Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals

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Introduction

This book is the third edition of Private Equity and Venture Capital in Europe.

As of today, private equity investments cover the majority in the investment class of private capital. Worldwide, there is currently a record level of Asset Under Management (AUM) for private equity managers supposed to increase up to $ 9tn by 2025. Despite a pause in growth in 2020 caused by the Covid-19 pandemic, analysts forecast a strong performance and net inflows into this asset class to drive a global growth rate of 15.6% over the period 2020–2025 (Source: Preqin).

European private equity is keeping up with the pace in the light of an increasing interest by investors. Among others, the increase in the number of investors keen on investing in private equity is a consequence of the ever-growing interest of some specific categories like sovereign wealth funds that increased the capital allocation to private equity investments by more than 350% in the past 5 years (Source: Preqin).

The final effect of both the increasing interest of investors and the rising AUM of private equity operators is that there is a greater space for deals with a larger average size. As of November 2020, in spite of a lower volume of deals, in Europe, deals with a size larger than half a billion US Dollars accounted for 85% of the aggregate volume of deals involving buyout transactions (Source: Preqin).

Given the importance that updated information has in nowadays world, this third edition of the book presents various charts and league tables to transfer to all readers how this asset class will become more and more important in the next years.

To walk readers through their endeavors, the book presents pop-up messages, wrapping up some contents and creating links among the different sections of the book.

Finally, to provide a full hands-on view, this book presents three interviews (Voices from the Practice) to three top-tier private equity managers:

•W. Dexter Paine, III; Chairman and a Founding Partner of Paine Schwartz Partners.

•Fabio Lorenzo Sattin; Executive Chairman and Founding Partner of Private Equity Partners.

•Nino Tronchetti Provera; Founder and Managing Partner of Ambienta SGR.

We hope you will enjoy the book as much as we enjoyed writing it!

Stefano and Giulia

Part 1

Private equity business: General framework and theories

Introduction

Abstract

The first part of the book is aimed at introducing how the private equity business works. Chapter 1 describes the foundation of the private equity business, presenting the main definitions and the motivations behind the partnership between companies and private investors. Chapter 2 shows how the private equity business is managed in terms of firms, funds, and investors as well as how they are related to each other, the second part of this chapter reports recent industry trends. Chapter 3 presents a brief literature review of corporate finance principles underpinning private equity business, while Chapter 4 introduces the taxonomy of the different private equity businesses.

1: The fundamentals of private equity and venture capital

Abstract

This chapter presents the fundamentals of private equity and venture capital. In the first place, the chapter covers private equity and venture capital, underlining important differences between American and European approaches to funding start-ups and the typical characteristics of the business describing why a company should address to a private equity investor. In the third section, the chapter explains how private equity finance is different from corporate finance and from the banking system, emphasizing the distinguishing elements. The final sections analyze private equity and venture capital from the entrepreneur's perspective, while the last section discusses the views of all types of potential investors.

Keywords

Private equity; Venture capital; Equity investor; Private capital; Startup

1.1: Introduction

This chapter presents the fundamentals of private equity and venture capital. In the first place, the chapter covers private equity and venture capital, underlining important differences between American and European approaches to funding start-ups and the typical characteristics of the business describing why a company should address to a private equity investor. In the third section, the chapter explains how private equity finance is different from corporate finance and from the banking system, emphasizing the distinguishing elements. The final sections analyze private equity and venture capital from the entrepreneur's perspective, while the last section discusses the views of all types of potential investors.

1.2: Definition of private equity and venture capital

There is evidence that investing in the equity of companies started during the Roman Empire. However, the first suggestion of a whole structured organization that funded firms to improve and make their development easier was found during the 15th century, when British institutions launched projects dedicated to the increase and expansion of trade to and from their colonies.

From an institutional point of view, private equity is the provision of capital and management expertise given to companies to create value and, consequently, generate big capital gains after the deal. Usually the holding period of these investments is defined as medium or long.a

One of first structured private equity investment dates back to 1901 when John Pierpont Morgan bought Carnegie Steel Co. from Andrew Carnegie and Henry Phipps. Modern private equity and venture capital as we know it today has been around since the 1940s when it started to be useful and essential for financial markets and companies’ development. Evidence shows that the first modern Private Equity contract was put in place in 1976 by Jerome Kohlberg, Henry Kravis, and George Roberts, creating the first private equity firm, Kohlberg Kravis Roberts & Co., in short KKR. Financing companies with private equity and venture capital has become ever since increasingly more important, both strategically and financially.

