Private equity and venture capital

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Private equity and venture capital
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The private equity market

• The private equity market (PE) is a source of
  funding for start-up firms, private middle-market
  firms, firms in financial distress, and public
  firms seeking buyout financing
• The size of the private equity market rose from
  0.8bn in 1980 to 148.4bn in 2000, while it was
  43.8bn in 2002
• The private equity market is divided into two
  parts
• Venture capital market, which includes funding
  for start-up firms
• Non-venture private equity market, which includes
  funding for established private firms (leveraged
  and management buyouts)

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• Well-known firms that have received PE financing
• Apple
• Cisco
• Microsoft
• Netscape
• Sun Microsystems
• Staples
• Starbucks
• Google
• Amazon

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Organization of the private equity market

• The private equity market is composed of the
  following groups
• The firms (issuers) that seek financing from
  private investors
• The private equity funds organized in the form of
  limited partnerships
• The outside investors who invest in the private
  equity market
• The agents and advisers whose role is to generate
  information

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Who are the issuers?

• Private equity financing is very expensive given
  the high returns expected by private equity
  investors
• The firms that go to the private equity market do
  so because they have no alternative sources of
  financing
• These firms may
• Be too risky to issue debt
• Require extensive due diligence due to the risks
  involved
• Need investor guidance and expertise
• Private equity investors can help resolve these
  issues

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Taxonomy of issuers

• Firms seeking venture capital
• Early-stage ventures
• Later-stage ventures
• Middle-market private firms
• Grown private firms that need financing to expand
  or change their capital structure and do not wish
  to go public
• Public and private firms in financial distress
• Public buyouts (LBOs)

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Percentage Invested by Stage in U.S. (1996-2000)

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Organization of PE funds

• The growth in the PE market during the past three
  decades is to a large degree attributed to the
  emergence of the limited partnership form of
  organization
• Limited partnerships are financial intermediaries
  that raise and invest funds from investors
• Until the late 1970s, most of the private equity
  investments were undertaken by wealthy
  individuals, large corporations, and banks
  investing directly into issuing firms

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• Private equity funds are mainly structured in the
  form of limited partnerships
• Limited partnerships are composed of
• General managing partners who are professional
  managers running the fund
• Limited partners who are institutional investors
  and other individuals who contribute to the
  funds capital

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• Typically, a group of experienced investors forms
  a a managing partnership or LLC to act as general
  partner
• The managing partners typically form a second
  entity called the PE fund partnership or a LLC to
  manage the fund
• Outside investors, as well as the funds
  managers, promise to contribute to the capital
  raised by the fund
• The fund managers identify and evaluate potential
  investments, monitor these investments, and
  recommend exit strategies

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Characteristics of limited partnerships

• General partners (GP) run the business and have
  unlimited liability
• Limited partners do not actively participate in
  the business
• Liability (but not tax liability) is generally
  limited to contribution to the partnership
• Limited transferability of partnership interest

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Typical Life of a Limited Partnership
Raise Capital
Identify and structure investments
Manage and liquidate investments
5
10
0
Year
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Taxonomy of PE funds

• Venture capital funds
• Leverage buyout funds
• Use significant amounts of debt borrowed by using
  the acquired firms assets as collateral
• Purchase firms with stable cash flows, large
  market share, undervalued shares, and in stable
  industries
• Mezzanine funds
• Either private equity financing before an IPO or
  private equity investments that use subordinated
  debt often with attached warrants
• Hedge funds
• Funds of funds

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Leading Technology Venture Firmsas of December
2002

• Capital
  Under Management
• Rank Company
  ( in billions)
• 1 New Enterprise Associates 4.9
• 2 Oak Investment Partners 4.2
• 3 Sprout Group 3.4
• 4 Accel Partners 3.2
• 5 Spectrum Equity Investors 3.0
• 6 St. Paul Venture Capital 3.0
• 7 Menlo Ventures 2.7
• 8 Austin Ventures 2.6
• 9 Kleiner, Perkins, Caufield
  Byers 2.6
• 10 VantagePoint Venture Partners 2.6

Source Private Equity Analyst
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Largest 15 Buyout Funds ClosedOctober 2001 to
September 2002

