23.2.1 Securities Used in Venture Capital

Venture capitalists usually invest in the convertible preferred stock of the start-up company. There may be several rounds (or series) of preferred stock financing before a successful start-up company goes public. Convertible preferred shares are the favored manner of investment because they are senior to common stock in terms of dividends, voting rights, and liquidation preferences. Furthermore, venture capitalists have the option to convert their shares to common stock when exiting via an initial public offering (IPO). Other investment structures used by venture capitalists include convertible notes or debentures that provide for the conversion of the principal amount of the note or bond into either common or preferred shares at the option of the venture capitalist. Convertible notes and debentures may also be converted upon the occurrence of an event, such as a merger, an acquisition, or an IPO. Venture capitalists may also be granted warrants to purchase the common equity of the start-up company, as well as stock rights in the event of an IPO.

23.2.2 The Payout of Venture Capital

The venture capitalist has a simple binary choice with respect to every potential investment in a start-up business: Invest or don't invest. Investing in a start-up company is similar to the purchase of a call option. The price of the option is the capital that the venture capitalist invests in the start-up company. If the company fails, the venture capitalist forfeits the option premium—the capital invested. However, if the start-up company is successful, the venture capitalist shares in all of the upside, much like a call option.

Most start-ups fail. Clearly, this investment class is not for the fainthearted. Given that venture capitalists are dealing with nascent companies that may or may not burst onto the scene (some just burst), a wide range of returns should be expected. When a company does well, it can result in dramatic upside gains, like a 20-bagger, for its VC investors. The terminology 20-bagger indicates a company that appreciates in value 20-fold compared to the cost of the VC investment. This return pattern is similar to a call option and tends to post a return pattern with a large positive skew and a large positive value of kurtosis.

23.2.3 Venture Capital Plans

How does a venture capitalist select investments? The most important document to a venture capitalist deciding whether to invest in a start-up company is the business plan of the entrepreneur. The business plan should clearly state the business strategy, identify the niche that the new company will fill, and describe the resources needed to fill that niche, including the expenses, personnel, and assets. It must be comprehensive, coherent, and internally consistent. The business plan of the entrepreneur has two key objectives: (1) to provide the information necessary to attract financing from a venture capitalist, and (2) to serve as an internal game plan for the development of the start-up company.

Business plans should typically have an executive summary and sections that analyze or detail the plans for the market, the product or service, intellectual property rights, the management team, operations, the prior operating history, financial statement projections, the amount of and schedule for financing, and exit opportunities.

The exit plan describes how venture capitalists can liquidate their investment in the start-up company to realize a gain for themselves and their investors. Facilitating exit strategies is a way venture capitalists can add value beyond providing start-up financing. Venture capitalists often have many contacts within established operating companies. An established company may be willing to acquire the start-up company for its technology as part of a strategic expansion of its product line. Additionally, venture capitalists maintain close ties with investment bankers. These bankers are necessary if the start-up company decides to seek an IPO. In addition, a venture capitalist may ask other venture capitalists to invest in the start-up company. This helps to spread the risk and also provides additional sources of contacts with operating companies and investment bankers.

23.3.1 How Venture Capitalists Obtain Financing

Before investing money with start-up ventures, a VC fund manager must go through a period of fundraising with outside investors. The VC fund manager is the general partner of the VC fund; all other investors are limited partners. As the general partner, the manager has full operating authority to manage the fund, subject to restrictions placed in the covenants of the fund's documents. These limited partnerships are designed to provide limited liability to the investors. Limited liability is the protection of investors from losses that exceed their investment. Limited partners are not responsible for liabilities beyond the total loss of their investment, even if the partnership has further losses and unmet liabilities due to the use of leverage or from lawsuits. To have limited liability, a partner must be a limited partner and must not take an active role in the partnership's management. The general partner does not have limited liability and takes an active role in the management of the partnership.

The terms of the partnership agreements of VC funds contain details regarding the partnership's funding, the distribution of cash, the operation of the fund, the investment practices of the fund, and various covenants. Typically, the most important covenant is the size of an investment by the VC fund in any one start-up venture, usually expressed as a percentage of the capital committed to the VC fund. The purpose is to ensure that the manager does not commit too much capital to a single investment. In any VC fund, there will be start-up ventures that fail to generate a return. This is expected. By diversifying across several venture investments, this risk is mitigated.

Other covenants may include a restriction on the use of debt or leverage by the fund. Venture capital investments are risky enough without the manager gearing up the fund through borrowing. Gearing is a term for increasing risk through leverage. In addition, there may be a restriction on co-investments with prior or future funds controlled by the manager. If a VC fund manager has made a poor investment in a prior fund, the investors in the current fund do not want the VC fund manager to throw good money after bad by coinvesting the current fund's money with the funds that are in need of capital. Furthermore, there is usually a covenant regarding the distribution of profits. Investors find that it is optimal for them to receive the profits as they are realized. Distributed profits reduce the amount of committed capital in the venture fund, which in turn reduces the fees paid to the manager. It is in the VC fund manager's economic interest to retain profits.

Primary among restrictions on the general partner's activities is a limit on the amount of private investments the VC fund manager can make on its own in any of the firms funded by the VC fund. If the VC fund manager makes private investments in a select group of companies, these companies may receive more attention than the remaining portfolio of companies funded by the VC fund.

In addition, general partners are often limited in their ability to sell their general partnership interests in the VC fund to a third party. Such a sale would be likely to reduce the general partner's incentive to monitor investments and produce an effective exit strategy for the VC fund's portfolio companies.

Two other covenants relate to keeping the manager's focus on managing the fund. The first is a restriction on the amount of future fundraising. Fundraising is time-consuming and takes time away from managing the investments of the existing fund. Also, limited partners typically demand that the general partner spend substantially all of the time managing the investments of the fund; outside interests are limited or restricted.

There are often additional covenants that keep VC fund managers focused on investing in those companies, industries, and transactions in which they have the greatest experience. For instance, there may be restrictions or prohibitions on investing in buyouts, other VC funds, foreign securities, or companies and industries outside the realm of the manager's expertise.

23.3.2 Venture Capital Fund Fees

Venture capital fund managers have the potential to earn two types of fees: a management fee and an incentive fee. Management fees can range from 1% to 3.5%, with most VC funds in the 2% to 2.5% range. Management fees are used to compensate managers while they look for attractive investment opportunities for their VC funds. The management fee is assessed on the amount of committed capital, not invested capital. Committed capital is the cash investment that has been promised by an investor but not yet delivered to the fund.

Consider the implications of this fee arrangement. The manager collects a management fee from the moment an investor signs a subscription agreement to invest capital in the fund, even though no capital has actually been contributed by the limited partners yet. Further, VC funds typically provide for capital calls. Capital calls are options for the manager to demand, according to the subscription agreement, that investors contribute additional capital. The potential for the manager to earn incentive fees on capital from capital calls may give the manager an incentive to call for capital, even when investment opportunities are not of the highest quality. Capital calls are typically made when each portfolio company investment is identified—that is, when the VC fund holds little or no uninvested cash.

