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1 Private Equity Investing Professors Spiegel, Sunder & Tookes Dolores Arton Thomas Ghegan Founders Equity Inc. November 2007.

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Presentation on theme: "1 Private Equity Investing Professors Spiegel, Sunder & Tookes Dolores Arton Thomas Ghegan Founders Equity Inc. November 2007."— Presentation transcript:

1 1 Private Equity Investing Professors Spiegel, Sunder & Tookes Dolores Arton Thomas Ghegan Founders Equity Inc. November 2007

2 2 The Private Equity Industry The Private Equity Process Founders Equity Portfolio Company Examples

3 3 Private Equity Fund Structure 10 years in total: 5 year investment period/5 year exit period As portfolio companies are sold, distributions are made Targeted IRR’s 25%+; 3x cash on cash return Limited Partners Private Equity Fund General Partner Portfolio Companies 99% interest 80% of profits Cash for 99% interest 2% management fee 1% interest 20% of profits (carry) Cash or notes for 1% interest Cash Equity Ownership

4 4 Who Invests in Private Equity? Pension & Retirement Funds Insurance Companies University Endowments Fund of funds Family Investing Offices High Net Worth Individuals Hedge Funds Real Assets Absolute Return Private Equity Foreign Equity Domestic Equity Cash Fixed Income Asset Allocation: Educational Institutions Percent of Total Source: The Yale Endowment 2006 Annual Report.

5 5 Fundraising has not slowed in 2007 despite the credit markets. $254 Billion Raised in 2006 $239 Billion Raised Through October 2007 Source: Private Equity Analyst $ Billions

6 6 Demand for Private Equity Funds Persists Continued Strength in Buyouts Buyout Funds dominated 2007 with 132 funds raising $155 billion YTD (up from $101 billion in 2006) Distressed Funds were $29.6 billion of the Buyout Funds Venture Fundraising remains sluggish 102 firms raised $19 billion YTD Large buyout firms currently in the market to raise their largest funds to date Carlyle: Targeting $17.0 billion fund Warburg Pincus: Targeting $12.0 billion fund

7 7 Private Equity Deal Environment Correction in credit market led to slowdown in the number of transactions Private equity firms announced $8.5 billion of new deals in October 2007, compared to $42.2 billion announced in October 2006 Effects of weakening financial market: Financing has become less available and more expensive Increased use of Material Adverse Change (“MAC”) clauses Increased time to complete deals (especially large deals dependent upon public credit markets) Average purchase price multiples continued to climb through May 2007: 9.18x EBITDA for $500+ million deals 8.24x EBITDA for deals between $250 million and $499 million 7.64x EBITDA for deals under $250 million

8 8 Private Equity Firms Various Strategies for Success Buyouts vs. Growth Equity Industry Specialization Operational Expertise Geographical Focus Origination Focus Focus on Particular Type of Transaction

9 9 Founders Equity Investment Focus Venture InvestingBuy-Out/Corporate Finance SeedStart-up Early- Growth Accelerat- ing Growth Later-Stage Growth Special Situations Growth/ Mature Small-Cap Market Middle- Market Large- Cap Market Concept Stage Development and Initial Implementation of Business Model Successful “Beta” Version; Few Customers Successful Business Model Rolled Out Accelerating Growth, Profitable Business Potential IPO Turnaround Situations: Financial Restructuring Replacing Management, Altering Business Model, etc. $5-$100MM Acquisition With Targeted Follow-on Acquisitions $100MM- $500MM Above $400MM Founders Investment Focus

10 10 Founders Equity Lower Middle Market Focus Founders Equity Focus $422 Billion Accumulated Under Management 97,000 Investment Opportunities 1 Billion + 3,100 cos (3.2%) $500 Million - $2 Billion 4,376 cos (4.5%) $20 - $150 Million 79,000 cos (81.3%) $150 - $500 Million 10,754 cos (11%) Mega LBOs $144 Billion (34.17%) Large LBOs $77 Billion (18.3%) Mid-Market $171 Billion (40.5%) Small Market $30 Billion (7.1%)

11 11 Founders Equity Annual Deal Sourcing 500 Potential Investment Opportunities Reviewed 100 Spend More Time on Book 50 Deeper Analysis 20 Real Interest 4-6 Deals Closed Per Year  Industry outlook  Opportunities for growth?  Identify risks  Reasonable valuation expectations  Does it meet our investment criteria?  Quality of management  Management calls  Outside experts  Limited due diligence  Full due diligence

12 12 The Private Equity Industry The Private Equity Process Founders Equity Portfolio Company Examples

13 13 The Private Equity Process Sourcing Deals Initial Evaluation of Deal Exit/ Sale of Company Portfolio Company Monitoring/ Value Creation Financing Transaction Closing Due Diligence Letter of Interest Letter of Intent Merger or Asset Purchase Agreement Agreements:

