PE and the causes of LBO's

Question 1

Explain private equity (PE) FIRMS

Answer 1

PE firms acquire mature firms, divisions/subsidiaries via a Leveraged Buyout (LBO)

Question 2

Explain private equity (PE) FUNDS

Answer 2

PE funds are ‘closed end’ funds:
- raise a fixed amount of money at one time
- Investors get money back when fund closes, not as requested.

Typically 10-year span with extension of 2 years.

Question 3

What is the goal of PE Firms?

Answer 3

buy firms,
increase their value, and
sell firms to achieve a capital gain

Question 4

How do PE Firms raise capital?

Answer 4

using PE funds and invest the capital by acquiring a portfolio of mature businesses (portfolio firms)

Question 5

How is a PE fund structured?

Answer 5

They are structured as limited life partnerships

• The partnership is not taxed, income from partnership forms part of each partner’s tax return.
• The limited life saves on the costs of winding up the business arrangement as it has a predefined end point.

Question 6

What are Limited Partners?

Answer 6

• Investors providing most of the fund capital e.g. institutional investors/wealthy people.
• Little say over running of firm. They get back investment + interest at end of period.
• Limited liability - only their investment is at risk

Question 7

What are General Partners?

Answer 7

• Specialist investors that manage the fund
• Contribute relatively small amount to a fund and Receive management fees + ‘carried interest’
• Can have personal assets used for the business as they have unlimited liability

Question 8

Explain sources of leveraged Buyouts

Answer 8

• Insolvency: LBOs for financially distressed companies.
• Foreign Divestment: LBO where foreign investors acquire a company’s assets/divisions.
• Local Divestment: LBO involving sale of assets/divisions to local investors.
• Private: LBO by private equity or investors.
• Privatisation: Purchase of a public company by a private entity via Govt initiatives
• Public to Private: LBO shifts a public company to private ownership.
• Secondary Buyout: Private equity firm sells a portfolio company to another.

Question 9

What is a leveraged buyout?

Answer 9

LBOs are the main investment vehicle of PE funds, involving the acquisition of a firm, subsidiary/division.

The purchase is facilitated by the use of debt secured against the target’s assets and/or future cash flows – hence, they are leveraged transactions

Question 10

What are the Characteristics of an LBO?

Answer 10

1) High leverage – debt is used to facilitate the deal resulting in a debt for equity swap

2) Management hold a significant equity stake:
- 60-80% in deals valued at less than £10m
- 25-40% in deals valued greater than £10m

3) PE firms are active investors
- PE firms typically have representation on the Board of Directors

Question 11

What are the types of LBO’s?

Answer 11

1) Management Buyouts (MBOs) – incumbent management initiate the deal e.g. Ben Sherman 1993

2) Management Buy-In (MBI) – outside management team initiate the deal e.g. Manchester United 2005

3) Institutional Buyout (IBO) – Private Equity firm initiates the deal e.g. Alliance Boots 2007

4) Secondary Buyout – when a Private Equity firm buys a firm from another Private Equity firm e.g. Ben Sherman 2000

Question 12

Explain the agency perspective of LBOs

Answer 12

The agency perspective is that there is large PLC companies with managers spending excess FCF due to personal interests and not shareholders. This excessive discretion is not successfully managed by CG devices such as BOD, Executive Remuneration.

This wastage leads to Takeover activity/threat as PE firms can see the excess FCF on over-diversification and look to sell the separable assets to service LBO and make overall returns.

Other interested parties: Hostile Takeover, Friendly Merger and Anti-takeover devices being used to manage this takeover threat.

Question 13

Explain the LBO governance structure and its hypothesised impact on management behaviour

Answer 13

Governance structure: Management and ownership is now aligned, Financial incentives to actively monitor senior management and strategic decisions and make decisions that increase firm value, PE Firm has BOD Representation typically in Chair position to heavily scrutinise.

Behaviour: Incentives to not waste cash and refocus firms as its their personal money + need to service debt, FCF not used on unprofitable projects e.g. over-diversification, reduced agency costs = higher value

Question 14

How does the entrepreneurial perspective explains the LBO of divisions/subsidiaries of large firms

Answer 14

Some divisions/subsidiaries become financially constrained by power dynamics within a company leading to lack of investment and this stunts profit maximisation.

LBO target this and take over with better management incentives through the LBO Governance Structure and give the division access to entrepreneurial finance.

Question 15

How does a LBO of divisions/subsidiaries create entrepreneurial incentives?

Answer 15

LBO structure inserts entrepreneurial incentives via -
- Financial rewards linked to performance
- Financial alignment between management and owners (personal stake in success of division)
- PE Firms provide complementary skills to management to go after profitable growth opportunities.

Question 16

What are two ways that a LBO of division/subsidiaries can relax financial constraints?

& how is this different from corporate

Answer 16

• PE Firms have existing connections to sources of finance that can be inserted easier than private firms.
• Governance structure and experience of PE firms reassures creditors to lend based on past performance.

Different from corporate as prior to this it was hard for non-core divisions/subsidiaries and private firms to get access to finance in larger firms leading to stunted performance.