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Primer on Private Equity Edited Summary of “The Oxford Handbook of Private Equity” 1 Introduction to Private Equity This primer introduces the reader to the financing and governing behaviours employed by private equity investors in order to manage investment risks and related agency problems. A special focus is devoted to how venture capitalists affect the governance of their portfolio companies. Private equity and leveraged buyout transactions represent crucial governance mechanisms to restructure firms. Venture capitalists contribute to improving the governance structure of the firms they finance by influencing their board composition, creating a more independent and involved board, and providing strong oversight. A growing body of economic literature shows that private equity investors provide valuable managerial support to their investment companies by playing an active role in monitoring and governing them, as well as offering them crucial value-added advice and services. The ultimate investment depends not only on the quality of the entrepreneurial team, but also on the effort exercised by both the entrepreneur and the venture capitalist, who is supposed to provide valuable managerial support and services to portfolio firms. To mitigate these problems, venture capitalists need to devote a great amount of time and effort in setting appropriate mechanisms to incentivize the entrepreneur to act in the best interests of the company and the venture capitalists. Venture capitalists devote significant attention and time to screening and evaluating the investment proposal in order to select the most attractive ones. According to economic literature and empirical evidence, the positive influence that venture capitalists exercise on the governance of their portfolio firms seems to lead to better firm performance. Information Asymmetry and Agency Problems In the absence of appropriate screening and control mechanisms, the presence of information asymmetry and agency problems may lead to: Adverse selection, which arises before the financing is made and refers to a situation of misrepresentation of reality by the entrepreneur in order to induce the venture capitalist to provide the financing. Defining: Private Equity The term “private equity” refers to the expansion financing of existing firms. The definition includes leveraged buyout (LBO) transactions and excludes start-up financing (defined as venture capital [VC]). A leveraged buyout involves the acquisition of the equity capital of a target firm with the adoption of a large amount of debt relative to the asset value of the target. Defining: Private Equity Investors & Venture Capitalists Private equity investors target high-growth-potential firms with the hope of receiving an adequate return to compensate their underlying investment risk. Venture capitalists derive their returns from the capital gain they obtain by divesting (or exiting) their portfolio companies.

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Edited Summary of “The Oxford Handbook of Private Equity”

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  • Primer on Private Equity Edited Summary of The Oxford Handbook of Private Equity

    1

    Introduction to Private Equity This primer introduces the reader to the financing and governing behaviours employed by private equity investors in order to manage investment risks and related agency problems. A special focus is devoted to how venture capitalists affect the governance of their portfolio companies. Private equity and leveraged buyout transactions represent crucial governance mechanisms to restructure firms.

    Venture capitalists contribute to improving the governance structure of the firms they finance by influencing their board composition, creating a more independent and involved board, and providing strong oversight.

    A growing body of economic literature shows that private equity investors provide valuable managerial support to their investment companies by playing an active role in monitoring and governing them, as well as offering them crucial value-added advice and services.

    The ultimate investment depends not only on the quality of the entrepreneurial team, but also on the effort exercised by both the entrepreneur and the venture capitalist, who is supposed to provide valuable managerial support and services to portfolio firms. To mitigate these problems, venture capitalists need to devote a great amount of time and effort in setting appropriate mechanisms to incentivize the entrepreneur to act in the best interests of the company and the venture capitalists.

    Venture capitalists devote significant attention and time to screening and evaluating the investment proposal in order to select the most attractive ones. According to economic literature and empirical evidence, the positive influence that venture capitalists exercise on the governance of their portfolio firms seems to lead to better firm performance.

    Information Asymmetry and Agency Problems In the absence of appropriate screening and control mechanisms, the presence of information asymmetry and agency problems may lead to:

    Adverse selection, which arises before the financing is made and refers to a situation of misrepresentation of reality by the entrepreneur in order to induce the venture capitalist to provide the financing.

    Defining: Private Equity The term private equity refers to the expansion financing of existing firms. The definition includes leveraged buyout (LBO) transactions and excludes start-up financing (defined as venture capital [VC]). A leveraged buyout involves the acquisition of the equity capital of a target firm with the adoption of a large amount of debt relative to the asset value of the target.

    Defining: Private Equity Investors & Venture Capitalists Private equity investors target high-growth-potential firms with the hope of receiving an adequate return to compensate their underlying investment risk.

    Venture capitalists derive their returns from the capital gain they obtain by divesting (or exiting) their portfolio companies.