14 14 Sourcing Deals: Buy Right Auction Process Investment banks work with companies to create an Information Memorandum which is distributed to strategic and financial buyers Investment bank’s process focused on achieving highest value for the Seller Proprietary Sourcing Contact companies directly (no intermediary) Networking with business brokers, accountants, attorneys and other industry participants Fundless sponsors

15 15 Initial Evaluation: The First Look CompanyIndustryFinancial Management team (bench strength) Value proposition and differentiation Business model economics Relationships with customers and suppliers Organizational model (e.g., incentive compensation) Competitive dynamics Industry size and growth Cyclicality Fragmentation vs. consolidation Identification of key risks Comparable company analysis Financial model (historical and projected) Working capital Capital expenditures Capital structure and leverage Investment security Target returns Valuation Development of the investment thesis

16 16 Valuation: In the Eye of the Beholder IRR/ Multiple of Cost Analysis: “The Model” Incorporates the theory of a Discounted Cash Flow analysis Importance of sensitivity scenarios Focus on Free Cash Flow and debt covenants Public Company and Transaction Comparable Analysis Only as good as the comparability of the companies used May need to interpolate between multiple sets of comps Value of Assets Consider value based on assets rather than cash flow Triangulation across multiple methods is critical Valuation is an art not a science

17 17 Due Diligence: Trust but Verify Management Background and reference checks In-depth interviews Employment agreements Company and Industry Speak with industry experts, customers and suppliers Validate company value proposition and industry dynamics Quantify possible risks Accounting Independent accounting review Legal Identify any outstanding litigation and potential liabilities Intellectual property and patents Insurance Understand scope of coverage required and currently in place

18 18 Financing: Establishing the Structure Sources and Uses in a Leverage Buyout $ Millions Purchase Price $100.0 Million Fees and Expenses $100.0 Million Senior Debt Equity Subordinated Debt Key Terms Type of security (preferred equity or common) Pay-in-Kind (“PIK”) Coupon Term of loan Amortization schedule Rate Covenants Often a “bullet” loan May ask for warrants Often a “bullet” loan May ask for warrants

19 19 Value Creation: Ideas into Action Board of Directors representation Identify new Directors with relevant experience who can assist the Company Develop a “100 day plan” Augmenting the Management Team If necessary, recruit new CEO/ CFO Identify functional areas to add additional talent Incentive key players Execution of the growth strategy Buy and Build: Add-on acquisitions Accelerating Growth: Investments in new products or markets Transformation: Professionalize operations

20 20 Exits: Realizing the Investment Initial Public Offering (“IPO”) Sale to strategic buyer (e.g., industry competitor) Sale to another Private Equity Fund (“Financial buyer”) Sale to management (Management buyout or “MBO”) Recapitalization (raise debt and provide a dividend to the equity sponsors)

21 21 The Private Equity Industry The Private Equity Process Founders Equity Portfolio Company Examples

22 22 Stone Source Sourcing Date Sourced: 10/26/2005 Date Closed: 6/30/2006 Source: Proprietary Referral: Fundless sponsor Investment Thesis: Transformation Unique marketing focus with products sold thru architects and designer Business model generates high margins with cash deposits upfront Large, fragmented market with opportunity for geographic expansion Excellent vendor relationships provide competitive advantage in product sourcing Opportunity to transform company from entrepreneurial company to professionally managed company Company Overview Headquarters: New York, NY The Company sources and markets natural stone, ceramic tiles, glass tiles, engineered stone and other materials with decorative surfaces Founded in 1988 by Jeff Green (CEO) and Mark Shedrofsky (COO 2006 Revenue: $44.9 million

23 23 In The Swim Sourcing Date Sourced: November 2004 Date Closed: February 2005 Source: Competitive auction / Proprietary referral Investment Thesis: Accelerating Growth The pool supply industry is a stable $3.8 billion market with a definable universe of 7.6 million residential pool owners and 260,000 commercial pools with recurring needs for pool supplies The pool supply market is a particularly attractive industry for direct marketing due to the prosaic, consumable nature of the product lines and the repeatability of pool utility needs Strong historical cash flow with high predictability 60.0% of revenues visible from existing customers Company Overview Headquarters: West Chicago, Illinois In The Swim (“ITS”) is the leading direct marketer of pool supplies to residential and commercial consumers in the United States and is know as “America’s #1 Direct Source for Pool Supplies” The Company’s product offering focuses on “need-based” consumable and periodic maintenance products utilized in swimming pool openings, closings and general maintenance 2006 Revenue: $71.9 million

24 24 Richardson Foods Sourcing Date Sourced: 3/21/2005 Date Closed: 3/20/2006 Source: Referral from deal broker Investment Thesis: Buy and Build Opportunity to leverage underutilized manufacturing assets through operational improvement and synergistic acquisitions. Base business operating at 30% capacity Strong distribution channels Professionalize management by partnering with seasoned industry executives Reinvigorate old brands through new sales and marketing initiatives Company Overview Headquarters: Canajoharie, NY Richardson produces, markets and distributes bulk confectionary products and specialty sauces under the Richardson, Beechies, Dryden & Palmer and Gravymaster brand names 2006 Revenue: $17.6 million

