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Private equity
demystified
An explanatory guide
THIRD EDITION
John Gilligan and Mike Wright
BUSINESS WITH CONFIDENCE icaew.com/financingchange
Private Equity Demystified – An Explanatory Guide
An initiative from the ICAEW Corporate Finance Faculty
Private Equity Demystified provides an objective explanation of private equity, recognising that
for public scrutiny of this sector to be effective it must be conducted on an informed basis.
This is recognised by the work featuring on reading lists of leading business schools.
Since the publication in 2008 of the first edition of Private Equity Demystified the major
economies have moved from growth to recession to evidence of emergence from recession.
We have seen the enactment and subsequent implementation of the European Commission’s
Alternative Investment Fund Managers Directive which covers private e
Private equity demystified An explanatory guide
Private Equity Demystified – An Explanatory Guide
Private equity demystified An explanatory guide
Contents Page Preface to the third edition
1.3.6 Captives versus independents
2.1.21 Fund management fees
3. EVALUATING, STRUCTURING AND RESTRUCTURING A P
3.4 Distress and restructuring
5.8 Is there a culture of secrecy?
Preface to the third edition For over two
Acknowledgements This report has benefited
About the authors John Gilligan is a Corpo
List of figures and tables 1. THE PRIVATE EQ
Figure 2.22: European primary and secondary buy-
Table 4.1: Operating profit projections
1. The private equity market In this section we
1.1 What is private equity? `Private' Private equ
The term, therefore, has a confusingly loose defi
Some argue that private equity is an alternative
2. Source investment opportunities A private equ
1.1.8 What rewards do private equity investors ea
Figure 1.2: Effects of leverage – 50% debt 50% eq
Figure 1.4: Effects of leverage – 50% debt, 50% r
from £400 to £1,840, arguably not meaningful. If
Furthermore, nobody invests in the belief that th
private information to achieve superior returns.
1.3.3 1980s ‘hands-off, eyes-on’ Virtually all ea
Table 1.1: Selected large UK buy-out firms and the
New businesses emerged that mimicked the use of l
of the cycle, hoping to profit on the upturn, alt
Figure 1.6: Global private equity funds raised ($
As illustrated in Figure 1.7, the market for buy-
Figure 1.9: £100m buy-outs as a percentage of the
Second, the largest deals have increasingly invol
1.4.4 Deal initiation and proprietary deal flow P
Of the largest transactions shown in Table 1.2 no
1.4.7 What are the largest private equity funds i
1.4.8 How significant are public to private trans
2. Private equity funds, funders and other
2.1 The private equity fund 2.1.1 What is a priva
To solve these types of problems, in the UK, stru
Table 2.1: Top 20 fund-of-funds investors in glob
Figure 2.3 shows the private equity and venture c
Figure 2.4: The relationship between costs and in
Theoretically the fund could go ‘into carry‘ if a
The objective of all of these structures is to al
Table 2.2: Key differences between private equity
Table 2.2: Key differences between private equity
Table 2.3: Key differences between private equity
The differences in the risks of the traditional p
Table 2.4: Key differences between private equity
Hedge funds, in their private equity activities,
Figure 2.6: Forms of diversification undertaken by
An unusual circumstance arose in the case of UK i
Figure 2.7: Investment $bn by country January 200
reliant on third-party advisers both for t
2.1.19 Committed versus invested capital It is im
No recycling of capital: return flow is the name
2.1.21 Fund management fees The fund investors pa
The demand for investing in a particular fund wil
would be a significant burden. This minimum varie
Findings 2.1: Secondary fund market. The academic
It is common practice for managers to carry out q
5. Discounted cash flows from the investment: whe
Figure 2.12: Illustrative equity valuation bridge
The cash flows of the fund are initially negative
Figure 2.14: Distribution of returns to mid–large
Thus, while the median outcome in funds has favou
Findings 2.2: Do investors earn superior returns?
More information about the process and logic of s
Bank covenants: if a business with borrowings doe
2. Liquidity risk arises when a bank mismatches
For simplicity we ignore the terminological diffe
Figure 2.17: Flow of risks from original lenders
As discussed above, the banking market saw a chan
· Investment bankers: both a source of deals fo
emerged both within the funds themselves and outs
acquiring company. This is almost always the case
Findings 2.5: Do private equity and buy-outs adve
2.4 Taxation The structuring of a fund will have
different from either where they are resident, or
However, most of the profits attributable to a ge
Fund managers who are individuals investing via a
Figure 2.20: Different common buy-out structures
The ‘paid basis’ was originally introduced as an
2.5.2 What has been the pattern of exits from pri
Where a fund is approaching the end of its agreed
Figure 2.23: European primary and secondary buy-o
2.5.4 What is a leveraged recapitalisation? As wi
Figure 2.24: Typical simplified fund structure to
renegotiate the terms of the partnership and ther
Findings 2.9: Do private equity deals involve the
Findings 2.10: What is the extent of asset sales
2.6.1 What are the Walker Guidelines? The Walker
At the time they were introduced, there was some
The Directive requires AIFM to introduce a remune
3. Evaluating, structuring and restructuring
3.1 Who's who in a private equity transaction Fig
Where management have a conflict of interest, the
Figure 3.2: Equity value, enterprise value and as
3.1.3 Net present value, IRR and theoretical valu
