PE WiSe 2014/2015

1.

Vorlesung Introduction
Venture Capital (VC)
financial capital provided in early stage of the company
Leveraged buyouts (LBO)
when asset/firm is bought with a significant amount of borrowed money, so that the CF of
the purchase is used to repay the borrowed money.
Private Equity Funds
investment organization focusing on high-risk projects with a high reward
Private Equity Niche
no debt as there are no promised payments, not public as there are no withdrawals
Structure of private Equity Firms
limited partners: contribute capital but not in management. Have only limited liability to
their capital. Investor. No participation in investment policy or portfolio
companies
general partner: unlimited liability and runs operations. Manages funds and invests money.
Builds up a portfolio of companies that should invest in. Treuhndler =
fiduciary

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Main Characteristics of private Equity

Illiquidity: if a firm is private it cannot sell stakes to get money. Therefore the investors
want to have influence in running the firm.
Uncertainty and asymmetric information: without a market price, which is a stake, it is
hard to value a firm and measure its performance, therefore it moral-hazard is possible
Cyclicality: all elements in PE are cyclical: fund raising, sales, IPOs (Initial Public
Offering: shares are sold to institutional investors who then sell it to the public. Through
this a company becomes a public company)
Certification: in a repeated game with information problems it is very important to have a
good reputation
Incentives: Where illiquidity is possible deals have to be carefully coordinated
Deal Context: The context of such a deal matters. Private Equity investments are managed
therefore the investors matter and what type of investor it is
Human Capital: provides career opportunities
Instances of PE
Angel Investing: individual invests capital < 1Mio
Venture Capital: investment fund, organized as limited partners Equity stakes are going to
an entrepreneurial firm. 8Mio
Growth Capital: capital injection to fund a risky project for which no debt can be raised
2Mio investors get equity stakes
LBO (Leverages Buyout): Investor purchases the majority of the company
Properties of private equity transactions
Illiquid Assets: No market for privately held shares. PE stakes are often sold to another PE
Fund but it can take years to turn the stake into money
Long-term relationships: beyond 1. PE stakes are not sold quickly even when investment
goes good.VC investments 5-7 years, LBO 9 years
Active governance: PE investor is not only an investor but is also active in running the firm
smart money > PE investor can have connections and know-how
Deal sourcing: PE managers find investment opportunities and are searching for investors
to get the target amount 1 year, then deal is negotiated

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Investors
Endowments: pool of money supporting unis or foundations. Long time horizon.
Pension fund: long time horizon but very stable flow.
Corporations: either purchase or searching for new developments. As they are taxable,
timing is very important.
Sovereign wealth fund: state owned funds investing in financial assets (Abu Dhabi etc.).
Long time horizon
Funds of funds: agent(intermediary) allowing small PE investors to invest

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2. Vorlesung - Fund Raising (The limited Partnership)

1.Limited Partnership Agreement
1.1 Timeline of a PE Fund
1.2 Legal Organisation
Limited partnership is the standard organisational form, bc it is flexible and has legal
benefits.
flexibility is very important as PE funds cannot be planned out in advance
Private placement memorandum (PPM):
private offering to a small number of investors. like a very detailed and accurate
contract, defining the conditions of the investments, but unclear about:
- which investment
E
- who the other LPs are
1 - when the money is invested
compared to a mutual fund manager: investors know where the money will go.
GP is the manager of the fund but it is very hard to control which makes incentives
necessary
1.3 Agency Problems in the General Partner and Limited Partner relationship
LPs want measure to guard their investments
GPs are legally bounded by fiduciary duty (Treuhand) to act in the interest of LP
BUT very hard to verify. Lawsuits are expensive and inefficient > ensure alignment
of interests with three measures:
LPAC (Limited partner advisory committee): important decisions have to be approved
LPA (Limited partnership agreement)
profit split
1.4 Limited Partnership Agreement
defines major characteristics of the fund
duration
costs and fees, profit calculation and profit splits
restriction
1.5 Characteristics of the fund
minimum and maximum
size of fund
contribution of LP`s (sidepocket funds:
contributions of GP (usually 1%)
life time limits:
E Venture Capital (VC (Riskokapital)): 10years + 2 optional 1 year extensions
E Limited Buy Outs (LBO): 7years + extensions
E > can be pushed for growth strategies, defines what happens under extreme
circumstances
E
how fund is dissolved unter extreme circumstances

