Private EquityAn Overview

Clark L. Maxam, Ph.D.Director of Research – Braddock Financial Corporation

andEl Pomar Professor of Entrepreneurial Finance – University of Colorado,

Colorado Springs

Private Equity – Broadly Defined

• Technically refers to any type of equity investment in an asset in which the equity is not freely tradable on a public market.

• Less liquid• Long Term in nature

Private Equity – Categories and Players

• Angel– Early Stage: Seed, Start-up

• Professional Venture Capital– Early Stage, Expansion, Later Stage

• Private Equity– Later Stage, Buyout, Special Situations

• Hedge Funds– All Stages

The Private Equity Market

Venture Capital

Private Equity Hedge Funds

Angel

Key Player Overlap

Traditional Private Equity – Primary Activity

• Professional pools of capital that buy all the publicly traded equity of target companies = “Go Private”

• Usually done with borrowed money– High degree of leverage

• Aka : Leveraged Buyout

The Basic Value Creation FormulaFundamental Ideas

1) Re-focuses acquired businesses resulting in lower costs and improved efficiency.

2) Value is created through basic finance that says debt can increase firm value if you can afford it!

• Exploits corporate aversion to debt (Henry McVey, Morgan Stanley).

3) Regulatory Arbitrage – Sarbanes-Oxley

The Basic Value Creation FormulaDebt can increase Value

Dupont Equation

Equity

AssetsTotalX

AssetsTotal

SalesX

Sales

NI

Equity

NIROE

Leverage – Debt as % of Assets Equity Multiplier ROE

The Basic Value Creation FormulaDebt can increase Value

ROEEquity

AssetsTotalX

AssetsTotal

SalesX

Sales

NI

%16100

16

100

100

100

160

160

16XX

Consider a company that takes on debt at a cost of $3 in Net Income, but changes NOTHING ELSE.

Could drop NI to 4.8 and still match the previous ROE!!

%4030

12

30

100

100

160

160

12XX

The Basic Value Creation FormulaAn Example – Carlyle Group

Leveraged Buyout

Case 1 (5 years) – No Profit Increase Case 2 (5 years) – Profit Increase

Source: International Financial Services

Regional Breakdown of Private Equity InvestmentsFunds Raised

69%52%

17%38%

7% 8%7% 2%

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

2000 2005

North America Europe Asia/Pacific Other

Source: International Financial Services

Private Equity Investments by Country

Source: National Venture Capital Association,Thomson Venture Economics

Source: National Venture Capital Association,Thomson

Source: Cambridge Associates, LLC

Cambridge Associates U.S. Private Equity Index (period ending 9/30/2006)

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• PE as a new Model of General Management (Jensen) – Overcomes entrenched thinking, management and

disjoint between manager incentives and capital markets.

– Problematic Trends• Publicly held Private Equity – oxymoron• Fee Structures not tied to exit • Hedge funds in the PE business – not a transaction

business.

Private Equity Issues Going Forward

• 2007 estimate of$160B in dry powder $750B $590B in debt appetite.– Banking capacity is finite and already

extended.– Potential regulatory limits

Private Equity Issues Going Forward

• PE Boom has been fueled by– Historically low rates– Regulatory arbitrage

• Both could reverse quickly and change the metrics dramatically

Private Equity Issues Going Forward