The business evolved in the past decades, and because of this, a unique definition of private equity does not exist. However, it is clear that a broad definition does exist: private equity is not public equity. This provocative sentence means that private equity encompasses investments made by a financial institution in the equity of a company, whose shares are not listed as it typically refers to investments made in assets and securities that are not publicly traded.

The term private equity refers to investments made in private companies that may find themselves at every stage of their life cycle. They may be newly founded companies and bankrupt companies. In case the investee company finds itself in a development stage and in the first years of business activity, the investment is referred to as venture capital.

In modern finance, as venture capital was born before the rest of private equity, many terms, definitions, and associations’ names come from it, even though they refer to both investments in the first stages of life of the company and those in a mature age, that is, venture capital and private equity. For example, this is why the company in which the private equity is investing is called venture-backed company regardless the kind of deal that is being made. Hereinafter, the company in which the private investment is made is called Venture-Backed Company (VBC).

1.2.1: Difference between private equity and public equity

In addition to the destination of the money injection (i.e., listed and unlisted shares), private equity differs from public equity under five other aspects (Fig. 1.1):

•Pricing. As shares are publicly traded, in public equity the price is driven by the market fluctuations, either upwards or downwards. On the other hand, the price of a share of a private company is defined on the basis of the negotiation between the preexisting shareholders and the incoming shareholder, which is to say, the private equity investor.

•Liquidity. Publicly traded stocks are characterized by a high level of liquidity, whereas private equity stocks are illiquid. In fact, the selling of a private equity share corresponds to the exit of a private equity investor from an investment, where the private equity investor has to find another potential buyer for the stake.

•Monitoring. Investments in publicly traded stocks are strongly regulated by domestic and international laws and supervisors. On the contrary, investments in private equity are safeguarded by a contract between the parties (i.e., the preexisting shareholders and the private equity investor).

•Disclosure. Listed companies are mandated to publish annual, half-year, and quarterly reports as well as data about their future developments and business plan. In addition to numeric pieces of information, they have to disclose information about industry trends, management choices and Board of Directors composition details. Private companies are not under any of these obligations, and can freely decide which information to publish on their website, if none. This may constitute an advantageous position for the private investor when they have already invested, but before the investment is made the private equity has to carry out a thorough due diligence due to the lack of publicly available information.

•Financial exposure. In the light of the factors above mentioned, there is a direct and tangible consequence reflected on the cost of capital of a listed company opposite to that of an unlisted company. In the light of the impossibility to determine with certainty a specific price (pricing), of the difficulty in the exit from the investment (liquidity), in the absence of a supervising boar (monitoring), and without public economic and financial data (disclosure), the cost of capital is larger for unlisted companies with respect to comparable listed companies.

Fig. 1.1 Differences between public equity and private equity.

These five factors entail that the level of risk changes according to the listing status of a company and they imply that the expected return from a private investor is larger than the one expected from an investor in public securities.

The definitions provided earlier in this chapter, despite being very broad, cannot be applied globally, as operators’ national associations (i.e., NVCA, Invest Europe, BVCA, AIFI, and EVPA) or central banks interpret the definition according to the countries in which they operate. For this reason, many definitions still exist. For instance, according to the American approach, venture capital is a cluster of private equity dedicated to finance new ventures. Therefore, venture capitalists fund companies in their initial phases of life or that are seeking for sources to expand and develop the operations, whereas private equity operators finance companies that have completed at least their first/fast growth process.

The European definition proposes that private equity and venture capital are two separate clusters based on the different life cycles of the firm. Venture capitalists provide the funding for start-up businesses and early stage companies, whereas private equity operators are involved in deals with firms that find themselves in their mature age of the life cycle.

In recent years the American definition has been adopted in the European context too. As such, in this book the American definition will be considered when mentioning private equity and venture capital, where private equity includes also venture capital deals.