Most VC partnership agreements include a clawback provision. A clawback provision is a covenant that allows the limited partners to receive back (or claw back) previously paid incentive fees. The previously paid incentive fees are returned if, at the end or liquidation of the venture fund, the limited partners have a net loss. There is often an escrow agreement, in which a portion of the manager's incentive fees are held in a segregated account until the entire fund is liquidated. This ensures that the fund manager does not walk away with incentive fees unless the limited partners earn a profit. Only after every limited partner has earned a profit are the escrow proceeds released to the manager. Sometimes this covenant may stipulate that all management fees must also be recouped by the limited partners before the manager can collect incentive fees.

23.4.1 Life Cycle of a Venture Capital Fund

A VC fund is a long-term investment. Typically, investors' capital is locked up for a minimum of 10 years, the standard term of a VC limited partnership. During this long investment period, a VC fund normally goes through five stages of development.

The first is the fundraising stage, in which the VC firm raises capital from outside investors. Capital is committed, not collected. This is an important distinction. Investors sign a legal agreement (typically a subscription) that legally binds them to make cash investments in the VC fund up to a specified amount. This is the committed, but not yet drawn, capital. The VC firm or general partner also posts a sizable amount of committed capital. Fundraising normally takes six months to a year. However, the more successful venture funds can raise funds in just a few months.

The second stage is sourcing investments, the process of locating possible investments (i.e., generating deal flow), reading business plans, preparing intense due diligence on start-up companies, and determining the attractiveness of each start-up company. This period begins the moment the fund is closed to investors and normally takes up the first five years of the venture fund's existence to complete. During the first two stages, no profits are generated by the VC fund. In fact, quite the reverse happens: The VC fund generates losses because the manager continues to draw annual management fees based on the total committed capital. These fees generate a loss until the manager begins to extract value from the investments of the venture fund at a later stage.

Stage three is investment of capital. During this stage, the VC fund manager determines how much capital to commit to each start-up company, at what level of financing, and in what form of investment (convertible preferred shares, convertible debentures, etc.). At this stage, the fund manager also makes capital calls to the investors in the fund to draw the committed capital of the limited partners. Note that no cash inflow is generated yet; the venture fund is still in a deficit.

It might surprise many investors to learn that they should expect the accounting value of their investment in a VC fund to drop over the first three to five years. This is because the organizational expenses of the VC partnership are deducted immediately. In addition, management fees are charged on committed capital by the VC fund's general partner. Further, those investments that fail quickly are posted as losses, while investments that are showing excellent potential are not posted as profits (if they have not already been sold). All of this means that investors must be braced for a loss on their investments for the first three to five years of a VC fund's life. Truly, VC is for the long-term investor.

Stage four, which includes operation and management of the portfolio of companies, begins after all the funds have been invested, and lasts almost to the end of the term of the VC fund. During this time, the manager works with the portfolio companies in which the VC fund has invested. The manager may improve the management team, establish distribution channels for the new product, refine the prototype product to generate the greatest sales, and generally position the start-up company for an eventual public offering or sale to a strategic buyer. During this period, the VC fund manager begins to generate profits for the fund. These profits initially offset the previously collected management fees and other expenses until a positive cumulative profit is established for the venture fund.

The last stage of the VC fund is its windup and liquidation. At this point, all committed capital has been invested, and the fund is now in the harvesting stage. Each of the fund's portfolio companies faces three possible outcomes: being sold to a strategic buyer, being brought to the public markets in an initial public offering, or being liquidated through a bankruptcy liquidation process. Profits are distributed to the limited partners, and the general partner/fund manager now collects the incentive/profit-sharing fees.

The life stages of a VC fund follow the life stages of the portfolio companies that are contained within the fund. The life cycles of portfolio companies often follow similar stages and lead to what is known as the J-curve effect, as shown in Exhibit 23.1. The J-curve is the classic illustration of the early losses and later likely profitability of venture capital. The central return measurement for private equity is the IRR method detailed in Chapter 3. Although Exhibit 23.1 plots interim IRRs and the lifetime IRR of a typical portfolio company, the shape of the curve (i.e., the J-curve) approximates the IRRs of VC funds through time, since a VC fund is composed of a set of portfolio companies.

Exhibit 23.1 shows that during the early life of a portfolio company, the company generates losses and negative IRRs, but profits may eventually be harvested in the case of a successful company. Similarly, VC fund profitability often follows a J-curve. It should be noted that the J-curve focuses on computing IRRs with an accounting view of profits and losses. In a financial economics sense, many of the early accounting losses are due to writing off fees that, in many cases, may be better viewed as necessary and valuable investments in the fund's future. An analogy is the investment of a young person in a college education. A student accumulating debt to finance an education may experience declining net worth during those college years if the increase in the value of human capital is ignored. Instead of viewing the expenses of the education as a period of financial loss, the student should see herself as building human capital and the time period as being quite profitable.

23.4.2 Stages of Financing

Although some VC firms classify themselves by geography or industry, by far the most distinguishing characteristic of VC firms is the stage of financing. Some VC funds provide seed or first-stage capital; others wait to invest in companies that are further along in their development. Still other VC firms come in at the final round of financing before the IPO. A different level of due diligence is required at each level of financing because the start-up venture has achieved a different milestone on its way to success. In all, there are five discrete stages of VC financing: angel investing, seed capital, first- or early-stage venture capital, second- or late-stage/expansion venture capital, and mezzanine financing. Each of these is discussed separately.

ANGEL INVESTING: Angel investing refers to the earliest stage of venture capital, in which investors fund the first cash needs of an entrepreneurial idea. Angel investors often come from F & F—that is, friends and family. But sometimes venture capitalists include a third F, for fools. At this earliest stage of the venture, typically a lone entrepreneur has just an idea, possibly sketched out at the kitchen table or in the garage. There is no formal business plan, no management team, no product, no market analysis, just an idea.

In addition to family and friends, angel investors can be wealthy individuals who dabble in start-up companies. Many angel investors are successful businesspeople themselves who may prefer to focus their investments in the industry in which they have built their careers, so that they can offer industry-specific skills or analysis to the entrepreneur. This level of financing is typically done without a private placement memorandum or subscription agreement. It may be as informal as an agreement written on a cocktail napkin. Yet without the angel investor, many ideas would wither on the vine before reaching more traditional venture capitalists.

At the angel stage of financing, the task of the entrepreneur is to begin the development of a prototype product or service. In addition, the entrepreneur begins drafting a business plan, assessing market potential, and possibly even assembling some key management team members. No marketing or product testing is done at this stage.

