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Flashcards in private debt and private equity Deck (44):
1

Private debt refers to

loan capital
issued by companies

that is not publicly listed and traded
on a stock exchange.

is a debt capital market transaction that
generally has covenant features similar to a bank loan and

is often used as an alternative to bank funding.

2

Covenants are

requirements or restrictions
placed on the borrower
when a loan is undertaken.

3

Covenants aim to:

provide a degree of security for the lender and
may involve either:

1  a requirement
⁃ to do something (a positive covenant),
⁃ eg to meet specified financial or non-financial criteria 



2  a requirement
⁃ not to do something (a negative covenant),
⁃ eg not to sell certain assets used as security for a loan or not to borrow from third parties. 


4

Typical features of private debt

Unlike a traditional public debt market transaction private debt is not actively traded.

marketed to a much smaller number of long-term “buy and hold” investors,

with the deal eventually being distributed to between 6 and 12 interested parties.

generally a lot less marketable than publicly issued debt,
as it is neither widely held nor actively traded.

reinforced by the issue sizes involved,
which are typically smaller than in the public debt market.

Private debt is typically issued by small and medium-sized companies,
usually in their first forays into raising additional finance.

can be issued in any major currency,

most issues are fixed-rate US dollar-denominated transactions.

Private debt is issued for a range of long-term maturities longer than three years for amounts ranging from £10m to £300–400m.

5

When weighing up investment opportunities, private debt investors tend to be very focused on

covenant protection since illiquid markets mean
they may be unable to sell their private debt investments
in the event of a credit downturn.
may therefore demand a number of covenants,
both imposing requirements and
restricting the activities of the borrower,
in order to safeguard the security of the loan.

6

Reasons for issuing private debt

private debt issuer is able to issue capital market debt
without acquiring a formal long-term debt rating.
(A formal rating from at least one recognised debt-rating agency is required for most public debt issues.)
A key issue influencing the choice between a public or a private issue is the relative cost involved.
From a treasurer’s perspective,
the private debt market represents a major capital source with relatively competitive pricing.
Accessing this market also allows the treasurer to
free up credit lines with relationship banks – ie the company’s main providers of banking services.
In other words, the private debt market offers an alternative to borrowing from a bank.

7

the vast majority of private debt transactions are undertaken by

treasurers
who want to refinance existing term loans from banks,
but who would rather not go to the trouble and expense of obtaining a credit rating.

However, a treasurer may be able to
improve his covenant bargaining position (or improve his pricing)
by obtaining a private rating from an external rating agency.

This obviously depends on
the relative sizes of the cost of obtaining the rating and
the saving in borrowing costs.

In the sterling market,
a financial covenant is required for any issue with a maturity greater than ten years
or a credit rating less than a single A.

Covenants in the sterling market vary according to
the maturity of the deal and the industry sector of the issuer.

8

Financial covenants relate to

requirements that the borrower meets specified financial criteria.

9

Although the administrative costs associated with issuing debt privately are lower, what is likely to be a disadvantage of doing so compared to a public issue?

A key disadvantage of a private debt issue compared to a public issue is
likely to be the additional cost arising from
the higher return required by investors
to compensate them for the greater risks involved –
due to a lack of information and marketability.

10

In communicating to the bank or banks for private debt, the treasurer will need

to make clear the purpose of the funding.
This will enable the treasurer to
determine the levels at which
the all-in cost of private debt makes economic sense for the company
relative to borrowing from relationship banks
(given that the company usually has a choice between the different sources of funding).
The purpose of the funding is always
one of the key items of information
hat a lender will require
before agreeing to buy any debt.

11

Private debt funding is generally

medium-term to long-term (in excess of three years).

Although private debt can be repaid early, will require the issuer to make a costly “make whole” premium
(usually around 50 basis points) –
to compensate the lender for the earlier than anticipated redemption.

For this reason, private debt will usually run until its final maturity.

