various forms of PE firms: universally working PE companies, holding companies, international PE management firms, and investment companies specialized in VC and SME (standing for small and medium-sized enterprises).

Generally the group of investors directly approach private equity seekers or indirectly through PE firms. Hence depending on the approach of investors, they are limited partners (abbreviated LP), restricted in the provision of capital, or also general partners, when directly approaching (EVCA, 2007; Kasener et al., 2007). Both, GP and LP, should be considered under the term “investor” as a GP may invest own capital and labour for creating value and act on behalf of LPs (Rosenberger, 2008).

The last group of participants are the companies and organizations in need of equity capital. Prowse (1998) calls these issuers in accordance with the definition of selling “securities for the purpose of financing its operations” (Investopedia US, 2013 b). They strongly vary in size and motivation for raising capital; common to all is the requirement for expensive private capital. Strong regulations for debt financing create barriers, especially for entrepreneurs and SMEs. Entering the public stock market is restricted to companies with minimum equity levels. For example, the listing in the Xetra requires a liable equity amounting to 730,000 Euro (Deutsche Börse AG, 2012).

2.3 Process of PE investments and negotiation criteria

Compromised from the identification of investors the process of a PE investments starts with the creation of an investments strategy that will provide framework and guidelines for the transaction. On the other side issuers create their partnering strategy. Both will set the standards for potential participants by classifying legal structures, investment respectively fund size, management and performance fees (Rosenberger, 2008; EVCA, 2007).

Once the subscription is closed, target companies are screened in line with the agreed investments strategy. The shortlisted ones will run through a due diligence process before the investment will be committed on. The creation of value for investors and target companies is central part of the process. This value creation will be measured by the internal rate of return from acquisition to the exit. The choice of exit strategy therefore is a second important factor in the process. Potential exit strategies can be listings on the stock market, sale to other investors, repurchase by shareholders amongst others (Striebel, 2009).

It has to be noted that a PE investment is a formal contract. Investors, no differentiation of GP or LP, and target companies negotiate the content of this contract starting with the selling of shares and concluding with the payback of capital. Main contents of all PE agreement are the investment amount, duration of provision, and partnership type. In dependence on these many other criteria gain importance. They determine the rights and duties for both parties in legal terms.

The decision for co-management or silent partnership depends on situation of the target as well as the competencies of the investor (Lotze, 1993). Stage financing, meaning to commit capital batches over time depending on predefined performance indicators, is a preferred financing technique in VC contracts (Cornelli & Yosha, 2003). Consideration of financing syndicates or prevention of dilution effects should also be negotiated (Kasener et al., 2007).

2.4 Application of PE investments in the company life cycle

In conclusion to the provided definition of PE investments and the identification of participating firms, it has become obvious that a more detailed understanding of motivational factors for issuers is needed. The company life cycle closely relates to these and hence is described by help of figure 2 on page 6. Gompers (1995) as well as Kaplan et al. (2005) point out that the focus of investors is set by business stages rather than any other criteria, such as industry or size.

Figure 2: PE investments in different business stages

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Source: Rosenberger, 2008, p. 11

As previously defined for this paper PE investments can be categorized in VC and PE in a narrow sense. Companies in the pioneering stage are usually start-up firms that do have an excellent business idea. Alternatively these are innovating firms in technology. Both lack liquidity for realization (Prowse, 1998). In the expansion stage business operations are already running, plus there is a strong potential and need for internal respectively external growth. PE in these cases is used for capital expenditures and acquisitions. In contrast usage of PE for spinoffs represent a form of divestiture, at the same time can be regarded as start-up business (Holzschuh, 2011). Due to high uncertainty of success in all stages of seeding, start-up, and expansion PE investments are liable to high risks and therefore expect high rates of return (Jesch, 2004).

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