The amount of financing at this stage is typically very small: $50,000 to $500,000. Any more than that would strain family, friends, and other angels. The money is used primarily to flesh out the concept to the point at which an intelligent business plan can be constructed.

SEED CAPITAL: The seed capital stage is the first stage where VC firms invest their capital into a venture and is typically prior to having established the viability of the product. At this stage, a business plan is completed and presented to a VC firm. Some members of the management team have been assembled at this point, and the entrepreneur and a small team have performed a market analysis and addressed other parts of the business plan. Financing is provided to complete the product development and possibly begin initial marketing of the prototype to potential customers. This phase of financing usually raises $1 million to $5 million. At this stage of financing, a prototype is developed and product testing begins. This is often referred to as beta testing: A prototype is sent to potential customers free of charge to get their input into the product's viability, design, and user-friendliness.

Very little, if any, revenue has been generated at this stage, and the company is definitely not profitable. Venture capitalists invest in this stage based on their due diligence of the management team, their own market analysis of the demand for the product, the viability of getting the product to market while there is still time and no other competitor, the additional management team members who need to be added, and the likely timing for additional rounds of capital from the same VC firm or from other VC funds. Unfortunately, seed capital VC firms are not numerous; thus, the entrepreneur might have to rely on angel investors through this stage as well.

FIRST- OR EARLY-STAGE VENTURE CAPITAL: The start-up company should now have a viable product that has been beta tested. The next step is to begin testing of the second-generation prototype with potential end users. First- or early-stage venture capital denotes the funding after seed capital but before commercial viability has been established. Typically, a price or fee is charged for the product or service. Revenues are being generated, and the product or service is now demonstrating its commercial viability. Early-stage VC financing is usually $2 million or more.

Early-stage financing is typically used to build out commercial-scale manufacturing services. The product is no longer being produced out of the entrepreneur's garage or some vacant space above a store. The company is now a going concern with an initial, if not complete, management team. At this stage, at least one venture capitalist is sitting on the board of directors of the company. In addition, the business and marketing plans are refined, manufacturing has begun, and initial sales have been established.

The goal of the start-up venture is to achieve market penetration with its product. Some of this will have been accomplished with the beta and alpha testing of the product. However, additional marketing must now be done. In addition, distribution channels should be identified by now, and the product should be established in these channels. Reaching a break-even point is the financial goal.

SECOND- OR LATE-STAGE/EXPANSION VENTURE CAPITAL: At this point, the start-up company may have generated its first profitable quarter or be just at the point of breaking even. Commercial viability is now established. Cash flow management is critical at this stage, as the company is not yet at the level where its operating cash flows alone can sustain its own growth. Second- or late-stage/expansion venture capital fills the cash flow deficiency once commercial viability is established. Sometimes late-stage/expansion capital is broken down into finer stages, called second- and third-stage venture capital. This level of VC financing is used to help the start-up company get through its cash crunch. The additional capital is used to tap into distribution channels, establish call centers, expand manufacturing facilities, and attract the additional management and operational talent necessary to make the start-up company a longer-term success. Because this capital is earmarked for expansion, financing needs are typically greater than those for seed and early-stage capital. Amounts may be in the $5 million to $25 million range.

At this late-stage/expansion VC stage, the start-up venture enjoys the growing pains of all successful companies. The future is bright, but working capital is short. Sales are snowballing and receivables are growing, but the receivables have not yet been translated into a solid and stable cash flow. The start-up may need additional working capital because it has been focusing on product development and product sales but now finds itself with a huge backload of accounts receivable that it must collect from customers. Inevitably, start-up companies are very good at getting the product out the door but very poor at collecting receivables and turning sales into cold, hard cash. Also at this stage, market penetration has been established, and the company has met some initial sales goals. A break-even point has been achieved, and the company is now starting to generate profits, even though its cash is still lagging.

Again, this is when expansion capital can help. Late-stage venture financing helps the successful start-up get through its initial cash crunch. Eventually, the receivables will be collected, and sufficient internal cash will be generated to make the start-up company a self-sustaining force. Until then, one more round of financing may be needed.

MEZZANINE FINANCING: Mezzanine venture capital, or pre-IPO financing, is the last funding stage before a start-up company goes public or is sold to a strategic buyer. At this point, a second-generation product may already be in production, if not distribution. The management team is together and solid, and the company is working on improving its cash flow management. Manufacturing facilities are established, and the company may already be thinking about expanding internationally. Amounts vary, depending on how long the bridge financing is meant to last, but generally it is in the range of $5 million to $25 million.

The financing at this stage is considered bridge or mezzanine financing to keep the company from running out of cash until the IPO or strategic sale. At this stage, the company is a proven winner with an established track record. However, the start-up company may still have a large inventory of uncollected accounts receivable that need to be financed in the short term. Profits are being recorded, but accounts receivable are growing at the same rate as sales.

Mezzanine financing may be in the form of convertible debt. In addition, the company may have sufficient revenue and earning power to qualify for a traditional loan. This means that the start-up company may have to clean up its balance sheet as well as its statement of cash flows. Commercial viability is more than just generating sales; it also requires turning accounts receivable into actual dollars. In addition, mezzanine financing may be used to buy out earlier investors and pay for other costs incurred before going public.

23.4.3 Venture Capital as a Compound Option

Previously, the call-option-like nature of venture capital was discussed. Valuable insight can be derived from viewing VC as a compound option. A compound option is an option on an option. In other words, a compound option allows its owner the right but not the obligation to pay additional money at some point in the future to obtain an option.

For example, consider a project requiring $100,000 of angel capital and expected to last one year to explore a business idea potentially capable of receiving $2 million of seed capital. If successfully deployed, the seed capital may lead to early-stage financing of $5 million, which in turn could lead to later stages with even higher capital requirements, ultimately leading to the possibility of an IPO.

Money invested in each of these stages of a venture can be viewed as the purchase of a call option on investing in the next stage of the venture, which in turn is a call option. In the very first investment of $100,000, the $100,000 is the price or premium of the first option on the project, which has an expiration date of one year and a strike price of $2 million. If that option is exercised, the venture capitalist acquires another option costing $2 million, with a strike price of $5 million.

The compound option view of VC is synonymous with the analysis of real estate development as a string of real options in Chapter 15. In both cases, the key to the process is that the option's owner delays committing further capital until new information has arrived. Entrepreneurs may be charged with reaching milestones. A milestone is a set of goals that must be met to complete a phase and usually denotes when the entrepreneur will be eligible for the next round of financing. That is, the VC may explicitly state the specified operating goals of the firm that must be met before more funds are invested in the venture. It is the ability to defer investment decisions until uncertainty has diminished that gives these options their primary value, not the time value of money.

An option expiration date is the point in time at which either additional capital has to be invested or the project is abandoned or sold. Options are exercised when the option holder perceives that the value of the next option being acquired exceeds the strike price of the current option. If all options are successfully exercised, even the IPO and the resulting equity in the leveraged public company can be viewed as a call option. In a VC project, each call option is purchased far out-of-the-money and typically has modest chances of being exercised.