Exact details of any “make whole” premium will be included in the legal documentation issued with the debt.
medium-term to long-term (in excess of three years).

12

Give 3 possible examples of financial covenants that might be required for a private debt issue.

Possible examples of financial covenants include:
1  a minimum ratio of current assets to current liabilities 


2  a minimum required level of interest cover on the particular issue of private debt and/or on all outstanding debt 


3  a limit on the total level of higher or equal ranking borrowing 


4  a limit on the total level of total outstanding debt – as any problems with lower 
ranking debt may also lead to problems with the higher ranking debt 


5  limits on the payment of dividends, so as to retain sufficient funds to service the 
debt. 


13

Private equity is

the provision of equity capital
where there is no immediate exit route via the secondary market.

So, private equity is
investment in unquoted companies
that are not listed on a stock exchange.

Instead
their shares are issued and traded privately.

14

Private equity comes in two main forms:

venture capital
leveraged buy-outs
other forms:
development capital
restructuring capital

15

venture capital

capital for businesses
in the conceptual stage or
where products are not developed

and revenues and/or profits may not have been achieved. 


Venture capitalists rarely just “silent partners”,
investing their capital and then having no involvement in the operation of the business.

Rather, provide
expertise, their
guidance, and p
ossibly their contacts,
are often crucial to the success of the business.

some degree of involvement in the management of the private company
is often a precondition to investment in the first place. 


16

leveraged buy-outs is

--equity capital for acquisition or refinancing
of a larger company.

--differs from an ordinary acquisition

--because the shares of the acquired company no longer trade on the open market;

--instead,
they are held by the private equity investors.

--acquisition funded largely by borrowing, particularly if the buyers have insufficient personal funds to finance the entire purchase themselves. 


--Management buy-outs:
form of leveraged buy-out
in which the existing management buy-out the existing owners of the company –
ie buy their shares and
hence a controlling interest in the company.

--a management buy- in
occurs when the buyer is an external management team.

--Typically such a buy-out is highly leveraged (hence leveraged buy-out), as most of the money raised to buy control is obtained by the borrowing.


--resulting capital structure is thus highly leveraged or geared,
with the bonds issued typically having non-investment or “junk” status.


--After the buy-out or buy-in,
the management of the private company typically has a substantial equity stake in the company and
so should have a large incentive to try and ensure that the company is successful.

17

A management buy-out often involves replacing

the existing public equity of the company
with new private equity,
in which the buy-out team
own a controlling interest.

18

restructuring capital is

--new equity for
--financially or operationally distressed companies.


These are situations in which
--an unquoted company may seek additional private equity finance,
--whereas a quoted company may have a rights issue. 


19

development capital is

–growth or expansion working capital
--for mature businesses
--in need of product extension and/or market expansion. 


--This development capital may be provided en-route to a public issue when the company is sufficiently large and profitable.

-- can be used to fund organic growth,
ie the expansion of existing lines of production,
or new projects in different market

20

Private equity funds

--Providers brought together in a private equity fund. 

--make unlisted investments.
--As such unlikely to be a quoted price for the investment
--and there will be no easy way to sell the investment,
even in small amounts.

--may be restrictions on
--when and how the investment may be sold, --to which investors will have had to agree on entry. 


21

List the reasons why it might be advantageous to take a public company into private ownership?

advantages may be:
1  may be fewer regulatory restrictions on activities,
-- giving greater freedom to make profits

2 may benefit from closer relationship
--with a smaller number of
--more sophisticated investors
--who may provide management input

3 incurs lower costs
--in complying with less onerous financial reporting requirements

4 lack of a quoted market share price may enable
-- management to take longer-term view
--when making investment decisions.

22

A move to private ownership will often be associated with

management changes,
or
at least a review of existing management’s financial incentives.

usually involve ensuring that the management’s compensation depends directly on the success of the business,

so as to ensure the alignment of investors’ and management’s interests. 