1.2.2: Difference between private equity and the banking system

Regardless of the approach used for the main definition, in every deal of private equity it can be assessed that a strict relationship between the investor and the entrepreneur is created. This is a unique characteristic and it not commonly found in other financial investments. It is attributed to the typical characteristics of private equity financing schemes:

•Modification of shareholder composition (Fig. 1.2) as a result of the investor investing in the equity of the VBC

Fig. 1.2 Basic representation of the functioning of a private equity investment.

•Knowledge and nonfinancial support

•Predefined time horizon of the investment.

As private equity investments focus on private companies’ equity for which no public data is available, investors may also decide on the VBC's strategy and on the day-by-day management. This participation, and the admission of a new shareholder in the share capital, generates a metamorphosis in the decision process. Additionally a modification in the stability and symmetry of the organization and its consequences among original shareholders may be noted.

As a matter of fact, despite private investors provide money into the VBC, their role is very different from the one played by banking institutions. The difference between banking system and private equity is evident under many points of view, summed in Fig. 1.3:

•Balance sheet position. The first features that entails all other differences is intrinsic in the nature of both financing and it is very straightforward. Private Equity are shareholders, while banks are debtholders.

•Capital settlement. Whenever a company borrows a loan from a bank, the lent capital will have to be settled in the future, typically in one or more tranches, according to the terms agreed. In the context of private equity, no capital is being borrowed, as the resources coming from the private investors will allow them to become shareholders, and not debtholders. Hence, no capital will have to be settled by the VBC with respect to the private equity.

•Interest rates payment. In addition to the capital payback, a company has to pay periodically interest expenses to the borrowing financial institution. In the case of a private equity investment, no interest rate is paid by the VBC.

•Management involvement. When a company is granted a loan or a mortgage, the bank assigns to its creditors some rules in terms of key performance indicator to respect, that is, covenant. These covenants are assigned due to the impossibility of the bank to influence the company's decisions. If these covenants are not respected, the bank can waive the loan or the mortgage. As the private equity becomes a shareholder, its position is riskier than the one of a bank, in that shareholders are commonly referred to as residual claimant. This means that, in the case of a bankruptcy, the shareholders may not necessarily get back the amount of money they invested. Given this larger level of risk, in addition to covenants, typically private equity investors take part in the decision-making process of the VBC and oftentimes, they sit in their Board of Directors, or delegate someone to do so.

•Remuneration mechanism. If banks are remunerated with the payment of interest expenses and the capital settlement, the private equity remuneration occurs only when the investor exists from the investment and sells the participation to another subject. Hence the remuneration is linked to the difference between the exit price (i.e., the price at which they will sell the participation) and the entry price (i.e., the price at which they become shareholder at the beginning of the holding period).

•Cost of capital effect. In the light of the larger portion of equity generated after the entry of a private equity, that makes the company less risky, the Weighted Average Cost of Capital (WACC) of the VBC will decrease, leading to an implicit improvement of the Enterprise Value. On the contrary, the presence of financial debt makes a company riskier and for this reason, its credit rating worsens, leading to a larger WACC and to a lower Enterprise Value.

Fig. 1.3 Difference between banking system and private equity.

It can be gathered that a private equity investment is not limited to simple money injection; the financial support comes from managerial activity consisting of advisory services and full-time assistance for the company's development. For young ventures or new business ideas, the cooperation with financiers is very important, because reputation, know-how, networking, relationships, competencies, and skills are the nonfinancial resources provided by private equity and venture capital operators. Although they are difficult to measure, these resources are the true reasons underlying the deal and important to the firm growth. They may be defined as benefits or effects embedded within the money injection of the investor. In the private equity deals, there is evidence of four benefits:

1.2.2.1: Certification effect

For the law of the lemons market,b only the companies in need of financial resources will ask the investors for a financing. This makes it very risky of an investor to decide to finance a business, where by definition, they will only find lemons. Hence, it is relatively very rare for a private equity to finally accept to invest in a company; the investment is finalized only after a severe and detailed screening and only a few companies overcome such steps. It can then be gathered that the willingness of the private equity investor to invest in a specific company can be considered as a proxy of its high worthiness and potential.