The compound option view of VC facilitates an understanding of the high value to a venture capitalist of being able to make relatively small investments in projects that generate high profits if successful and can be abandoned if unsuccessful. The compound option view also clarifies the keys to successful VC investing:

• Identifying underpriced options by locating potentially valuable projects for which substantial information regarding likely profitability can be obtained prior to commitment of substantial capital
• Abandoning out-of-the-money options when they are expiring by ignoring sunk costs, and judiciously assessing likely outcomes of success based on the objective analysis of new information

23.4.4 The J-Curve for a Start-Up Company

Exhibit 23.1 illustrated the concept of the J-curve in private equity. The initial years of a start-up company also tend to generate a reported accounting-based loss. Money is spent in development, such as turning an idea into a prototype product and beta testing the product with potential customers. Little or no revenue is generated during this time, causing the initial dip in reported performance. Note, however, that the money being spent in development is being spent with the assumption that it is an investment that is creating value for the firm. In an economics sense, the firm may not be losing money, but rather exchanging cash for assets such as information, even if traditional accounting methods do not recognize the information as an asset on the balance sheet. Management believes that the firm is being made more valuable by the development work. It may only be in an accounting sense that the firm is sure to lose money at this stage.

Additional rounds of financing may be needed to get the company to generate cash and profit. Once critical mass is achieved—when products are sold, when sales are turned into profits, and when accounts receivable are turned into cash—the company turns a profit using traditional accounting. As the company realizes its profit potential, it enters into the higher range of profits on the right-hand side of the J-curve. The ultimate goal is at the rightmost part of the J-curve, when the start-up company achieves a public offering and the venture capitalists can exit the deal successfully.

The IRRs in Exhibit 23.1, except for the rightmost IRR, are generally computed as interim IRRs. Each interim IRR is therefore based on the nonmarket value (net asset value) that was estimated at that point in time. It is these interim net asset values that may be biased downward due to conservative accounting standards. Thus, it can be argued that the initial dip in profitability only reflects the conservative nature of accounting methods related to investment in development. As the project matures and anticipated cash flows become realized cash flows, interim IRRs approach the final IRR.

23.5.1 Three Main Risks and the Required Risk Premiums for Venture Capital

Most venture capitalists are long-term investors who expect to earn a premium from VC that is about 400 to 800 basis points over the returns of the public stock market, depending on the VC stage of financing. This risk premium can be viewed as providing compensation for three main risks.

First, there is the business risk of a start-up company. Although some start-ups successfully make it to the initial public offering stage, many more do not succeed. Venture capitalists must anticipate earning a return that sufficiently compensates them for bearing the risk of potential corporate failure. Although public companies can also fail, VC is unique in that the investor takes on this business risk before a company has had the opportunity to fully implement its business plan.

Second, there is substantial liquidity risk. There is no liquid public market for trading VC interests. The secondary trading that does exist is generally limited to exchange among a small group of other private equity investors. This is a fragmented and thus inefficient market. The tailored nature of a venture capitalist's holdings is unlikely to appeal to more than a very select group of potential buyers. Consequently, the sale of an interest in a VC fund is not an easy task. Further, another VC firm may not have the time or ability to perform as thorough a due diligence as the initial investing firm. Thus, a secondary sale often requires a substantial pricing discount.

Third, there may be an idiosyncratic risk due to the lack of diversification associated with a VC portfolio. The capital asset pricing model (CAPM) shows that the only risk that investors should be compensated for is the risk of the general stock market, or systematic risk. This is because unsystematic or company-specific risk can theoretically be diversified away. However, the CAPM is predicated on securities being freely transferable, securities being infinitely divisible, and portfolios being fully diversifiable. Since the lack of liquidity in VC severely impairs transferability, some venture capitalists are not well diversified, and they bear substantial idiosyncratic risk. In the case of numerous investors who are not highly diversified, the CAPM does not hold, and idiosyncratic risk may be rewarded.

Venture capital firms have become increasingly specialized as a result of the intensive knowledge base required to invest in the technology, telecommunications, and biotechnology industries, and specialization has expanded further to include the stage of investment in the life cycle of a start-up company. Unfortunately, specialization leads to concentrated portfolios, the very anathema of reduced risk through diversification. This concentration leads to the need for higher risk premiums.

23.5.2 Access and Vintage-Year Diversification

Two important keys to successful VC investing by institutions are (1) accessing the top-tier VC managers (boosting returns), and (2) achieving vintage-year and industry diversification (reducing risk). There is substantial evidence that return performance is very persistent in the private equity industry. The VC firms that are successful tend to form a series of VC funds through time. The VC managers that perform well in one VC fund tend to perform well in their next VC fund.

Return persistence in VC is different from that of other asset classes, including large-cap public equities, in which the marketplace is much more liquid and competitive. Superior management teams of public equities (such as Apple Inc.) are accessible to everyone; virtually anyone can purchase equity in such public firms. The result tends to be that the share price of public firms with highly successful management teams is bid up to a market price that reflects the likelihood that the management team will continue to be successful. In a competitive and efficient market, those superior returns would not be likely to persist. However, VC funds are not funded at market prices driven through competition.

Superior performance in a private equity firm's most recent funds is usually viewed as a predictor that the firm's next fund will also generate superior performance. Quite a bit of this performance persistence can be explained by the reputation of the general partner managing the VC fund. The best VC firms attract the very best entrepreneurs, business plans, and investment opportunities. The most successful VC firms have an established track record of getting start-up companies to an initial public offering. Their track record allows them to attract investment capital from their limited partners, as well as proprietary deal flow from start-up companies seeking venture capital. The general partner of a better-performing VC fund is more likely to raise a follow-on fund and to raise larger funds than a VC firm that performs poorly. General partners of the most successful private equity funds can pick and choose among numerous investors desiring to participate in their next fund.

The second key to successful VC investing by institutions is vintage-year diversification. Vintage year tends to be an important determinant of fund success, reflecting the tendency of VC to follow a cycle of boom and bust. An institution that concentrates investments in a particular vintage year runs the risk that the vintage year will turn out few winning ventures. Accordingly, investors should diversify into private equity funds of different vintage years, as well as consider diversifying in terms of geography and industry.

23.5.3 Historical Return Analysis

Exhibit 23.2a summarizes the quarterly returns of private equity and VC alongside major market indices for the first quarter of 2000 through the fourth quarter of 2014. The venture capital index is based on quarterly net asset values (NAVs) and cash flows rather than market prices. The returns for venture capital therefore depend heavily on changes in fund NAVs. Changes in NAVs are sensitive to the timing of portfolio company exits, at which point accounting values of portfolio companies are replaced with exit values. Accordingly, high returns in a particular quarter may simply reflect recognition of value that was created in previous quarters. Cambridge Associates compiles its VC index from VC partnerships and its private equity index from data on LBOs, subordinated debt, and special situations funds.

