WCM Educational Recap #8: Intro to Private Equity

Recapped by Alyssa Choi

Welcome to the Western Capital Markets blog! This week, we dive into buy-side roles like private equity, venture capital, and growth equity, with a focus on private equity and how it works.

Overview of Common Buy-Side Roles

• Private Equity: Firms that purchase companies using investor capital and debt, make improvements over 5–10 years, and then sell them for a return
• Asset Management: Firms that buy, sell, and manage a portfolio of stocks and investments on behalf of private or institutional clients
• Venture Capital: Similar to private equity, except they invest in startups, early-stage, and emerging companies that have high growth potential

Overview of a Company’s Lifecycle

Venture Capital

• Early-stage companies
• Pure equity or convertible debt
• Dependence on industry or product innovation

Growth Equity

• Proven business models
• Funding used for scalability
• More mature or emerging markets

Private Equity

• Mature companies
• Highly leveraged
• Mature and well-established industries

Venture Capital

Venture capital (VC) involves private investment into early-stage companies with growth potential.

Companies may take VC funding if they lack access to other financings. Moreover, VC has no collateral and no repayment period and provides the ability to plan into the long term as well as access to valuable resources.

Investment Process

Fundraising → Investment Evaluation → Investment & Capital Allocation → Governance & Business Growth → Exit & Distribution of Returns

Fundraising Process

• Round 1: Friends, Family, and Angels
• Round 2: Pre-Seed and Seed
• Round 3: Series A-E
• Round 4: IPO, Acquisition, etc.

VC firms look at criteria such as the business model, experienced management, product and competitive advantage, market size, and expected forecast.

Growth Equity

Growth equity involves private investment into established companies with proven business models.

Companies may take growth equity due to the positive impacts to customer acquisition, enhancing product, and operational scalability. Moreover, growth equity offers resources to compete in markets, as well as access to industry expertise.

Potential risks may include execution risk, management risk, market risk, default risk, and product risk

Private Equity

Private equity involves purchasing a company through a leveraged buyout (LBO), where most of the transaction is funded through debt. After 3–10 years, the PE firm will sell the company to realize a return on its investment.

• Fundraising: Raise funds from institutional investors and invest capital into private companies
• Diligence: Search for new transaction opportunities require a lot of due diligence
• Returns: Achieve above-average profit through leverage, growth, and operational improvements

Firms by Size/Purpose

• Search Funds: Investment firms where an entrepreneur raises funds to acquire a company and assume day-to-day leadership
• Middle Market: PE firms that typically invest $100M — $5B in capital commitments
• Mega Funds: Largest private equity firms that typically invest >$5B per fund
• Pension Funds: Capital accumulated from contributions from employers, employees, or both

Leveraged Buyout Overview

An LBO is like buying a house to rent to others and eventually sell rather than buying a house to live in. In leveraged buyouts, PE firms prefer to use as much debt and as little of their own money as possible to get a higher internal rate of return (IRR).

• Debt funding reduces the upfront cost of acquiring a company
• Debt funding lets the PE firm use the company’s cash flows to repay the debt and make interest payments

Compared to using 100% cash, using some cash and some debt to fund a purchase results in a higher IRR.

Transaction Timeline

The average process lasts 6–8 months, and a firm may look at 1000+ potential investment opportunities in a year. There are three stages: Marketing, Valuation & Due Diligence, and Negotiations & Closing.

Marketing Process

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 & Due Diligence Process

1. Initial Due Diligence: Researching 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 & Closing

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

Due Diligence Process

Due Diligence is the process of collecting and analyzing information before making a decision. You investigate the company’s business model, management, product design, target market, and operating history (Ex. How has the product mix changed as revenue has grown? What does the figure 67% YoY growth actually mean and what drove this figure?)

• Key participants in this process: PE Analysts, Investment Bankers, Accountants, Lawyers, Consultants, Industry Experts, and Management Team
• Criteria of a Strong Company: Proven management team, stable and consistent cash flows, defensible market position (i.e. economic moat), opportunities for growth/improved efficiency, and low maintenance capital expenditures
• Timeline: Source Lead (1–2 weeks) → Due Diligence (4–8 weeks) → Negotiating Price (2–4 weeks) → Structure Financing (2–4 weeks)
• Areas of Focus: Quality of earnings, margins, growth; Competition & industry trends; Management capabilities & plans; Key risks & catalysts

Private Equity Case Studies

Success Story: Hilton

• Buyer: Blackstone
• Seller: Hilton
• Overview: Hilton’s three consecutive years of profitability made it an attractive investment prospect. Blackstone had incorporated 5 hotel chains in its portfolio, making it an ideal candidate for the buyer. The deal was finalized in 2007 at a price of $26 billion with nearly 80% funded by debt.
• Rationale: Hilton was mature, yielding consistently high returns, and had the potential for expense reduction. There were feasible exit options, with Hilton IPOing or staying private. There was high collateral, in case debt needed to be repaid. Finally, there were potential synergies with existing hotel portfolio companies.
• Outcome: Blackstone wrote down its investment by ~70% during the 2008 recession due to the cyclical nature of luxury goods. Blackstone restructured their debt well, reduced cash outflows organically, grew Hilton in Europe and China, and pursued a high-margin franchising strategy. Blackstone more than tripled its initial investment through an IPO in 2013 and sold additional shares in 2018.

Failure Story: TXU Energy

• Buyer: KKR, TPG, Goldman Sachs
• Seller: Energy Future Holdings, TXU Energy
• Overview: Energy Future Holdings is a coal and nuclear-powered electric utility company headquartered in Dallas, Texas. In 2007, KKR, TPG, and GS conducted an LBO on Energy Future Holdings (formerly TXU Energy) for $45B.
• Rationale: TXU was the largest coal power plant operator in Texas. The PE firms’ underlying bet was that plunging natural gas prices had hurt wholesale electricity profits and would reverse course, and given the stability of TXU, the deal seemed safe at the time despite the 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. the PE firms divested part of the business, creditors took control of the rest; currently trades under Vistra Corp (NYSE: VST).

Private Equity Recruiting Opportunities

Second Year:

• Altas Partners, LaurelCrest Partners, Turtle Holdings Limited, Ashbridge Partners, Calistix Capital

Third Year:

• Megafunds: Blackstone, KKR, SilverLake, Ares
• Pension Funds: PSP Investments, CPP Investment Board, OMERS, Ontario Teachers’ Pension Plan

Key Takeaways

• Private equity firms use leveraged buyout to purchase a company, operate and make improvements, then sell it for a profit.
• Financing with both debt and equity offers a greater internal rate of return than just equity financing.
• Comprehensive due diligence is needed to assess if a company is a good potential acquisition, and even then, private equity deals may fail.