  • Primer on Private Equity Edited Summary of The Oxford Handbook of Private Equity

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    Moral hazard, which arises after the financing is made and refers to the possibility that the entrepreneur will employ opportunistic behaviours against the venture capitalists. The moral hazard problem is driven by a divergence of interests between the principal and the agent. The difficulty of combining the interests of the venture capitalist and those of the entrepreneur, as well as the difficulty of controlling and verifying the actions of the entrepreneur may encourage detrimental opportunistic behaviour.

    The interaction between the venture capitals and the entrepreneur is affected by agency problems and conflicts of interests, mainly due to asymmetric information that may lead to adverse selection and moral hazard consequences. To mitigate these risks, venture capitalists have learned to employ different risk mitigation mechanisms, such as adopting specific forms of finance and governance strategies.

    Defining: Information Asymmetry Information Asymmetry is when somebody knows more than somebody else. Such asymmetric information can make it difficult for the two people to do business together, which is why economists, especially those practising game theory, are interested in it. Transactions involving asymmetric (or private) information are everywhere. A government selling broadcasting licences does not know what buyers are prepared to pay for them; a lender does not know how likely a borrower is to repay; a used-car seller knows more about the quality of the car being sold than do potential buyers. This kind of asymmetry can distort people's incentives and result in significant inefficiencies. Source: The Economist - Economic Terms A to Z

    The Economics of Seinfeld - Asymmetric Information The Fusilli Jerry Jerry's car is broken and he takes it to a new mechanic. The new mechanic gives an estimate that Jerry believes is too high. George says, Of course they're trying to screw youthat's what they do. It's because you don't know anything about what's going on under there! George also says that Putty, Jerry's regular mechanic, wouldn't try to screw him. Reputation for honesty can overcome moral hazard problems.

    The Fusilli Jerry - Asymmetric Information - Video Link

    Defining: Agency Problems An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. The problem is that the agent who is supposed to make the decisions that would best serve the principal is naturally motivated by self-interest, and the agent's own best interests may differ from the principal's best interests. The agency problem is also known as the "principalagent problem."

    In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth. However, it is in the manager's own best interest to maximize his own wealth. While it is not possible to eliminate the agency problem completely, the manager can be motivated to act in the shareholders' best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing and the threat of takeovers.

    Source: The Economist - Economic Terms A to Z

  • Primer on Private Equity Edited Summary of The Oxford Handbook of Private Equity

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    Private Equity Risk Mitigation Financial contracting, control rights, and governance mechanisms play a crucial role in mitigation agency problems between venture capitalists and entrepreneurs, as well as providing the entrepreneur with the incentives to act in the best interest of the venture capitalist and the company.

    The choice of security in venture capital financing is context-contingent because it depends on the type of invested firm and on the type of transaction, as a response to different agency problems underlying the specific transaction.

    The legal environment and securities regulation also represent important determinants for venture capital contracting behaviour.

    More experienced venture capitalists tend to adopt a more sophisticated approach toward risk management. Sophisticated venture capitalists use the U.S.-style contract approach (characterized by the dominance of convertible securities), regardless of the legal origins.

    Sophistication is proxied by size of the venture capital (in terms of capital under management), age of venture capital firms (at least four years), and previous U.S. experience. Venture capitalists are more likely to use the U.S.-style contract when they are older, larger, and have U.S. experience.

    In civil law countries with low enforcement, venture capitalists tend to use common stocks and debt (instead of convertible securities) and tend to rely more on board control. Preferred stocks are used mainly in common law counties with high enforcement.

    The choice of securities is context-dependent: it mainly depends on the characteristics of the invested firms, as well as the institutional and legal environment.

    Screening and due diligence are important mechanisms to minimize adverse selection risk. The different groups of risk screening criteria used by venture capitalists may fit into the following categories:

    Firm: Criteria related to the target firms characteristics (e.g. business history, firm age, development stage).

    People: Criteria related to the quality, experience, and track record of the management team.

    Opportunity: Criteria related to the uniqueness and technology of the project or product, the business plan, and cash flow potential.

    Context: Criteria related to the market context (industry, competitors, suppliers, entry barriers).

  • Primer on Private Equity Edited Summary of The Oxford Handbook of Private Equity

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    Investment Risks and Reward: Criteria related to the investments characteristics and the related risks and returns (e.g. invested amount, venture capital ownership stake, time to reach the break-even point, strategic fit with other portfolio firms, expected internal rate of return (IRR), risk analysis).

    Risk Mitigation - Convertible Securities Convertible securities, especially if accompanied by the automatic conversion provision, appear to be the optimal contractual scheme to overcome agency conflicts between venture capitalists and entrepreneurs and to better manage adverse selection and moral hazard risks.