The general category of private equity performed very well over this 15-year period according to the index with high average annual returns (11%) and moderate risk as indicated by the standard deviation of returns, the minimum quarterly return, and the maximum drawdown. The result is a high Sharpe ratio relative to the major market indices over the same time interval. The high autocorrelation coefficient for private equity (and the even higher autocorrelation coefficient for VC) indicates potential smoothing of returns, which raises concerns of risk underestimation, especially when returns are based on non-market price data.

As noted in Exhibit 23.2a, VC underperformed the other indices while exhibiting moderate to substantial risk. The modest 15-year performance of VC is illustrated in Exhibit 23.2b. The 15-year performance of VC was driven by a massive three-year drawdown of almost 70% near the start of the period and a modest recovery over most of the remaining years. As indicated in Exhibit 23.2b, the VC index recovered steadily since 2010; however, the 15-year result is an unimpressive Sharpe ratio of 0.09.

Exhibit 23.2c confirms the positive exposures of both private equity and VC returns to the returns of world equities, while indicating negative exposures of private equity returns and VC returns to commodity returns, equity volatility, and credit spreads.

Exhibit 23.2d focuses on the private equity returns and indicates the strong positive association between private equity and public equity returns, with almost all quarters of data sharing the same sign (i.e., residing in the upper right and lower left quadrants). Especially noteworthy is that the most extreme negative return to private equity occurred during the worst return for world equities.

23.6.1 Leveraged Buyouts (LBOs)

A leveraged buyout (LBO) is distinguished from a traditional investment by three primary aspects: (1) an LBO buys out control of the assets, (2) an LBO uses leverage, and (3) an LBO itself is not publicly traded. The target firm of an LBO is typically a publicly traded firm, but the term may also be used to describe buyouts of private firms. Thus, most LBOs transform the target company from being publicly traded to being highly leveraged private equity. LBOs are distinguished from mergers and acquisitions that typically fold the structure and operations of the target firm into the acquiring firm.

An LBO involves a higher level of commitment than does a traditional investment in terms of time horizon. Also, an LBO typically includes an effort to make fundamental changes in the management and/or operations of the target.

A buyout that is termed an LBO often involves bringing in a new management team to replace the firm's existing management. A leveraged buyout led by the firm's existing managers that retains most top members of the management team is usually referred to as a management buyout.

23.6.2 Management Buyouts (MBOs)

A management buyout (MBO) is a buyout that is led by the target firm's current management. Control of the new company is concentrated in the hands of the buyout firm and the target company's management, and there are no public shares left outstanding. The goal of the buyout is to increase the value of a corporation by unlocking hidden value, maximizing the borrowing capacity of a company's balance sheet, taking advantage of the tax benefits of using debt financing, and/or exploiting existing but underfunded opportunities. Private companies often state that it is easier to make long-term investments without the oversight of investors in public companies, who may focus on short-term results and quarterly earnings.

The private equity managers often add professional management to create value. Since the ownership of the firm becomes much more concentrated, with a longer-term investment horizon, management can focus on making the kinds of decisions that are more likely to increase long-term value. Virtually all MBOs are LBOs, since substantial leverage is almost always required to complete the purchase.

23.6.3 Other Types of Private Equity Buyouts

A management buy-in (MBI) is a type of LBO in which the buyout is led by an outside management team. Control of the new company is taken over by the new (outside) management team, and the old (incumbent) management team leaves. The compensation package, if any, offered to or negotiated by the incumbent managers can be a critical issue, which is discussed in the next section.

A buy-in management buyout is a hybrid between an MBI and an MBO in which the new management team is a combination of new managers and incumbent managers.

A secondary buyout is an increasingly important sector of buyouts. In most large buyouts, a public company is being taken private. In a secondary buyout, one private equity firm typically sells a private company to another private equity firm. In effect, a secondary buyout is typically an ownership change among private equity firms. Secondary buyouts provide a secondary-market-like opportunity for private equity firms to exit a buyout.

23.6.4 Agency Issues of Buyouts

Buyouts can have large economic consequences to both the managers and shareholders of the target firm. There is an inherent conflict of interest between the shareholders as principals and the managers as agents with regard to most buyouts. That conflict of interest can become especially important in the high-stakes environment of buyouts. The primary conflicts involved in management buyouts are quite distinct from the conflicts involved in management buy-ins.

In an MBO, the existing management team takes over ownership of the firm from the firm's existing shareholders. Managers clearly owe a fiduciary duty to the shareholders of the firm in which they are employed. Managers tend to have superior information regarding the firm and its potential value. Presumably, in a management buyout, the incumbent managers perceive that there are substantial gains that can be unlocked through their actions. A critical issue is whether managers choosing to pursue a path of unlocking those gains through a management buyout are violating their fiduciary responsibilities to the firm's shareholders. In other words, if a management team leads a buyout that unlocks tremendous value to themselves rather than implementing those changes for the firm's existing owners, has the management team as agents enriched themselves at the expense of the principals? Or do the existing shareholders receive a generous sales price based on the anticipated benefits that the new management team will be able to unlock after the buyout—benefits that could not be unlocked under the current ownership structure and incentives? In the latter case, the managers might be best fulfilling their fiduciary responsibility by initiating an MBO.

In an MBI, an external management team replaces the existing management team. The outcome of an MBI for incumbent managers can vary tremendously depending on the extent to which the managers are compensated upon their departure. A generous compensation scheme, known as a golden parachute, is often given to top managers whose careers are being negatively affected by a corporate reorganization. Two primary conflicts of interest emanate from these potentially lucrative compensation schemes. First, incumbent managers have a strong incentive to resist any buyout attempt that displaces them as managers if the buyout does not provide them with generous compensation. Second, incumbent managers have a strong incentive to encourage buyouts that offer them generous compensation. Thus, incumbent managers are incentivized to interfere with buyouts or promote buyouts based on the financial implications to themselves rather than based purely on their duties to serve the interests of the shareholders.

Agency relationships are discussed later in greater detail.

23.7.1 LBO Fund Structures

Almost all LBO funds are structured as limited partnerships. This is very similar to the way that VC funds are established, as illustrated in Exhibit 23.1. LBO funds are run by a general partner, typically an LBO firm. All investment discretion and day-to-day operations vest with the general partner. Limited partners, as the name implies, have a very limited role in the management of the LBO fund. For the most part, limited partners are passive investors who rely on the general partner to source, analyze, perform due diligence, and invest the committed capital of the fund. The number of limited partners in a private equity fund is not fixed. Most private equity funds have 20 to 50 limited partners, but some have as few as five, and others more than 50.