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1.6 Management of the fund

Covenants (specification in contracts) specify:
concentration limits:
E percentage that can be invested into one company
E bc diversification and risk-shifting
1 debt limits:
E not allowing risk increase through debt
E investors cannot borrow or guarantee debt
E if it is allowed only possible for a specific percentage of
committed capital
1.7 Activities of the General Partner
E covenants restricting the activities of a GP
E Investment of personal funds
1 no cherry picking to not disturb portfolio balance
E Sale of partnership Interest
1 sale of partnership in the LPA.
E Future Fund Raising
1 risk that GP loses track of current funds if raising money for a future fund,
therefore not allowed until a date or a % that is already invested
E Time Investment
1 GP are required to invest all their time into that fund
E New GP
1 if GP is new, needs resources for training but needs LPAC approval.
1.8 Types of investments
E investment is not known, but LPs want to restrict the possibilities
E large fees are not accepted if investment is not active enough
E GP have to orient themselves in one asset class (group of securities with similar
characteristics) even though they might be also interested in new areas.
1.9 Time Variation in strength of covenants
E covenants are used to align incentives between GP and LP
E representing the bargaining power by how much one partner is less powerful
E over time bargaining power can shift when e.g. venture capital firms are limited
and partners want to invest, then also the capital flow is faster.
E a PE firm takes years to build a record, to raise capital etc.
E when capital flow is faster VC firms can negotiate less covenants and PE higher fees
2. Payment structures
2.1 The payment structures
E covenants can prevent conflicts of interests
E 10 years of managing the funds a strong alignment has to be made to prove that GP
is work hard
E proving that with upside potential (difference btw current trading price and short
term earnings)
E during fund life time GP is paid with management fees and carried interest (share
of profits)

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2.2 Management Feesd

E fees are used to cover salaries, travel costs, rents etc.
E fees are determined using the raised capital and are like a tax reduced investment
(usually 2% p.a. while established PE firms can charge more and can be reduced
during life of fund)
E Budget-Based Fees:
E LPAC and GP determine expensed and afterwards the size of fund is created
> transparency, usually <2%
2.3 Carried Interest
E share of investment gains go to the GP > usually 20%
E hurdle rates:
E minimum rate of return goes first to LPs and then GPs. Another hurdle can
be there when the carry increases.
E usually 20% carry with 8% return to LP hurdle, 25% carry after 15% return
2.4 Distribution of carried interest
E distributed at time of exit, PE is not reinvesting until the current fund has ended
E distribution of gains:
E whole of funds: when LPs full investment is repaid then LP and GP share
the gains
E deal by deal: at every exit capital invested by the LPs for that investment
are repaid and carries distributed, the gains are split.
E BUT:
E CON: deal by deal increases risk for LP and can decrease the carry %
E PRO: LPs can invest again with the distributed money and reduces risk of
early exits.
2.5 Clawbacks
E deal-by-deal can lead to an overdistribution to GP when the market for later
investment declines.
1 Clawback is a clause in a LPA which forces GP to compensate the LPs when
there was over distribution
2 when it becomes clear that clawback will hold, GP offer reducing fees etc.
E whole of funds
1 first the investment is returned then the distribution starts > no clawbacks
necessary
2 BUT: leads to too early exit,when return is reached
2.6 Other Fees
E VC firms charge carry and management fees, while LBOs receive add. fees
1 transaction fees: paid by firms (usually 1 -2% of transaction value), as compensation
for the effort put into deals that are almost lost
2 monitoring fees: add. 1 -5% if EBITDA
E usually not these fees, but normal management fees are taken
3. Elements outside the LPA
carry split
vesting schedule: timing when GP earn the profit
Diversification: actual activity of a GP?