1.2.2.2: Network effect

As investors gets involved in the day-by-day life of the company, they can share with the company a very strong network, in terms of, among others, suppliers, customers, and banks.

1.2.2.3: Knowledge effect

A company can address to a private equity investor when it looks for specific competences, either hard or soft. While hard skills may support the company in the management of the business and these set of competences change with the company industry, soft skills passed down by the private equity may support the company in the management of the company regardless the industry in which it operates.

1.2.2.4: Financial effect

The last benefit is a consequence of the previous three effects and was anticipated in the previous section. From the moment in which the private equity invests, the rating of the company improves. Several researches proved that the cost of equity for companies with a private equity investor as a shareholder is lower if compared to other similar companies. The rating enhancement positively affects the average cost of capital (usually measured with the WACC), which may ease in the future capital collection among the banking system.

To sum up

Why should a company turn to a Private Equity Investor?

For at least one of the following benefits:

1.Certification Effect

2.Network Effect

3.Knowledge Effect

4.Financial Effect

If a company needs at least one of the four benefits, together with the money provision, it shall ask to a private equity firm to finance it.

Private equity and venture capital agreements always define the holding period and exit conditions of the financier and they are typically active shareholders, engaged in the company management.

Despite this, they are not interested in taking over total control or transforming their temporary participation into long-term involvement. Venture capitalists and private equity operators, sooner or later, sell their stake; this is the most important reason for defining this type of investment as financial and not industrial. The presence of a predefined time horizon for the investment makes private equity and venture capital useful for companies wanting quick development, managerial change, financial stability, etc.

1.2.3: Main differences between corporate finance and entrepreneurial finance

What is the difference between corporate finance and private equity finance (or entrepreneurial finance)? This is a very interesting question and the answer is not as easy as it may seem. The question can be answered in two different ways: institutionally and environmentally (Fig. 1.4).

Fig. 1.4 Corporate finance versus private equity finance—institutional approach.

According to the institutional approach, where the standpoint of the financial institution is assumed, corporate finance, the most traditional way to fund firms, is more standardized, less flexible, and focused on debt. Expected returns are lower, if compared to private equity investments, and linked to the costs that financial institutions incur while collecting money from savers. The reference point for the valuation (i.e., costs and feasibility) is the whole company, independent of funded sources. Another interesting point is the financial institution's unwillingness to participate in the firm's decision framework.

Private equity finance is very flexible and the expected returns are higher (nonfinancial resources described in the previous section must be paid) than corporate finance. It is characterized by a medium to long time horizon, higher options available for the financial institution's exit strategy, and by its high profile in the decision process. The focus of private equity finance is the potential growth path of a company.

The institutional approach, despite distinguishing between corporate and entrepreneurial finance, does not consider the environment companies deal with when they contemplate private equity as a financing option. The environmental approach does consider the environment and the situation faced by entrepreneurs during the financial selection process. Some aspects of the environmental approach are the same as the institutional approach, whereas some aspects explain better the consequences of entrepreneurial finance.

The elements in the following list distinguish private equity finance from corporate finance using the environmental approach, hence considering the environment in which the company operates:

•Interdependence between investment and financing decision

•Managerial involvement of outside investors

•Information problem and contract design

•Value to entrepreneur

•Legal and fiscal ad hoc rules.

With the institutional approach, private equity financing does not fund the whole company. In this scheme of financial and nonfinancial support, a specific project of the entrepreneur is targeted and financed. Because of this, a strong and effective interdependence between the firm's investment and financing must exist and must continue during the entire length of the deal.

Private equity operators and venture capitalists provide financial and nonfinancial sources. This generates the involvement of third parties (external investors) in the decision process and/or company management. It must be emphasized that only in private equity finance there is a decisive participation in the firm's administration.

The third issue seen in the environmental approach is that private equity operators support firms on risky projects. This increases conventional information problems occurring in all firm financing schemes. These problems lead to a lack of standardized agreements, so a special settlement is signed for every funded project.