Some LBO funds have advisory boards composed of the general partner and a select group of limited partners. The duties of the advisory board are to advise the general partner on conflicts of interest that may arise as a result of acquiring a portfolio company or collecting fees, to provide input as to when it might be judicious to seek independent valuations of the LBO fund's portfolio companies, and to discuss whether dividend payments for portfolio companies should be in cash or in securities. Like hedge funds and VC funds, LBO funds must be aware of the regulatory restrictions that apply to offering interests in their funds.

Private equity funds have contractually set lifetimes—typically 10 years, with provisions to extend the limited partnership for one to two more years. During the first five years of the partnership, deals are sourced and reviewed, and partnership capital is invested. After companies are taken private, the investments are managed and eventually liquidated. As the portfolio companies are sold, taken public, or recapitalized, distributions are made to the limited partners, usually in cash but sometimes in securities, as is often the case when an IPO is used to exit an investment. Generally, private equity firms begin to raise capital for a new fund once the investment phase for the prior partnership has been completed. Fundraising should occur about every three to five years in a normal private equity cycle.

23.7.2 Fees

Leveraged buyout firms have numerous ways to make money. First, there are the annual management fees, which range from 1.25% to 3% of investor capital. Incentive fees, or carried interest, usually range from 20% to 30% of the fund's total profits.

For arranging and negotiating an LBO, an LBO firm may also charge fees of up to 1% of the total selling price to the corporation it is taking private. As an example, Kohlberg Kravis Roberts & Co. (KKR) earned $75 million for arranging the buyout of RJR Nabisco and $60 million for arranging the buyout of Safeway, Inc. Some LBO firms (i.e., general partners) keep all of these fees for themselves rather than sharing them with the limited partner investors. Other LBO firms split the transaction fees, with limited partners receiving typically 25% to 75%. Still other LBO firms include all of these fees as part of the profits to be split up among the general partner and the limited partners. Not only do LBO firms earn fees for arranging deals, but they can also earn breakup fees if a deal fails.

In addition to earning fees for arranging the buyout of a company or for losing a buyout bid, LBO firms may charge a divestiture fee for arranging the sale of a division of a private company after the buyout has been completed. Further, an LBO firm may charge directors' fees to a buyout company if managing partners of the LBO firm sit on the company's board of directors after the buyout has occurred. Thus, there are many ways for an LBO firm to make money.

The debate over private equity fees has intensified in recent years. As buyout funds have grown in size, the management fees of the funds have not been adjusted downward as a percentage. When the buyout industry started, the 1% to 2% management fee was necessary to pay the expenses of the private equity general partner. This fee covered travel expenses, utility bills, and the salaries of the general partner's staff. In short, the management fee was originally used to keep the private equity manager afloat until the incentive fee could be realized, which often took several years. Now, however, private equity funds have grown to immense size; $10 billion funds are common. The private equity manager now earns a considerable amount of profit from its management fees as opposed to its incentive fees. This could blunt the incentive of the private equity manager to seek only the most potentially profitable private equity opportunities.

Let's take a simple example of typical fees. Assume a private equity firm raises a $10 billion buyout fund and charges a management fee of 1.5%. This is a fee of $150 million each year for the life of the fund. Assuming a 10-year life for the fund and an 8% discount rate for the time value of money, the present value of the management fees to the private equity firm is $1.006 billion. With management fees like this, there could be a disincentive to take risks. In summary, LBO firms are masters of the universe when it comes to fee structures. It is no wonder that they have become such popular and profitable investment vehicles.

23.7.3 Agency Relationships

The objectives of senior management may be very different from those of a public corporation's equity owners. For instance, management may be concerned with keeping their jobs and presiding over a large empire. Conversely, shareholders want value creation (i.e., share price maximization). In a corporation, senior management is the agent for the shareholders. Shareholders, as the owners of the company, are the principals who delegate day-to-day decision-making authority to management with the expectation or hope that management will act in the best interests of the shareholders. However, in a large company, equity ownership may be so widely dispersed that the owners of the company cannot make their objectives the top priority to management or otherwise control management's natural tendencies. Thus, the separation of ownership and control of the corporation results in conflicts of interest and agency costs.

Agency costs come in two forms. First, there is the cost to properly align management's goals with the value-creation goal of shareholders, including the cost of monitoring management, which may include audits of financial statements, shareholder review of management perquisites, and independent reviews of management's compensation structure. Alignment is also usually achieved via the compensation arrangement. Compensation arrangements that reduce conflicts of interest include stock options, bonuses, and other performance-based compensation.

Second, agency costs can include the erosion of shareholder value from managerial actions that are not in the best interests of shareholders. The optimal strategy regarding agency conflicts is to implement only those actions that have benefits that exceed their costs, not necessarily to minimize agency costs. Thus, conflicts of interest and agency costs are realities of doing business in an agency relationship.

Leveraged buyout firms replace a dispersed group of shareholders with a highly concentrated group of equity owners. The concentrated and private nature of the new shareholders allows the management of the buyout firm to focus on maximizing cash flows. Further, the management of the now private company is often given a substantial equity stake in the company that provides a strong alignment of interests between the management/agents of the company and its principals/shareholders. As the company's fortunes increase, so do the personal fortunes of the management team. The large incentives to an LBO's management team are often vital to the LBO's goal of unlocking value.

With a majority of the remaining equity of the once public, now private company concentrated in the hands of the LBO firm, the interaction between equity owners and management becomes particularly important. After a company is taken private, LBO firms maintain an active role in guiding and monitoring the management of the company; LBO firm managers are active, not passive, shareholders. After a transaction is complete, an LBO firm remains in continuous contact with company management. As the majority equity owner, the LBO firm has the right to monitor the progress of management, ask questions, and demand accountability.

23.7.4 Five General Categories of LBOs That Can Create Value

Most LBOs can be identified with one of five major categories based on the motivation or circumstances of the deal.

1. EFFICIENCY BUYOUTS: Efficiency buyouts are LBOs that improve operating efficiency. A company may be bought out because it is shackled with a noncompetitive operating structure. For large public companies with widespread equity ownership, management may have little incentive to create shareholder value because it has a small stake in the company's profit. Under these circumstances, management is likely to be compensated based on revenue growth, which may result in excessive expansion and operating inefficiencies. These examples often occur in mature industries with stable cash flows.

   Efficiency buyouts often lead to a reduction in firm assets and revenue with the goal of eventually increasing firm profits. Such a buyout introduces more concentrated ownership and a better incentive scheme to mitigate agency problems. Management is given a stake in the company with an incentive scheme tied not to increasing revenues but to increasing operating margins and equity value. In addition, a high leverage ratio is used to ensure that management has little discretion to invest in inefficient projects. Last, the LBO firm replaces the diverse shareholder base and provides the active oversight that was lacking with the prior widespread equity owners.