Figure 3.3: Types of financial instrument: risk an
Figure 3.4: The basic building blocks of financial
Table 3.3: Creating a hierarchy of financial instr
3.1.6 What is a ‘Newco’? Figure 3.5: Outline stru
– unless the vendor is a group selling a
What is senior debt, junior debt and subordinated
Figure 3.6: Relationship between length of loan,
If we compare two situations with the same total
3.2.3 How did banks increase the levels of borrow
2. One-third eight-year ‘B’ senior bullet loan:
incentives were to maximise the amount lent and s
Mezzanine therefore typically uses capital holida
3.2.7 Can Newco repay the borrowings? The ability
Figure 3.10: Structural subordination PE fund £X
The tax charge is dealt with in a detailed worked
Figure 3.11: Illustration of the restructuring in
In the case of Southern Cross Group, a large reti
Findings 3.3: What are the effects of buy-outs on
Findings 3.6: Do private equity deals and buy-out
to secure 100% control subject to a vote of quali
covenants that are a series of tests that measure
the projected value of the equity and therefore t
3.2.21 Restoring leverage: asset-based lenders Fi
3.3 Institutional and management equity The proce
Table 3.5: IRRs calculated at varying exit years
Over the years the target rate of return in a ‘va
Arguably the most appropriate measure should be t
Figure 3.14: European deal structures (deals €100
Table 3.8: Largest private equity-backed receiver
Taxation of ratchets is complicated and needs car
than you earn before finance costs. Unless
However, the difference in the scenario lies in t
However, in many situations the complex interacti
3.4.6 What tools are available to restructure a b
circumstances of the company. Ultimately, a bank
The growth of traded buy-out bonds has also resul
There are therefore a strong set of incentives to
buy-outs. Debt repurchases can be achieved in two
will typically, at a minimum, include both some d
4. A worked example In this section we apply th
4.1 A detailed worked example of a leveraged buy-
Figure 4.1: Actual and forecast sales and profit
Figure 4.2: EBITDA and operating cash flows 20 1
impact morale which may impact the motivation and
The profit bridge highlights the salient features
From the perspective of the borrower all of these
Table 4.5: Sources of funding Funding structure
Table 4.6: Illustrative financing structure Fundin
6. Institutional ‘A’ preferred ordinary shares:
Figure 4.6: Profit: EBITA, EBIT, NPBT 35 Net prof
Table 4.8: Reconciliation of interest charges Act
Table 4.9: Summary of cash flows after funding Sum
Figure 4.9: Forecast values of interest cover and
4.3 Restructured balance sheet The output of the
The presentation highlights a fundamental feature
We call the situation when managers have a high-e
Figure 4.12: The book value of assets is differen
Note 4 – goodwill deductibility In section 3, we
• As a result of these disallowances, even comp
4.9 Sensitivity analysis Sensitivity analysis is
Table 4.15 below shows the projected value of the
Table 4.17: Projected share of exit enterprise va
Table 4.19: Split of proceeds on exit Split of pr
Table 4.21: Private equity investor blended retur
5. Critics and the research In this section, in
Several years ago, we published an assessment of
When we look at the risk element in the equation,
Figure 5.1: Buy-out types, strategy and timescale
5.7 Is there tax avoidance and why are tax havens
5.10 Is there sufficient permanent capital in priv
5.11.3 Zombie funds As funds have started to ‘fai
5.12 Do the conclusions to be reached about priva
• What are the relative contributions of differ
Appendix: Summaries of studies of buy-outs and pr
Table 1: Pre-buy-out governance in P2Ps
Table 2: Financial returns to private equity and
Table 2: Financial returns to private equity and
Table 2: Financial returns to private equity and
Table 2: Financial returns to private equity and
Table 3: Employment, wage and HRM effects
Table 3: Employment, wage and HRM effects (contin
Table 3: Employment, wage and HRM effects (contin
Table 3: Employment, wage and HRM effects (contin
Table 4: Effects on debt-holders, taxation
Table 5: Longevity
Table 6: Asset sales and disposals
Table 7: Post-exit effects
Table 8: Distress, failure and recovery
Table 9: Operating performance changes post-buy-o
Table 9: Operating performance changes post-buy-o
Table 10: Productivity changes in buy-outs and pr
Table 11: Strategy, investment, R&D and control s
Table 11: Strategy, investment, R&D and control s
Table 11: Strategy, investment, R&D and control s
Table 12: Drivers of post-buy-out changes
Table 12: Drivers of post-buy-out changes (contin
Table 13: Secondary buy-outs
References Acharya, V., Hahn, M. and Kehoe
Asquith, P. and Wizman, T. (1990), ‘Event risk, w
Brown, D.T., Fee, C.E. and Thomas, S.E. (2007), ‘
Cornelli, F., Lichtner, K., Perembetov, K., Simin
Easterwood, J.C. (1998), ‘Divestments and financi
Gospel, H., Pendleton, A., Vitols, S. and Wilke,
Jelic, R. and Wright, M. (2011), ‘Exits, performa
Lichtenberg, F.R. and Siegel, D.S. (1990), ‘The e
Phalippou, L. (2011), ‘Why is the evidence on pri
Strömberg, P. (2008), ‘The new demography of priv
Wilson, N., Wrig
Glossary Source This glossary is adapted f
Beauty parade An accepted mechanism for an invest
Chinese walls Deliberate information barriers wit
Conditions precedent Certain conditions that a pr
Debt:equity ratio A measure of a company’s levera
Equity kicker In a mezzanine loan, equity warrant
General partner's commitment Fund managers typica
IRR, definition of An IRR is the value of r that s
Management buyout (MBO) A buy-out in which the ta
PIPE Generally referring to a private investment
Secondary loan market Market in which loans trade
TVPI (Total Value to Paid-In) TVPI is the sum of
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