• Committed
  Capital
• Rank Company
  ( in billions)
• 1 Blackstone Capital Partners IV,
  L.P. 6.45
• 2 DLJ Merchant Banking Partners III,
  L.P. 5.40
• 3 Warburg Pincus Private Equity VIII,
  L.P. 5.30
• 4 Apollo Investment Fund V, L.P. 3.75
• 5 CSFB Global Opportunities Fund,
  L.P. 2.20
• 6 Global Private Equity IV, L.P. 1.90
• 7 J.W. Childs Equity Partners III,
  L.P. 1.75
• 8 Berkshire Fund VI, L.P. 1.70
• 9 Hicks, Muse, Tate Furst Equity Fund
  V, L.P. 1.60
• 10 The Resolute Fund, L.P. 1.50
• 11 Heartland Industrial Partners,
  L.P. 1.40
• 12 Angelo Gordon Capital Recovery
  Partners III, L.P. 1.00
• 13 OCM Emerging Markets Fund III,
  L.P. 0.96
• 14 Fremont Partners III, L.P. 0.92
• 15 CIVC Partners Fund III, L.P. 0.80

Sources Alternative Investor/Private Equity
Analyst/VentureOne
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Who are the investors?

• Thirty years ago, wealthy individuals accounted
  for the largest share of PE investments
• The prudent man rule of 1979 allowed pension
  funds to invest in riskier assets and gave a
  boost to the PE market
• Institutional investors (private and public
  pension funds, financial and insurance firms) put
  today almost all of the contributed capital in PE
  funds

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Investors In Private Equity (continued)LP
Capital Commitments to VC Funds
Source Venture Economics/NVCA
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Investors In Private Equity (continued) LP
Capital Commitments to Buyouts/Other Non-Venture
Funds
Source Venture Economics/NVCA/Private Equity
Analyst
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Main developments in the PE market

• 1940s The American Research and Development
  (ARD) Corp. was established in 1946 to pursue
  investments based on technology developed in
  World War II
• Almost half of profits in 26-year life came from
  investment in DEC
• 1950s Not much growth in venture capital
• Venture capital firms were organized as
  publicly-traded closed-end funds
• Unscrupulous brokers took advantage of
  inexperienced investors who experienced
  significant losses

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• 1960s and early 1970s Not much growth in VC
• The federal government launched the Small
  Business Investment Companies (SBIC) program in
  1958
• VC firms obtained generous marching funds or loan
  guarantees through SBIC
• Again, inexperience and fraud led to significant
  losses
• Investment in venture capital was flat (about
  2-3bn during 1969-1977)

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• 1970s Limited partnerships gained in popularity
  and regulatory and tax changes help PE market
• 1974 Pass of Employee Retirement Income Security
  Act (ERISA) that attempts to eliminate abuses in
  corporate pension funds by restricting risk
  investments
• 1978 Prudent man amendment to ERISA allows
  pension funds to invest in riskier assets
• 1978 1981 Capital gains tax rate reduced from
  49.5 to 28 and then to 20

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• 1980s and early 1990s
• Venture capital financing increases tenfold in
  early 1980s
• But, funding drops during 1987-1991 due to
  disappointing losses by investors
• Rise in buyout funds coincided with the rise in
  the high-yield debt market
• 1990s Dramatic rise in PE market

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Capital commitments to PE funds
Note 2Q03 values are annualized based on 2003
results.
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Venture capital firms

• VCs differ from banking institutions in a number
  of ways
• They obtain funds by issuing equity shares on a
  quasi-private basis
• They specialize in financing very young,
  high-risk firms
• They accept equity securities in exchange for the
  capital they provide
• They are much more involved with the management
  of these firms
• They are less regulated than banks

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How do VCs value a new venture?

• It is very difficult to value a young firm that
  has no history of earnings and plans to operate
  in an industry with few existing comparable firms
• VCs use the venture capital method
• Estimate the projected earnings of the firm at
  some future date when the VCs want to take the
  firm public, which will be given by the terminal
  value at that date (e.g. 8 years from today)
• Use a P/E or market-to-book multiple to obtain a
  value for the firm at that date

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• Discount the terminal value back to the present
  by using a target rate of return for the VC,
  typically pretty high (50-70 for early ventures,
  30-40 for later ventures)
• This gives the fair value of the venture today
  and can be used to allocate ownership shares
  among VCs
• High discount rates are justified due to
• Premium for risk and illiquidity of investment
• Value added by VCs
• Offset for overly optimistic cash flows