The strong interdependence among companies and financial institutions generates problems in wealth and value distribution too. As private equity financiers become shareholders, a strong co-participation between the entrepreneur's desires and the financial institution's purposes exists. Private equity financiers support companies with their skills, competencies, know-how, etc. Because this creates value for funded firms, the investor allows the entrepreneur to take value from the funded idea. In most cases, without private equity or venture capitalists, the same company would not have been able to develop projects.

The special legal and fiscal framework for the investor and/or vehicle used to realize the deal is the last factor that sets private equity finance apart from venture capital. It will be shown throughout the following chapters that the private equity industry, needs special treatment regarding taxes and legal frameworks to develop and carry out investments as the investor simultaneously acts as entrepreneur/shareholder and financier.

In the private equity business, relationships between entrepreneur, shareholders, and external investors are intertwined. In large deals involving big corporations, there is a clear convergence between the entrepreneur (and many times, the founding family) and the shareholders. This modifies the traditional perspective of corporate finance in which shareholders and managers are two separate blocks with different goals and tasks.

This is particularly true for venture capital. The smaller the firm or the earlier the life cycle, the more likely the entrepreneur is the shareholder and the manager. This makes it easier for the deal to be realized, developed, and carried out.

1.3: The map of equity investment: An entrepreneur's perspective

The development of the private equity and venture capital involvement starts when the entrepreneur or the management team realizes the need to be funded by external investors to support the expansion or the transformation of the company. Therefore equity investment provides a firm's specific financial needs if not the finance necessary to actually start up a company.

Firms need funding during sales development, which occurs during different stages for each firm. The drivers that measure the firm's need for funding are investment, profitability, cash flow, and sales growth. These four variables are strictly linked together, and should be evaluated from a long-term perspective. These four variables/drivers represent the stage the firm is in, which helps financiers define their strategy.

Analyzing the four drivers, typical stages of the firm used to classify financial needs can be identified. There are six different stages:

1.Development

2.Start up

3.Early growth

4.Expansion

5.Mature age

6.Crisis and/or decline

These stages affect the four drivers—investment, profitability, cash flow, and sales growth—used when analyzing financial needs and equity capital demand of a firm as shown in Figs. 1.5 and 1.6.

Fig. 1.5 The flows of revenues, profitability, cash flow, and investment in the six stages of a company's lifecycle.

Fig. 1.6 The characteristics of the four drivers in a firm's six different stages.

During the first stage, the entrepreneur has to cope with development, the length of which depends on the business features and the entrepreneur's commitment. The objective is to define the most convenient structure for the project's progress. In this phase, sales do not exist and profitability and cash flow are negative due to the presence of unavoidable investments such as the completion of information memorandum, costs for legal and fiscal advisory, and engineering development.

The start-up stage consists of company creation and launch of firm activity. During this period, sales start, but the trend is not solid enough to support costs incurred by sizeable and substantial investments related to the acquisition of productive factors. Consequently, cash flows and profitability are strongly negative.

The next stage, early growth, occurs just after start up. Investments have been made and the firm's current needs are related to inventory, rather than working capital; the revenues realized by the company are increasing. There is a rise in profitability and cash flow, even though they remain negative. However, the whole trend is positive and stable and the negative value is slowly becoming greater than zero.

The next stage is expansion. The investments needed are the same as the early growth stage. In this period, sales are increasing but the growth trend is negative and cash flow and profitability are positive and increasing.

After the expansion stage, there is a period of maturity and firms enter the mature age phase. The sales growth tends to zero while profitability and cash flows level off. During this phase, investments are not just related to inventory and/or working capital but the replacement of ineffective or unused assets also must be taken into account. The last of the six stages is the crisis or decline phase. During this period, sales, profitability, and cash flow fall and the firm is unable to decide what investments should be completed to overturn the decline.

These stages create a demand for financial resources measured by the net cash flow produced by the firm. Demand for financial resources is satisfied by different players with different tools ranging from debt capital to equity capital.

1.4: The map of equity investment: An investor's perspective

Private equity operators and venture capitalists are just a sample of the groups in the financial system. They represent one of the various options that entrepreneurs consider to finance their business. At the same time, entrepreneurs must think about profitability, investment needs, sales growth, and cash flow to find the right counterparty.

Many potential investors are considered from both a debt and an equity