25 25 Richardson Foods: The Flood

26 26 Richardson Foods: Turning Adversity to Advantage Improve Operations Distinguishes the high performing employees Opportunity to reconfigure equipment Build relationships in the community Upgrade Equipment with insurance proceeds Improve infrastructure reliability Re-build better than new Replace with upgraded performance Fix historical pesky problems Change culture Sense of urgency Importance of a team Pride of ownership


28 28 Valuation - Cash Flow Analysis is Key EBITDA The more EBITDA that comes from EBIT the better Embedded accounting assumption that D&A is a proxy for ongoing capital needs OCF is a more conservative measure Be skeptical of adjustments; think of as two types: Simple add-backs Synergies and cost savings on the come EBITDA can be manipulated by changes in accounting practices

29 29 Impact of Cost Structure Variable Costs Move in a direct relationship with sales Cost of goods sold and some SG&A (eg, cleaning supplies for production) machinery, payroll taxes for factory workers, gas for delivery trucks, etc.) Warning: Some Variable Costs can become Fixed (i.e. hourly labor in a tight labor market) Fixed Costs Can increase or decrease unrelated to sales growth Corporate overhead (eg, officers’ salaries, rent, office supplies, etc.) Generally fixed costs grow at inflation as company grows – but can sometimes be lumpy as you add high-salary management, etc.

30 30 Leverage Need to put in place proper Senior Credit Facility Asset Based Lenders vs. Cash Flow Lenders Focus on asset values vs. business value Focus on liquidation value vs. potential sale price Revolvers can be one of two types Asset Based (Eligibility and Advance Rates) Cash Flow Based (Typically subject to Senior Leverage and Total Leverage caps) Term Loans A Loans – straight amortization w/ possible payment holiday for first 6 months to one year B Loans – Amortize 1% in the early years and remaining amount in last 1-2 years. Helps provide greater operating flexibility –maturity 6-8 years

31 31 Overview of Credit Statistics Role of credit statistics Used to give a snapshot of the capital structure and the risk profile of deal Helpful to use when determining the optimal capital structure Necessary to analyze when setting covenants Understand potential revolver availability issues Certain benchmarks are particularly important (i.e. fixed charge coverage a minimum of 1:1)

32 32 Key Credit Statistics Look at Trailing Twelve Month EBITDA/OCF to understand most recent actual performance Always understand adjustments used to arrive as “adjusted EBITDA” The following are key credit statistics and general guidelines as to their range Key Credit StatsGeneral Guidelines Total Debt/EBITDA<3.5x-4.75x Senior Debt/EBITDA<2.0x-3.25x EBITDA/Total Interest>2.0x Fixed Charge Coverage> 1.0x Other Covenants Minimum EBITDA Maximum cap ex Restricted Payments

33 33 Structuring Conclusion Easy to get “lost in the analysis” – don’t forget to step back and assess the business thesis/rationale A good capital structure can only partially offset a mediocre business.

34 34 Plain Vanilla Convertible Preferred Simplest form of institutional private equity Preference equal to face value; therefore, somewhat protected from loss of principal because “first equity out” (before common) Convertible into common shares at conversion price Example: $10.0MM invested $10.0MM redemption value/preference $40.00 per share conversion price Convertible into 250,000 common shares Owns 25.0% of company

35 35 Participating Preferred Stock “Double dip” equity – investor gets back principal invested plus ownership in the company (i.e., converts into underlying common stock) Can be effective way to bridge valuation gaps as Investor willing to pay higher price per share for participating preferred Mechanics One unit is convertible into both: For example, $10.0MM investment at $90MM pre-money value $10.0MM of capital back redeemable preferred at liquidity event, plus 10.0% underlying ownership stake

36 36 Dividends Dividend can be paid in cash, stock, or paid-in-kind (PIK) Cash/stock dividends Usually 8-12% coupon Compounding vs. non-compounding (usually non-compounding) Usually accrue and paid at liquidity event (IPO, sale or liquidation) Example: $10MM invested at $10.00 per share; 8% compounding dividend for 3 years (e.g., $2.6MM) Private Equity Firm gets either $2.6MM in cash or stock (i.e. 86,571 shares assuming $30.00 IPO price)

37 37 Dividends (cont.) PIK dividends yield better results for Private Equity Firm Usually compounding Earn additional shares at deal price (e.g. above example would yield 259,712 shares vs. 86,571) Earn additional shares of underlying security (e.g. participating preferred results in “triple dip”)

38 38 Overview of Typical Mezzanine Investment Deal Size:$10 million to $100 million Current Cash Coupon: 12% to 14% Target IRR at 5 Years:Market pricing (typically 13% to 16%) Prepayment Penalty:Scheduled payments and/or Treasury Makewhole Transaction Fee:0%-2.5% Term: 6-8 years Representation:Board seat or observation rights InterestCan be PIK or cash or both, typically compounded on a quarterly basis WarrantsOn a deal by deal basis

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