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3. Vorlesung: Fund Raising / Deal sourcing

o Deal Sourcing
2 Primer task is to invest the fund raised
3 GP need to:
3.1
Find a deal
3.1.1 Difficult even though a lot entres need money
3.2
Evaluate the deal
3.2.1 Asymmetric information leads to refusing deals that came out
good, team maybe inexperienced, market unknown. In
buyouts difficult to evaluate how the staff will react and
perform.
3.3
Winning the deal
1. Finding the deal
o Specialisation vs. Diversification
PE funds usually specify in an area while mutual-funds try to difersify
to reduce risk
More risk for PE, but is balanced out with:
o Experience
o Networks
o Consistency of investments
Depending on VC fund:
o Early stage VC Firms: concentrated in industries and
geography
o Corporate VC Firms: concentrated in industry but not
geography
o Large VC firms: diversify strong in industry and geography
1.3 Attracting vs. finding deals
Attracting:
High reputation of a PE firm:
o They attract deals and are found by investees to invest in sth.
proprietary deals
Reputation leads to:
o Self-reinforicing cycle
High reputation PE firms, are backed up with high
reputation VC firms who have access to high reputation
customers attract higher reputational LPs
Other PE firms need to find deals.
1.4. Proprietary deals
Investors reach investor
Time advantage

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High expertise with VC and therefore in depth evaluation and better

collaboration
For buyouts important:
o Auctions can be avoided
o For target: avoiding risk of failed auction
o Avoiding spreading of information; qualified buyers receive
memorandum (Confidential information memorandum CIM)

1.5 Active deal sourcing

1. GP`s develop a road map looking for good opportunities in
their area of expertise and looking for potential investors
2. Contacts start mostly personally or through intermediaries
a. Friends
b. Commercial bankers: providing loans
c. Investment bankers: not getting a fee for introduction
but a fee for completed transaction
d. Stockbroker: knows who wants to sell a fraction
e. Service providers: lawyers, come when entres need
their service
2. Deal Evaluation
2.1 Deal evaluation
Simultaneously evaluating:
o Due diligence: intensive evaluation of a firm to foresee risks
o Internal evaluation for approval
Deals are evaluated through 5 dimensions:
o Market attractiveness size, growth
o Product differentiation patents
o Managerial capabilities skills in management, marketing etc
o Environmental threat resistance entry barriers, life cycle
o Cash out potential possibilities for mergers
2.2 Due Diligence
Business plans change very little, management teams
change
Overcoming adverse-selection problem:
o High quality entrepreneurs will not enter in a VC to
keep everything for themselves, unless they are
risk averse and want to split the risk
o Low quality Entres will try to get VC funding to
share the risk
o VC Firm has to try to separate the two
CHECKLIST
o Management Team:
Changes can have huge hidden costs but are
needed when the company growth

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Investors will check the team and search for
strength and weaknesses
o Customer Checks:
When customers are checked and talked to
then this can lead to biased information.
Ideally personal contacts are needed in the
target firm

o Sales Pipeline
Affected by the pipeline of PE funds
Entire sales process relevant
o Financials
Start-ups: simple metrics used, s.a. cash
needs, sales etc.
Buyouts:
o Product Evaluation
Preferably in house evaluation as domain
expertise crucial
o Execution Risk
If product badly executed can fail to fill
needs
Separating technology risks as production
o Legal risk
Patents
Legal framework might be unclear for
innovative markets
Changes in legalisation
2.3 Serial Entrepreneurs
Entrepreneurs who had multiple successful ventures
1. They build up a track record and higher chances for success
2. Success depends on
o Timing: right sector
o Managerial skill: regardless of sector
o Support by top VC firm is not increasing success for good entres but
is increasing it for unsuccessful
2.4 Deciding on a deal
Process:
o GP finds deal and may search for resources
o GP team meets company
o GP introduces deal informally
o Company formally meets with partnership
o Partnerships approves/declines/requests more information
o GP issues letter of intent(term sheet)
o Term sheet is negotiated
o Deal is signed

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2.5 Networks and syndicated

o syndicates share deals while PEs are very competitive
PROs of syndicated VC deals:
1. Expertise is combined
2. PR
3. Reduced uncertainty
4. Ability for larger buyouts
5. Might reduce competition
CONs of syndicated VC deals:
Complicates dynamic of team
Potential conflicts if investment with different
stages

3. Winning the deal

3.1 winning the deal
If there is competition within PE funds for a deal it will
not go to the best price
Critical how much value the GP can add
Not sure how the investor will cooperate under
unexpected circumstances
3.2 Follow-Ons
1. Follow ons: Issuing shares after the first offering after IPO
2. If milestone met: easier process as GP are involved and monitored
3. If milestone are not met: GP team needs new members to ensure
objectivity