2. ENTREPRENEURSHIP STIMULATORS: Entrepreneurship stimulators are LBOs that create value by helping to free management to concentrate on innovations. One frequently used strategy focuses on an unwanted or neglected operating division. Often an operating division of a conglomerate is chained to its parent company, which may impede its ability to implement an effective business plan. An LBO can free the operating division to control its own destiny.
3. THE OVERSTUFFED CORPORATION: One of the main targets of many LBO firms is conglomerates. Conglomerates have many different divisions or subsidiaries, often operating in completely different industries. Wall Street analysts are often reluctant to follow or cover conglomerates because they do not fit neatly into any one industrial category. As a result, these companies can be misunderstood by the investing public and perhaps undervalued. Sometimes conglomerates drain profits from profitable divisions within the firm and use them to prop up failing divisions rather than reinvesting them in successful divisions or distributing them to shareholders as dividends. An LBO can be used to dismantle inefficient conglomerates, shut down or sell inefficient operations, and allow profitable divisions to reinvest and meet their growth potential.
4. BUY-AND-BUILD STRATEGY: A buy-and-build strategy is an LBO value-creation strategy involving the synergistic combination of several operating companies or divisions through additional buyouts. The LBO firm begins with one buyout and then acquires more companies and divisions that are strategically aligned with the initial LBO portfolio company. The strategy seeks to benefit from synergies realized through the combination of several different companies into one. In some respects, this strategy is the reverse of that for conglomerates. Rather than strip a conglomerate down to its most profitable divisions, this strategy pursues an assembling approach. This type of strategy is also known as a leveraged buildup or roll up.
5. TURNAROUND STRATEGY: Traditional buyout firms often look for successful, mature companies with low debt-to-equity ratios and stable management. The economic recession that began in 2007 highlighted another form of LBO: the turnaround LBO. A turnaround strategy is an approach used by LBO funds that look for underperforming companies with excessive leverage or poor management. The targets for turnaround LBO specialists come from two primary sources: (1) ailing companies on the brink of bankruptcy, and (2) underperforming companies in another LBO fund's portfolio. In some cases, the private equity firm does not buy out the complete company but makes a large equity contribution at a price discounted to the public market price of the stock and takes seats on the target company's board of directors.

23.7.5 The Portfolio of Companies

A private equity limited partnership fund typically invests in 10 to 30 portfolio companies. This translates to approximately two to six companies per year that are sourced, reviewed, and purchased in the first five or so years of the fund's life. In a buyout, the private equity fund takes seats on the board of directors. The general partner of the private equity firm supplies these new directors, usually picking one to four of its partners to sit on the company's board. As directors, the private equity firm interacts with the management of the private company on a weekly, if not daily, basis. The private equity firm assists the private company in developing a new business plan. This plan might entail expansion or contraction, adding new employees or deleting part of the workforce, and introducing new products or cutting off unproductive and distracting product development. In a majority of cases, the private equity firm gets the private company to streamline its workforce, reduce its expenses, and increase its balance sheet capacity for more leverage.

Leveraged buyout funds distinguish themselves by the size of the companies they take private. Generally, they classify themselves as investing in small-capitalization companies ($100 million to $1 billion in sales revenue), mid-capitalization companies ($1 billion to $5 billion in sales revenue), or large-capitalization companies ($5 billion and above in sales revenue). The large-cap category of LBOs also includes supersized or mega LBOs.

23.7.6 The Appeal of a Leveraged Buyout to Targets

Leveraged buyouts can have a number of appealing characteristics to corporate management and investors of the target firm. From the perspective of the shareholders of the target firm, LBO offers are usually accepted because the bid price for their shares is typically at a large premium compared to the market price. More to the point, LBO firms often target companies that have a depressed stock price. Consequently, shareholders often welcome an LBO bid. From the perspective of the target firm's corporate management, the benefits to those who are retained can include the following:

• The use of leverage where interest payments are tax deductible
• Less scrutiny from public equity investors and regulators
• Freedom from a distracted (and potentially distracting) corporate parent
• The potential of company management to become substantial equity holders and thereby benefit directly from building the business

The benefit of an LBO to the acquiring LBO fund is the potential for attractive risk-adjusted returns. The following section provides a simplified example of the profit potential from a successful LBO.

23.7.7 A Stylized Example of an LBO

The potential payoffs of an LBO are like a call option: large upside potential relative to downside risk. Consider a publicly traded firm that is viewed by a private equity firm as a potential target, since it is failing to use its potential to generate earnings. The company has equity with a market value of $500 million and debt with a face value of $100 million. The company is currently generating earnings before interest, taxes, depreciation, and amortization (EBITDA) of $80 million, which represents the free cash flow from operations that is available for the owners and debtors of the company. This equates to a 13.3% before-tax return on assets for the company's shareholders and debt holders.

An LBO fund uses $700 million to purchase the equity of the company and pay off the outstanding debt. The debt is paid off at a face value of $100 million, while the remaining $600 million is offered to the equity holders to entice them to tender their shares to the LBO fund (i.e., a 20% premium is offered over the current market value). The $700 million LBO is financed by the LBO fund with $600 million in debt at a 10% coupon rate and $100 million in equity. Thus, the company must pay $60 million in annual debt service to meet its interest payment obligations.

After the LBO, the management of the company improves operations, streamlines expenses, and implements better asset utilization. One explanation for the improved managerial performance might be that the LBO fund brought in new management. Another possibility is that some or all of the existing top management initiated the LBO and became highly incentivized to improve profitability. As a result, assume that the cash flow from operations of the company improves from $80 million to $120 million per year. By forgoing dividends and using the free cash flow to pay down the remaining debt, the LBO fund can own the target company free and clear of the debt used to finance the acquisition in about seven years. This means that after seven years and ignoring potential growth in cash flows, the LBO firm as the sole equity owner can claim the annual cash flow of $120 million completely for itself.

After the seven-year point, assume a forward-looking long-term growth rate of 2% per year and a discount rate of 12%. The value of the unlevered firm in seven years can be projected using the constant dividend growth model, as follows:

Under these assumptions, the LBO fund can own the $1.2 billion company free and clear in seven years, starting with an equity investment of only $100 million. The total return on the investment for the LBO transaction would be as follows:

The total return of 42.6% represents the annual compounded return on the equity portion of the LBO fund's investment. Notice the impact that leverage has on this transaction. The company is financed with a 6:1 debt-to-equity ratio. This is a very high leverage ratio for any company. The cash flows generated by the company were used to pay down the debt to a point where the company is completely owned

by the equity holders. The equity holders receive a very high return because the debt used to finance the transaction is locked in at a 10% coupon rate. This means that most operating efficiencies and capital gains generated from the business accrue to the benefit of the equity holders—a keen incentive for equity holders to improve the operations of the company.

