WCM Educational Recap #11 : Introduction to Private Equity, Growth Equity, and Fundraising

Recapped by Akul Shah

Private Equity

This week we went over the key components of the buy-side, covering segments such as Private Equity.

Buy-side

Finance can be broken down into two main segments: buy-side and sell-side. The sell-side refers to firms that issue, sell, or trade securities. On the other side, the buy-side refers to firms that make investments or purchase securities in public and private companies. Private Equity (PE) belongs to the buy-side as firms purchase companies using investor capital and debt. PE firms aim to make operational improvements over their 3–10 year holding period before selling the company for a return.

Leveraged Buyout

PE firms acquire companies using a leveraged buyout. A leveraged buyout is a method of buying a company using mostly debt and a minority of equity. As the PE firm holds their investment, they will service interest expenses and pay down their debt balance using the cash flow generated from the company. As the outstanding debt decreases, the PE firm grows its equity stake within the business. When it is time to sell the business, the PE firm will realize an amplified return on their initial equity because their equity stake in the business has increased while selling for a higher exit multiple.

Since there is a lot of risk with buying a company with a lot of debt, PE firms maintain strict investment criteria:

1. High cash flow yield: PE firms need to service consistent interest and debt payments over the holding period; stable and high cash flow yield is critical to not default.
2. Sustainable advantage: Companies with a sustainable economic moat have much less risk for PE companies to invest in as their holding period can extend beyond 10 years.
3. Turnaround potential: The company must have the capability to be sold at the end of the holding period because that is when the PE firm realizes the bulk of its return.

The average length of the process for a PE firm to execute a company’s purchase can range from six to eight months. The process includes marketing, valuation and due diligence, negotiations, and closing. Some firms will look at upwards of 1,000 potential investment opportunities a year.

Marketing Process (Average process: 10 weeks)

1. Sourcing & Teasing: Finding potential investment opportunities and sending a two-page summary of a company available to purchase.
2. NDA Signed: The management of the target company will begin to provide confidential information about their business.
3. CIM Sent by Bankers: Includes an investment thesis, financials, projections, and capital structures.

Valuation and Due Diligence Process (Average process: 20 weeks)

1. Initial Due Diligence: Research the target company and its industry.
2. Investment Proposal: Presents it to their investment committee.
3. First Round Bid: Interested PE firms provide a valuation range of the target.
4. Internal Operating Model: Highly detailed revenue and cost breakdown.
5. Preliminary Investment Memorandum: 30 to 40- page document that summarizes the investment opportunity to the PE firm’s investment committee.
6. Final Investment Committee Approval: A Final Investment Memorandum (FIM) is created.

Negotiations and Closing (Average process: 6 weeks)

1. Final Binding Bid: Includes final price, financing documents, and preliminary merger agreements.
2. Signing the Deal: A Purchase Agreement and other documents will be created.

Private Equity Success Story — Hilton

Overview:

After three consecutive years of profitability, Hilton Hotels & Resorts became an attractive investment prospect for PE firms. Blackstone, a mega-fund PE firm, had incorporated five hotel chains in its portfolio, making Hilton an ideal candidate to purchase. The deal was finalized in 2007 for $26 billion, with nearly 80% funded by debt.

Rationale:

Hilton was mature, yielding consistent high returns, and had the potential for expense reduction. There were feasible exit options, and taking Hilton private would have allowed for a re-IPO of the company if Blackstone desired. Hilton as a hotel chain has high collateral when securing large amounts of debt. Between Hilton and Blackstone’s current portfolio hotel companies, synergies would be unlocked.

Outcome:

Hilton’s acquisition came at poor timing with the financial crisis in 2008, and Blackstone wrote down the investment by 70% during the recession. Hilton was hit hard by the recession because the business is cyclical as it operates as a luxury good. Blackstone was able to restructure the debt extremely well by reducing cash outflows and organically grow Hilton in Europe, China, and pursue a high-margin franchising strategy. Blackstone more than tripled their initial investment through an IPO in 2013 and selling additional shares in 2018.

Private Equity Failure Story — TXU Energy

Overview:

Energy Future Holdings (formerly TXU Energy) is a coal and nuclear electric utility company headquartered in Dallas, Texas. KKR, TPG, and Goldman Sachs conducted a leveraged buyout on TXU in 2009 for $45 billion.

Rationale:

TXU was the largest coal power plant operator in Texas and served 3 million retail utility customers. The underlying bet was that plunging natural gas prices had hurt wholesale electricity profits and would reverse course. Given the stability of TXU, the acquisition seemed safe at the time despite taking on a high amount of leverage.

Outcome:

Natural gas prices fell even further, making it difficult for TXU to compete with natural gas power plants. In 2014, the company defaulted on its debt and was forced into bankruptcy. Divested part of the business, creditors took control of the rest; currently trades under Vistra Corp (NYSE: VST).