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4.Vorlesung: Valuation
1. Conceptual Bases of Valuation
1.1 What is value?
Price:
Easy concept
Characteristic of a transaction
Observable
Value:
o Abstract concept
o Can also be a personal preference
o St used synonymously with price
o Greater fool theory: buy sth worthless when you expect sb will buy it
for a higher price

1.2 Values and valuation, Objectivity and subjectivity

Value of a good is objective
Valuation as process to find the value
CF are vague, so there is no unique way to estimate
Assumptions necessary to perform valuation

1.3 Valuation and market efficiency

- If markets are inefficient:
o Buy below value leads to money making
- Valuation is necessary when
o No observable market price venture capital
o A change occurs in assets leveraged buyouts
presume market price is right, and when saying under/overvalued then
with respect to

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1.4 Time value of value

- Valuation means finding an expected value conditional on the
information
- Trying to get the distribution
1.5 Pre-Money and post-money valuation
Post-money valuation = amount invested/(ownership shares)=Y/y
Y:investment y:fraction of firm
if investment is not creating value, the firm value increases by the
cash got
Pre-money valuation = Post-money valuation investment
Y/y -Y
Pre-money valuation is the value if investment were not made
if investment is creating value, then the difference between post
and pre money valuation will exceed the investment
Capitalists obtain rights also having a value:
o they have convertible ownership and equalizing them with common
shares would:
o under-estimate the value of their shares
o under-estimate their fraction
o over-estimate the value of the firm
2.Revisiting Comparables
2.1. Idea
Idea: similar assets should have similar prices
1. identify key variables that are related to value
2. identify comparable firms
3. for each, calculate multiple key variable which yields to market price of
the firm take average over the firms
4. apply multiple key variable of the target firm
Pro:
o simple
o market-based and forward-looking
Con:
no link between key variable and future CF
for new technology ventures no comparable firms
no information about key variable in target firm
2.2 Comparables for PE
Valuing PE with comparables:
private-transaction multiples:
o pricedata from previous PE transactions
o large dataset

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o beware of timing differences

public multiples:
o use multiples from public firms
o adjust for illiquidity discount

2.3 Adjusting for non-diversification

public markets: investor holds diversified portfolio
if company privately held by undiversified investor, he wants to
be compensated for risk that is potentially above market risk
which is used depends on investor:
o diversified investor e.g. IPO market
o undiversified investor depending on
diversificationdegree market or total

2.4 Adjusting for Illiquidity

o discount usually used 25% to 30%
o BUT: discount should be firm specific:
Size
IPO prospects
Financial situation
o Better approach is running a regression and apply equation to a
concrete firm bc
Discount directly
3. DCF
3.1 Revisiting DCF
o Value derived from future CF
Estimate CF over next years CFt
Estimate terminal value of remaining CF TVt=CTt (1+g)/(r-g)
Find appropriate discount rate:
Identify costs of debt rD
Estimate cost of equity via CAPM: re=rf+(rm-rf)
relever capital structure of target: u=t E/E+D
calculate WACC: r=D/(E+D) x rD x (1-T)+ re x E/E+D

Discount all
values to
today and
sum up:

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Pro:
o
o
Con:
o
o

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detailed information where value comes from

less sensitive for irrational enthusiasm
to find need comparable firms
insufficient as a risk measure

3.2 Adjusted Present Value (APV)

APV is valuing CF from assets as if they were all equity financed. Tax
shields and loss provisions are valued separately.
Pro:
o easy to deal with changes in cost of capital
o easy to deal with changes in capital structure
Con:
o cannot handle dynamic capital and loss provisions

4. Monte Carlo Simulation

4.1 Definition
o comparative statics/sensitivity analysis
looking how much the output changes when one input variable is
changed
o scenario analysis
setting some inputs and calculates the output
o Monte Carlo Simulation
Gives the distribution for all input variables and their
dependences.
Very easy to calculate
Quantifies the relations between variables, and not their value.
5. Venture Capital Method
5.1 Definition
o For start ups following values are important:
Current negative CF
No earnings
Potential to change
5.2 Applying the VC Method
1. VC value

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Company in several years time when successfully changed to

positive earnings and CF
also valuing the exit, usually time shorty after IPO

2. coming up with a target rate of return

Usually computed with intuition and high with 40% to 75%
3. Discount the terminal value with the target rate by today