    Convertible securities seem to be particularly attractive for various reasons. First, they combine elements of debt and equity and help to mitigate adverse selection and moral hazard problems, such as window-dressing problems. Second, convertible securities, especially in the form of participating convertible preferred equity, ensure the venture capitalist greater control rights and greater downside risk-protection (because venture capitalists have a claim on the assets of the firm as long as they choose to not convert their securities). Third, convertible preferred stocks allow venture capitalists to transfer the risk to the entrepreneur in the worst-case scenario. Fourth, they provide the holders with the right to convert them into equity. Prior to conversion, the venture capitalists holds a debt-like security with an option of conversion into equity, and until conversion these types of securities provide the venture capitalists with preferred dividends and liquidation priority rights. If conversion occurs, the venture capitalist loses dividend preferences and gains the ordinary dividends associated with common stocks.

    The key features of these types of securities are (a) they allocate different cash-flow rights depending on the type of exit (IPO or acquisition) that will occur; (b) they provide the venture capital with control power because the voting rights are applied on an as-if-converted basis. Given that these securities are often accompanied by an automatic conversion provision at the time of IPO, if the exit occurs through an acquisition the venture capitalist still holds preferred security. On the other hand, if the exit occurs via IPO venture capitalists automatically convert their securities into equity and will end up holding common stocks. Therefore

    Statistics on Convertible Securities vs. Common Stocks U.S.-style contracts (convertible securities) are less likely to fail, whereas 41 percent of venture capitalists that used common stocks have failed.

    Inexperienced venture capitalists may not completely understand the benefits offered by preferred stocks and may choose common stocks.

    Defining: IPO An IPO or Initial Public Offering is the process by which a company transforms from being a private company to a public company through the sale of shares to the public.

    Tendencies of Common Equity Common equity is more likely to be chosen by low-return entrepreneurs (the lemon principle), while high-risk entrepreneurs (nuts) are more likely to be attracted by debt contracts.

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    cash-flow rights are higher in the case of exit than through an acquisition than through an IPO. Moreover, given the voting rights on an as-if-converted basis, the conversion will not change the control rights held by venture capitalists.

    Risk Mitigation Differences Between the United States and Canada Convertible preferred stocks represent the most used form of finance in the United states. Outside the U.S. market, in fact, convertible securities are not the most commonly use form of finance. Instead a larger set of financial securities are adopted by venture capitalists.

    When there are no tax benefits from the use of convertible securities (as seen in Canada), U.S. venture capitalists tend to use a heterogeneous mix of forms of finance.

    Contrary to empirical evidence in the United States, in Canada a wide variety of forms of finance are used. Among them, common equity seems the most frequently used security: almost half of Canadian private equity financial contracts include common stocks.

    The use of convertible securities in the United States is justified by favourable tax treatment. However, the banking system in Canada is highly concentrated, and there may be fewer debt finance opportunities available for entrepreneurs. This open space may incentivize U.S. venture capitalists who want to invest in Canada to follow a one-stop shopping financing approach, by offering Canadian firms a wide set of alternative financing possibilities.

    In Canada, convertible securities are not the most frequently used. U.S. venture capitalists investing in Canadian firms use a variety of forms of finance other than convertible securities. The following table details the other forms of finance used for Canadian private equity financial contracts.

    Form of Financing Percentage of Total Forms of Private Equity Financing in Canada

    Common Equity 37% of Cases

    Debt 15% of Cases

    Convertible Debt 12% of Cases

    Mixes of Debt and Common Equity 11% of Cases

    Straight Preferred Equity 11 % of Cases

    Different Other Combinations of Preferred Equity and Debts 8% of Cases

    Straight Preferred Equity 7% of Cases

    Risk Mitigation - Control and Cash-flow Rights

    Behaviour of Private Equity Investors Private equity investors behave differently depending on the type of transaction (buyout or expansion).

    In expansion deals venture capitalists often acquire a minority equity stake. In contrast, a controlling majority

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    Private equity investors separately allocate control and cash-flow rights between venture capitalists and entrepreneurs in order to mitigate agency problems. Control rights are often made contingent on performance measures. Thanks to these contingencies, the venture capitalist gains more control rights or full control if the firm performs badly or if the targeted objectives are not fulfilled. If the firm performs well, the venture capitalist decreases control rights and gets more cash-flow rights instead.

    Venture capitalists may adopt different types of control rights: control over production and marketing decisions, power of hiring and firing of the CEO, power of having board control, and veto rights over some particular decisions (such as the issuance of securities, merger and acquisition possibilities, or large capital expenditure decisions).

    The presence of strong venture capitalist control rights (such as board control, veto rights, and the right to replace the CEO) is associated with a greater probability of exiting through an acquisition rather than through an IPO or write-off.