23

Returns in private equity can be

very high, as with any private business venture.

can be very mixed –
some investments do spectacularly well and 
some fail completely.

24

The risks associated with private equity

vary considerably according to the form.

Initial “seed” venture capital may see 80% of ventures failing,

while “development” capital failures may be only 10%.

25


Private equity isn’t a homogeneous asset class.

--different forms have very different characteristics and levels of risk,

--as will the individual companies themselves.

--Diversification within a private equity portfolio is therefore important. 


--Similarly, failure rates for restructuring capital will often be very high, compared to management buy-ins and buy-outs.

--
Recall that a management buy-in is the provision of funds to an external management team to enable them to buy into an established company.

--A management buy-out involves providing funds to an existing management team to enable them to buy an established company or part of a company,
eg a particular product or division

26


Private equity isn’t a homogeneous asset class.

--different forms have very different characteristics and levels of risk,

--as will the individual companies themselves.

--Diversification within a private equity portfolio is therefore important. 


--Similarly, failure rates for restructuring capital will often be very high, compared to management buy-ins and buy-outs.

--
Recall that a management buy-in is the provision of funds to an external management team to enable them to buy into an established company.

--A management buy-out involves providing funds to an existing management team to enable them to buy an established company or part of a company,
eg a particular product or division

27

Can you think of any disadvantages of venture capital finance to the current owners of a business?

1. loss of control over the company.

2. capital may only be made available in tranches
--with availability and/or cost of the later tranches
--being dependent on the venture capitalist

28

“survivorship” bias

-the fact that elimination of the disappearing (failed) ventures from the analysis
----will bias the reported results upwards.

29

example of survivorship bias

Company C collapsed in August and so the shares are worthless at the end of the year. The actual return an investor who invested equally in the five companies would have achieved is –5.0%. However, if a past performance table was being drawn up at the end of the year and Company C was excluded as it no longer existed, the performance shown would be 18.75%

30

Weighing up the pros and cons of private equity

--acted as a strong deterrent to investment by more traditional investors.

--However argued that the potential for high returns and
--the opportunities they may provide for diversification
--when compared to other more traditional investments should in fact

--make them suitable investments for insurance companies and pension funds,

--at least as a small part of a widely-diversified fund.

--This would also have the beneficial effect of making it easier for private companies to raise funds.

31

What are the possible disadvantages of private equity to institutional investors?

1 lack of liquidity and marketability
2 variable past performance record
3 difficulty in valuation
4 need for specialist investment advice
5 high costs
6 lack of reliable information
7 regulatory constraints.

32

Investors can diversify risk in PE investments:

--by buying into quoted venture capital and --development capital investment trusts
or
--by having segregated funds managed for them
----by private equity firms.

---Use of a fund-of-funds
(invests in a number of other private equity funds)
--offers greater diversification
--but usually involves a double layer of fees.

33

choices available for an investor who wants to invest in private equity are:

i)  directly
by purchasing shares in private companies 


(ii)  pay a private equity firm
to invest your capital for you 


iii)  invest in a private equity collective vehicle,
eg an investment trust 


iv)  invest in a fund-of-funds –
which invests in a range of private equity funds.

34

difference between the PE investment options.

In (ii) and (iii),
lots of investors invest in the fund,
which then supplies equity capital to businesses

In (iv),
there is an additional layer –
lots of investors invest in the fund,
which then invests in a range of private equity funds,
which then supply equity capital to businesses.
This is where the extra layer of fund management fees comes from.

35

Operation of a private equity fund

--arrangements for putting in and taking out investors’ money
---specified in detail up front.

---In practice, there is considerable variation between funds.

As an example,
--a private equity fund may be set up as a limited partnership
--with a fixed life.

At the end of this period,
capital is shared between the investors
in some way,
eg as specified in the partnership agreement.

36

Term of PE funds:

--usually 8-year to 12-year life,
--cycle will increase for early-stage investments
--and reduce for more mature investment
--eg venture capital investments may have longer life
--than leveraged buyouts.