4. relate discounted terminal value to planned investment to

determine how much of the company to get

5. adjust required ownership shares by retention ratio

5.3 Pros and Cons

Pro:
o easy valuation and focuses negotiation on the target rate
o industry standard
Con:
o target rate set without reasonable arguments
o hides value drivers
5.4 Value drivers
o using DCF gives a structural valuation (multiples)
o highly sensitive for the valuation are revenue of growth and sust.
Operating margins
6. Real-Options Approach
6.1 Definition
o financial options: right to buy a stock in future for a fixed price (calc.
with black-scholes formula)
o the same for real assets (real option) with option to:
increase/decrease production

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build new plant

enter new or leave market

6.2 Value of Real Option

o Value depends on
Price to exercise option
Underlying price: the value of project
Time to expiration: time when option becomes worthless
Risk free rate
Standard deviation of returns of underlying price
6.3 Pros and Cons
o Pro:
Decisions are transparent and values them
Ideal for scenario trees
o Con:
Hard to get good estimates for all input parameters

5. Vorlesung Deal Structuring

1. Securities
1.1 common stock
o Public companies raise equity trough common stocks
o Common stocks/shares: fractional ownership of a company
Common shareholder have no special rights (1vote per share in
general meeting) and receive ownership after more senior
shareholder are paid full after:
Taxes/duties
Employee claims
Trade debts
Bank debts
1.2 Private Equity and common stocks
o VC investors are not relying common stocks because:
Usually having only a minority share

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As there is no public market yet they cannot sell the shares if the
company acts against their interest which leads to illiquidity
o Problem is severe
Strong asymmetric information and therefore moral hazard

1.3 Security choice for PE investments

o Guarding against not aligned interest with pay-for-performance
principle where equity should be earned through value creation
Preferred stocks
o If Max had invested the 1.5m in preferred stocks instead of
common stocks, the preferred stocks have to be paid first
and have a face value such that Max would have gotten his
1.5m investment back instead of losing 500t.
Vesting owners shares
o Managers stocks are not his own until a specified time
passed. Max would have owned 100% of the shares and
Sam could not have selled it.
Covenants and super majority provision
o Selling a specified amount of shares is forbidden without
the approval of the investors.
separation of ownership and control
1.4
Redeemable Preferred Stock (straight preferred)
o Cannot be converted into common equity.
o Fixed amount is paid back after other fixed claims are paid back.
There is no fixed maturity but it has a maturity (earlier the IPO or 58yrs).
o E.g. Max has investest 1.5m into redeemable preferred stocks.
Stocks have face value of 1.5m and max gets his money back. When
selled for 2m Max would get 1,5m and 500t would split into the
ownership percentage.
o No catch-up phase for the entrepreneur mix of preferred and
common stock
1.5 pricing common stock along with redeemable preferred
o Downside protection:
When the investor has a high fraction of preferred stocks then the
entrepreneur will ensure that the gains overcome the investments so
that he has personal gains aligned investments
o Cheap common stock:
Hold by employees which aligns incentives
o Tax deferral:
Redeemable preferred stocks are no gain as it is only paying back
money, so no taxes occur. Taxes occur when common stock is sold.
1.6 Drawbacks of redeemable preferred

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o Slow catch-up phase for the entrepreneur lead to difficulties with

negotiation
o Redeemed is repaid slightly before an IPO money from IPO will be
used to repay the old investors, and can make the IPO difficult
SOLUTION: convertible preferred stock
1.7 convertible preferred stock to common stock
o If e.g. the company gets liquidated and the value is higher than the
value of the preferred stocks, than the investor will convert the PS
into common stocks to get a fraction of the gain.
1.8 participating convertible preferred stock
o Convertible preferred stock with additional right to participate in
gains if not converted
o Equivalent to common equity with preferential claim on the face
value
o Acts like redeemable preferred stock while firm is private and after
IPO converts into common stock
o No catch up phase for entrepreneurs
1.9 Multiple liquidation preference
o Multiple amount of invested capital needs to be paid first
o 2x preference: twice the amount invested needs to be returned after
that entrepreneur gets the gains
o catch up possible
2. Exotic securities (Gingerbread)
o combining different securities
2.1 Seniority
o securities have seniorities
o senior: the payoff of a higher seniority needs to be done before a
lower seniority
o seniorities with the same level are paid pooled