Note that the numerator of the constant dividend growth model is the cash flow that is anticipated one year beyond the valuation date. Thus, if the valuation is being performed in year 7, the cash flow that should be used as the numerator in the dividend growth model is the cash flow anticipated in year 8. Often this is expressed as the year 7 cash flow multiplied by (1 + g), where g is the projected annual growth rate. This aspect is introduced in the following application.

These applications illustrated a simplified LBO as being financed with a combination of debt and equity, with debt being the large majority of the financing. Generally in LBO deals there are three tranches of financing: senior debt, mezzanine debt, and equity. Senior debt typically entails financing from banks, credit/finance companies, insurance companies, or public debt offerings. Mezzanine debt is purchased by mezzanine debt funds (another form of private equity to be discussed in the next chapter), insurance companies, and other institutional investors. Last is the equity tranche, held by the LBO firm that has taken the company private, and it often includes some form of equity kicker for the mezzanine debt tranche.

23.7.8 Five LBO Exit Strategies

A key assumption in each of the previous examples is that the LBO transaction can be exited at the estimated values. Leveraged buyout funds can exit investments through any one or any combination of five methods:

1. SALE TO A STRATEGIC BUYER: This is the most common exit strategy. Management can sell the company to a competitor or another company that wishes to expand into the industry.
2. INITIAL PUBLIC OFFERING (IPO): If the underlying company would make an attractive stand-alone and publicly traded company, an investment bank could be retained to take the firm public.
3. ANOTHER LBO: The firm could be refinanced by the current owners using another LBO deal, in which debt is reintroduced into the company to compensate management for its equity stake. In fact, the existing management team may even remain the operators of the company with an existing stake in the second LBO transaction, providing them with the opportunity for a second round of leveraged equity appreciation. In this transaction (and the next transaction example), proceeds of the debt are used to purchase shares of the company from the sponsor of the initial LBO.
4. STRAIGHT REFINANCING: This is similar to the preceding example, in which a company takes on debt to pay out a large cash distribution to its equity owners.
5. BUYOUT-TO-BUYOUT DEAL: Buyout-to-buyout deals are increasingly common in the private equity industry. A buyout-to-buyout deal takes place when a private equity firm sells one of its portfolio companies to another buyout firm. The second buyout firm believes that it can create a second leg of growth after the original buyout firm sells the company. It is estimated that almost one-third of private equity deals are now buyout-to-buyout deals, also known as secondary buyouts. Initially, secondary buyouts were rare. Private equity firms were reluctant to sell a portfolio company to another private equity firm in a buyout-to-buyout deal because of the stigma of failure associated with not being able to take a company public or sell it to a strategic partner. Increasingly, private equity firms are selling to one another as an exit strategy.

23.7.9 Four Spillovers of Corporate Governance to the Public Market

The principles of corporate governance that LBO firms apply to their private companies have four important benefits for the public market.

First, the strong governance principles that an LBO implements in its private firms should remain when those firms are taken public again. Second, LBO transactions serve as a warning to the management team of other public companies: If a company has a poor incentive scheme and minimal shareholder monitoring, it may be ripe for an LBO acquisition. Third, the incentive and monitoring schemes implemented by LBO firms for their portfolio companies provide guidance to managers and shareholders of other firms searching for more efficient governance methods. Last, as indicated earlier, conglomerates can be popular targets for LBO firms, and this can help stop unnecessary and inefficient diversification of large corporations.

23.7.10 Auction Markets and Club Deals

In the past, LBO deals were sourced by a single private equity firm without any competitive bidding from other private equity firms. The traditional model of private equity was one in which a single private equity firm approached a stand-alone public company about going private or approached a parent company with respect to spinning off a subsidiary. In this model, the lone private equity firm worked with the executive management of the public company or the parent company to develop a financing plan for taking the public company or a subsidiary private. Bringing this deal to fruition may have taken months or years, as the private equity firm worked on building its relationship with the senior management of the company.

Whenever large sums of capital enter an investment market, inefficiencies begin to erode. An influx of investment in LBOs has led to the development of an auction market environment. Single-sourced deals are a thing of the past. Now, when a parent company decides to sell a subsidiary in an LBO format, it almost always hires an investment banker to establish an auction process. An auction process involves bidding among several private equity firms, with the deal going to the highest bidder. This competitive bidding process can often involve several rounds and can result in less upside for the private equity investor, yet it reflects the maturation of the private equity industry.

Another development in the private equity market is club deals. In the past, LBO firms worked on exclusive deals, one-on-one with the acquired company. However, the large inflow of capital into the private equity market and the increasing market capitalization of firms targeted for LBOs have forced LBO firms to work together in so-called clubs. In a club deal, two or more LBO firms work together to share costs, present a business plan, and contribute capital to the deal. There is considerable debate about whether club deals add or detract value. Both sellers of target companies and potential buyers can initiate club deals.

Some have expressed concern that club deals could depress acquisition prices by reducing the number of firms bidding on target companies. The reason is that there may be more competition from numerous individual bidders than from a few clubs of bidders. However, others have posited that club deals could increase the number of potential buyers by enabling firms that could not individually bid on a target company to do so through a club. A fund might not have sufficient capital to purchase a target alone because of either restrictions on investing more than a specified portion of its capital in a single deal or the large size of the target. For example, a common restriction found in many limited partnership agreements limits private equity funds from investing more than 25% of their total capital in any one deal. For some of the very large buyouts, club deals are necessary.

Another benefit of club deals is that they allow private equity firms to pool resources for pre-buyout due diligence research, which can often be quite costly. In addition, club deals allow one private equity firm to get a second opinion about the value of a potential acquisition from another member of the club. However, there is a concern that in a club deal it is less clear who will take the lead in the business plan, which private equity firm will sit on the board of directors of the private company, who will be responsible for monitoring performance, and who will negotiate with outside lenders to provide the debt financing for the LBO.

23.7.11 Three Factors Driving Buyout Risks Relative to VC Risks

Leveraged buyout funds have less risk than VC funds for three reasons. First, LBOs purchase public companies that are considerably beyond their IPO stage. Typically, buyouts target successful but undervalued companies. These companies generally have long-term operating histories, generate a positive cash flow, and have established brand names and identities with consumers. Also, the management teams of the companies have an established track record. Therefore, assessment of key employees is easier than assessment of a new team in a VC deal. Venture capital funds face the substantial business risks associated with start-up companies.

Second, LBO firms tend to be less specialized than venture capitalists. While LBO firms may concentrate on one sector from time to time, they tend to be more diversified in their choice of targets. Their target companies can range from movie theaters to grocery stores. Therefore, although they maintain smaller portfolios than traditional long-only managers, they tend to have greater diversification than their VC counterparts.

Third, the eventual exit strategy of a new IPO is much more likely for an LBO than for a VC deal. This is because the buyout company already had publicly traded stock outstanding. A prior history as a public company, demonstrable operating profits, and a proven management team make an IPO for a buyout firm much more feasible than an IPO for a start-up venture.