37

Which of the four main forms of private equity described towards the start of this section are likely to be the most risky?

Venture capital and
restructuring capital
are likely to be the riskiest.

because
venture capital
--involves a very new company,
--many of which fail, and

restructuring capital involves
--providing money to companies in financial trouble
--(financially distressed companies),
--many of which again tend to fail.

38

PE Initial fundraising

--Prior to fund launch
-- will be 3- to 6-month
--initial fund raising
--with monies usually raised by a marketing agent
-- receiving usually 1% to 2% of funds committed.

--cash flow structure
---allows investors’ commitments to be
--drawn down as required.

--A first closing will take place
--giving the manager the right
--to call on the funds committed,
--make investments and
--earn fees.

--Often the fund will continue to raise money for a time
---up to the final closing date.
--Hence new investors may join the fund and commit money over a relatively long period of time of say 12 months.

39

Commitment of funds to PE

1. not require the investor to transfer any cash at the time of commitment.

2. manager may call on committed funds
--with little notice and
--often in tranches of 5% to 10%
--during the investment period.

40

PE fund investment purchases:

1. All purchases made by the end of the investment period
which will be say 3 years from the final closing date.

2. gives manager reasonable time to make investments
whilst leaving time for divestment during the fund life.

41

Typical PE underling investment
term

1. will be held for say 3 to 5 years.
2. Sale proceeds returned to the investors.

3.possible for aninvestor to commence to receive distributions after say 3 years
--when part of his commitment has not yet been drawn down.

4. often the case that investor’s net investment in the fund
will be much less than the committed amount.

5. mature PE portfolio
--with regular new commitments
--could become self-financing cash generator within 7 to 10 years.

6. Undrawn commitments at end of the investment period will expire, and
--investor becomes free to use funds for other purposes.

7. At end of the fund’s agreed life,
--any remaining investments might be
--distributed to the investors pro-rata,
--the fund life extended or transferred into a new fund.

42

PE manager remuneration

1. by a fee of he order of 2 per cent per annum of commitments
--plus a share of profits.

2. is incentive to achieve strong performance and
--is often called “carry” or “carried interest”.


3.“carry” paid to the manager is
--often 20% of all profits over a hurdle amount.
--hurdle amount typically be
--the return of all drawn commitments plus interest at 8% per annum.

4. ie.the investments must exceed some specified rate of return--before the manager is entitled to any share in the profits.

43

Typical PE underling investment
term

1. will be held for say 3 to 5 years.
2. Sale proceeds returned to the investors.

3.possible for aninvestor to commence to receive distributions after say 3 years
--when part of his commitment has not yet been drawn down.

4. often the case that investor’s net investment in the fund
will be much less than the committed amount.

5. mature PE portfolio
--with regular new commitments
--could become self-financing cash generator within 7 to 10 years.

6. Undrawn commitments at end of the investment period will expire, and
--investor becomes free to use funds for other purposes.

7. At end of the fund’s agreed life,
--any remaining investments might be
--distributed to the investors pro-rata,
--the fund life extended or transferred into a new fund.

44

Explain what is meant by the:
. (i)  first closing date 

. (ii)  final closing date 

. (iii)  investment period.

(i) First closing date
The first closing date
(is typically 3 to 6 months after marketing of the fund commences),
1-- date at which fund manager can start to call on investors
--to hand over cash they have committed to invest.
2. enable the fund manager to start making investments in companies.
3. enables fund manager to start receiving his fee,
--as part of fee will be percentage of funds committed.


(ii) Final closing date

The final closing date is end of the marketing period of fund –
--after this
--are no new commitments to provide funds for investment.

--The final closing date is typically 12 months after the start of the marketing.


(iii) Investment period

-- is the time during which investors
--pay over the funds they have committed
--and fund manager makes investments in businesses.
--The end of the investment period
--is typically 2 or 3 years after the final closing date.