2. Terms of purchase agreement

To avoid potential conflicts of interest
2.1 Vesting
o Acquisition of ownership over time
o Long term perspective for managers and ties hem to the company
o For an employee it is an incentive to stay (golden handcuffs)
o Acceleration of vesting: percentage which becomes vested

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2.2 Covenants
contractual agreements between investor and firm
o Two types of covenants:
Positive covenants:
o Require certain actions of the manager
o Provision
o Reporting
Negative covenants:
o Disallow actions
o Stock sales
o Asset sales
o Major financing decisions
Mandatory redemption provisions
o Allowing investors to put preferred stocks back into company
o Increases bargaining power of investors who do not want to liquidate
firm
Registration rights
o Holder can demand to register the share for public trading
Piggyback rights
o Holder can sell shares into anything public which the company
already undertakes

8. Vorlesung Deal Management and Governance

1. The board
Source of all setup that ensures that firm is working how it should
1. The board
o Board has investors, management and outside directors
o Term sheet states voting power and exceptions etc

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o Board members have a fiduciary duty to shareholders

2. Board member activities
o Usual VC manager is sitting in 5 boards and is monitoring 9 portfolios
o Main tasks in order:
1. Raise additional financing
2. Strategic planning
3. Recruitment management
4. Operational planning
5. Introduction to suppliers and clients
6. Resolving compensation issues
7. Serving as CEO
3. Value creation
o Value creation start with deal evaluation
o For LBOs the first decision is to decide whether management should
run it further
o Sources (external):
General market and specific sector conditions
Deal-making ability
Risk arbitrage when firm mispriced
o Sources (internal):
Multiple expansion
o firms are valued with multiples which depends on characteristics of
firm
o while firms develops the characteristics can change
Operative performance
o Main point to become efficient and grow
o When LBO: cutting costs, reduce/increase scale and scope to an
optimal level
o When VC: building a product, bring it to the market, increase market
share
o Both: focus on core competencies and outsource tasks outside
Capital structure
o Working on the financial side
o Minimizing requirement for working capital
o Optimization trough e.g. leasing
2. External Growth M&A
o Fastest way to grow is to merge and acquisitions
o Motifs for acquisitions:
o Economies of scale
o Diversification
o Synergies

3. Staging of Financing
o LBOs have long term financing through the deal

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o Refinancing only happens if firm has distress

9. Vorlesung Exit decision

9.1. Exit Time

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1. optimal to exit when the benefit of the value is bigger than the costs to
spent more time into the portfolio.
2. when the outside opportunity is bigger than the gain.
9.2 Exit Methods
1. Acquisitions (Mergers & Acquisitions; M&A)
Selling company to another investor most common
If the new investor buys it for strategic reasons it is called: trade sale
If another PE firm buys it: secondary buy-out
IPOs are st used to increase the price of the acquisition. After the
IPO potential buyers are more informed and confident to buy and
can raise the competition. IPo`s are normally used for non-debt
financing of a good working company, while acquisition is more
about a company who is highly levered and investors want
immediate illiquidity.
Difference between merger and acquisition
o Acquisition: management can stay but board doesnt longer
exists.
o Mergers: stock for stock trade. Board has directors of each
company.
1.1 Trade sales (approc 4-6 months)
Find an acquirer
Compared to an IPO the trade sale is
o Not so regulated
o Not dependent on market conditions
o Cheaper
Procedure:
Bank
o Investment bank pre values the firm
o Makes a list of potential buyers
o Produces the memorandum ( bank book or CIM (confidential
information memorandum)
Iterative Procedure
o High level information is distributed
o Interested buyers sign an agreement and get the CIM
o Initial non-binding bit and signing a letter of intent (LOI)
o Some bidders then get into the data room, where binding bits
are given
Signalling via CVC (Corporate venture capital)
o Credible information and signalling can increase the returns
o Venture capital investors gain knowledge already and it is very
possible that it will bid for the firm.
1.2 Secondary buy outs
New investors are familiar with the business and procedure
LPs usually critical because
o if invested in both firms, the new transaction didnt increased
their gain
o the first PE firm did not improved