    Examples of different control and protective rights retained by venture capitalists include:

    Cash-flow rights: Claims on cash payouts. Dividend priorities and liquidation rights: When venture capitalists hold

    preferred stocks, they expect to have priority rights over common shareholders in the event of dividend payments, liquidations, or merger.

    Voting rights Control rights: Venture capitalists typically hold a vast set of control rights (e.g.

    power of hiring or firing the CEO, right to replace the founder or the entrepreneur, right to retain board control, right to set restrictive covenants or stock transfer restrictions).

    Board representation rights: The venture capitalists retains the right to choose one or more board components, as well as the right to increase board representation in the case of poor firm performance or inexperience management team.

    Veto rights: The veto rights included in private equity contracts may be related to asset sales, asset purchases, ownership changes, and equity increases.

    Information rights: Investors often retain the right to receive information on financial statements and other firm-related information.

    Right of first refusal in sale: This represents a call option for the venture capitalist. When a shareholder wants to sell his or her shares, the private equity investor has the right to buy them before the shares are offered to a third party.

    equity stake is typically acquired in the case of buyouts.

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    Pre-emptive rights on new share issues: In the case of issuance of new shares, venture capitalists have the option of maintaining their ownership stake into targets equity by acquiring at least the same percentage of the future share offering.

    Exit rights: International literature shows that venture capitalists structure their deals in order to facilitate their future exit; they may preplan possible exit routes or retain several exit rights to ensure an exit. Venture capitalists in fact acquire an equity stake in a target company with the aim of exiting their investment after a few years. The divestment allows them to have sufficient liquidity to guarantee a satisfactory rate of return to their external investors.

    Contingencies Contingencies are events upon which a change in the control rights and ownership structure of the business would occur. The most used contingencies included in venture capitalist term sheets are related to the achievement of:

    Economic milestones (sales, EBITDA, EBIT) Financial milestones (ROE, EPS, cash flows, debt-equity

    ratio) Strategic objectives (such as patents, client number,

    strategic market positioning)

    Changes in control rights may also occur in the case of breaches of contractual investor provisions, as well as in the case of asset sale.

    Private equity deals are structured so as to attribute more control power to the entrepreneur if the company performs well. Therefore, if the company reaches the pre-planned milestones, the controlling power exercised by venture capitalists decreases over time; if the company fails to fulfill certain milestones or objectives, the venture capitalists acquire full control.

    Risk Mitigation - Board Control Governance and contractual investor rights represent important mechanisms adopted by venture capitalists to mitigate risk and agency conflicts. For example, private equity investments are structured in such a way as to allow venture capitalists to actively participate in the managing activity of their portfolio companies through different control rights (contractually regulated), veto rights, board representation, protective provisions, affirmative and negative covenants, exit rights and stock transfer restrictions.

    Typically venture capitalists expect to partake in management decisions by having a strong position on the board of their portfolio companies. Venture capitalists often negotiate with the entrepreneur the right to take full control of the board of directors if the company fails to reach certain milestones or certain business plan goals, as well as if the entrepreneur and management team violate certain contractual provisions. Furthermore venture capitalists expect to increase their representation rights in the

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    case of poor firm performance or in the case of a weak or inexperienced management team.

    Risk Mitigation - Syndication Another risk mitigation mechanism is represented by syndication. The decision to invest is often conditional to the presence of syndicated investors. Syndication mitigates adverse selection problems and helps venture capitalists select high-quality projects. Venture capitalists seek syndication not only to minimize adverse selection risks, but also to share the overall investment risk and to increase portfolio diversification. Additionally the specialization and previous industrial experience of venture capitalists play a crucial role in the success of the investment.

    Generalist investors are associated with poorer firm performance that are due to inefficient allocation of funds across industries and to inefficient selection of investment projects.

    Risk Mitigation - Stage Financing An incentive mechanism often adopted by venture capitalists is represented by stage financing, which allows venture capitalists to monitor the progress of the project and the firm. By staging the capital injections in such a way that each financing tranche is contingent on reaching a particular goal, the venture capitalist retains an option to abandon the project.

    The possibility of abandoning the venture may be a threat for the entrepreneur, who is then encouraged to maximize effort and work in the best interests of the company.

    Stage financing may also have some side effects and sometimes fails as an incentive mechanism. For example, it may induce the entrepreneur to engage in opportunistic behaviour (such as window dressing or reality misrepresentation) in order to receive the next round of financing.

    Risk Mitigation - Debt Debt is frequently considered a powerful incentive mechanism for managers to reduce agency costs and align management interests with those of shareholders (the disciplining role of debt). Debt increases the probability of attracting high-risk firms (nuts) who follow the Heads I win-tails you lose investment logic.