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The development and performance of Private Equity Tim Jenkinson Said Business School, Oxford University

outline of this session how is the private equity sector organised? how has the private equity sector grown in recent years? how good has the performance been? are the buy-out houses capitalisms new kings? are private equity ownership and incentive structures simply more efficient than public markets? should policy-makers and regulators worry about the leverage currently being employed?

what is private equity? Private Equity Buy-outs Later stage financing Secondaries Venture capital Early stage financing Public equity Stock market listed companies Private equity is illiquid, ownership is concentrated, valuation is difficult, intermediaries tend to be small, finance is accompanied by control and mentoring Public equity is liquid, ownership is dispersed, valuation is relatively easy, intermediaries are large, finance is often divorced from control and mentoring

how are funds structured? marketingdraw down/investmentRealisation or returns and exitextension marketing follow-on fund 10 years1 year2 years Cash flows back to investors Indications of fund performance commitments by investors multiple closings most private equity is invested via partnerships of a limited duration

how big is the sector? global fundraising from estimated at $1000 billion US represents about two-thirds Europe represents about one-quarter; not much left for the rest of the world, but some signs that the focus is spreading East about two-thirds of the equity raised for PE is devoted to buy- outs (in both Europe and US) but these are highly leveraged – often with only 30% equity in capital structure; so the value of transactions is much larger than the equity figures suggest money is pouring into buy-out funds: $96 billion was committed to US funds alone in the first half of 2006 funds are getting bigger: Blackstone recently raised a $15.6 billion fund; TPG raised $15 billion; Permira raised 11 billion … secondary deals are on the rise: in 2005, 28% of all buy-out deals were between PE houses, amounting to over $100 billion (Dealogic)

source: EVCA survey of pan-European Private Equity and Venture Capital Activity, 2004 Funds committed and investment, Europe

fees and performance measures annual fees at 2% of committed capital varies from 1% to 3% large buy-out funds are closer to 1.5% and fees drop after investment period carried interest usually equal to 20% of profits profits are worked out on the basis of the entire fund; losses are netted against profits but if the fund produces an overall loss, PE fund does not share in the losses there is often a hurdle to jump, such as 8% IRR note that this is a hurdle – once it is jumped, then GP gets 20% of total return (e.g. if IRR = 7% GP gets zero; if IRR = 10%, GP gets 2%) investors normally focus on two metrics: IRR x money – sometimes called total value to paid in (TVPI)

European returns – the macro view This table presents returns on an annualized pooled basis for European private equity funds over the period The remaining unrealised value is as estimated by the private equity fund. The sum of the money paid out and the value still remaining produces the TVPI. Source: EVCA (2005).

private equity returns early-stage returns have been very disappointing but the figures in the previous slide are almost certainly an over- estimate, due to selection biases, and the problems of measuring returns on non-liquidated investments also, they do not measure performance relative to other assets a recent paper by Phalippou and Zollo (2006) takes the Thomson Venture Economics dataset of private equity performance – gathered from GPs and LPs It looks at quasi-liquidated funds raised from 1980 to 1996 either the funds were formally liquidated by end 2003 or had not reported any cash flows during 2002/03 they compute IRRs and a profitability index (PI) – comparing the PV or cash inflows to the PV of cash outflows – using the S&P 500 to discount both (so a PI > 1 indicates a better performance than the S&P 500)

private equity returns PIIRR VCBuyoutsVCBuyouts 25 th percentile %1.29% 50 th percentile %9.60% 75 th percentile %18.31% Source: Phlippou and Zollo (2006). The authors conclude that the returns earned from PE raised between 1980 and 1996 lags the S&P 500 by around 3.3% per annum. Manager selection is absolutely critical, but comparisons are difficult since evidence on returns is opaque

the European highlight: large buy-outs within Europe the highest returns have been earned by buy-out funds, and in particular funds focussed on large buy-outs VentureXpert figures suggest cumulative net IRRs on European large buy-outs (> 1 billion) of around 21% (from inception to 2005) returns on similar US buy-outs have been lower, at around 14% the number of European buy-outs valued > 1 billion has been increasing dramatically recently – especially in 2005 there still remain considerable opportunities for European integration, de-conglomeration, dealing with family ownership and succession issues, etc. and the number of funds focussed on European buy-outs has also been increasing, with active participation by the big US houses in part this growth has been fuelled by low interest rates, and huge liquidity in the syndicated loan market

Source: LPC LoanConnector Syndicated loans to financial sponsors, (including LBOs and recaps) W. Europe

Lending multiples to financial sponsors, (including LBOs and recaps) W. Europe Source: LPC LoanConnector

source: S&P LCD European LBO Review Q Valuation and capital structure of LBOs, W. Europe

Debt 2500 Preference Shares 2400 Management Equity 5 PE Equity 95 Debt 1600 Preference Shares 4230 PE Funds Equity 2061 Management m 8000m 5000m enterprise value 12% rolled up dividend to preference shares Management contribute 5m of equity PE funds 95m equity and all the preference shares Lenders fund the debt InvestedProceedsMultipleIRR Management5m109m21.7x85% PE fund2495m6291m2.5x20%

the new Kings of Capitalism? PE has grown dramatically in recent years: PE, especially buy-outs, now makes an significant contribution to economic growth European VC performance has not been impressive private equity will continue to grow, and will play an increasing role in European acquisitions, restructurings, and earlier stage investing PE is now viewed as a plum job, and many executives even prefer to work for PE owned portfolio companies many investors outside the US currently allocate a very small proportion of their funds to private equity; this is changing the use of debt, and valuations, have been increasing to all-time highs but history tells us that in periods when capital is plentiful, valuations rise and returns disappoint – so now may not be the best time to be investing certainly, PE is here to stay, and, and will become increasingly important in Asia over the coming years the nature of the intermediaries is evolving e.g. distinctions between hedge funds and private equity funds are getting blurred

questions for discussion: does private equity ownership provide a better form of governance and incentives? if so, will publicly quoted companies start to mimic PE houses – some evidence that this is starting companies are increasingly owned by one PE house after another – what explains this, and how do such secondary and tertiary buy- outs perform? What implications will this have for the size of the public equity markets? should policy makers be worried about the practices of PE houses? evidence on returns and performance is opaque – can investors really judge the good from the bad managers? Are investors qualified to understand all the fee and cost allocation issues – will this always have to remain a qualified investor product? Are the current levels of debt excessive – might there be concerns about systemic risk? Who is actually at risk?

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