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o investors for the second fund are paying twice the fee, to the
old investors and to the new ones
2. IPO
Prime way to exit, but not an exit more an opportunity
3. Buy-Backs
4. Liquidation
Can be in the interest of investor to liquidate soon, when other
opportunities are generating more value (active investing)
interests are not aligned anymore
LBOs are usually done after failed negotiation
5. Partial/delayed exits
5.1 Dividends (Partial Exits)
Can be seen as partial exits as money goes back to the investor
Bigger dividends are paid when firm has repaid some debt
5.2 Private to private M&A (delayed exits)
Share Deal:
o When merged the investors get again non-liquid stock of the
merged company
o Often acquiring firms that are not failing but also not
succeed loss minimizing strategy
Asset Sale:
o Assets are sold (patents) and company shell is shutted down
9.3 Distribution of proceeds
PE fund gets the proceeds (cash or stock) and distributes them to
the LPs
If proceeds in cash: usually distributed immediately in cash
-- in shares: lock up period when shares cannot be sold
Advantages of distributing stocks:
o SEC regulation:
Size restrictions when selling
o Tax consideration:
Capital gains are taxed
o Performance measurement

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10. Vorlesung Performance Measurement

10.1 Typical Measures
Cash on cash returns
o CoC= Sum(money distributed to LP) /Sum(paid in capital)
o CoC (during lifetime)= Sum(money returned) + current valued
of funds /Sum(paid in capital)
o If < 1 fund has lost money
o BUT: ignores the time value of money, therefore calculating
the IRR
Internal rate of return (IRR)
o 0 = Sum(CFt(1+IRR)^-t -> IRR and NPV, when disagree NPV is
right
o BUT; IRR favourises early repayment difficult for PE where
investment over years is not repayed
10.2 Meaningful measures
NPV
o Better than IRR to compare
Public market equivalent (PME)
o Benchmark the investment against the market
o Relates the sum of distributions to the sum of investments,
while both are related to the public index at that date

o PME <1 market realized higher returns

o PME >1fund has generated more value than the investment
would have gained in the public market
o BUT: doesnt account for risk, illiqiuidity
Asset Pricing Theory (APT)
o Individual return = sum of risk compensations plus a constant
o High beta more risk

PE WiSe 2014/2015
o Alpha implies also management skills making it higher when
managers are good (performance)
o Rt = a + Sum(Bi*rt) + et
o Stale price: last observed price, s.t. regression has missing
values. If too many are missing regression is not good
o Mark to market: market value of pf determined as often as
possible
10.3 Diversification
Asset Allocation
o Only a diversified pf is efficient and a mix of various assets
needs to be determined
Across vintages
o Vintage is the year the PE fund it set up
o Capital is illiquidit for years

Across classes
o Classes of different characteristics and different return
opportunities
Across regions
o Diversifying over geographic areas, being diversified over
economic conditions
Across industries
o PE funds often highly specialized

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11. Vorlesung Growth and cycles

11.1 Growth
Growth of PE fund only by raising more funds
Dispersion (distribution)
o Differences in funds and their performance
Persistance (patience)
o The performance of the last fund has an impact on the
performance of the next fund. When the fund previously
outperformed it is likely (48% while staying the same means
33%)
Maturity (due date)
o First time funds usually underperform, while in time they
perform better. Reasons can be that: greater experience and
therefore better judgement. Or Darwinian effect where
improvement is because ineffective groups do not survive.
Size
o When capital is expanded too quickly the returns decrease.
Peak performance at 300m$.
o But different peaks for Buyouts and for VC. For VC inverted U is
true and peak is at 280m$, while buyouts are flatter with a
peak at 1.2b$
Changes in size
o With increased fund size the internal rate of return decreases
not because of the fund at the beginning
o Investment per investor increases as fund size grows faster
than number of investors
11.2 Cycles
Funds raised
o High stock prices are a sign for a hot IPO phase

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o LPs rate of investment:

Pro-cyclical: hot periods lead to large CF and LP will
invest more
o Herding:
Investors will concentrate on hot sectors
o Capitalising reputation:
Good reputation leads to easier acquired funds and more
capital
Investments
o Debt level Is important for LBOs
Performance of investments
o Investments at market peak seem to underperform
o High leverage makes firm vulnerable
Dealing with cycles
o