8
PRIVATE EQUITY | DEMYSTIFY
HOW PRIVATE EQUITY WORKS CONTINUED
negotiating power the vendors and management have, the better their packages will be. The element of the ordinary shares owned by management that is not associated with loan notes is referred to as ‘sweet equity’. It is called this when the plan is met or exceeded the percentage growth in value of this equity should far exceed the percentage growth in value of the institutional strip. For a sense of proportion, if the institutional strip is expected to double in value over the period of the investment, then the value of the sweet equity might be expected to grow to 10 times its initial value. Mathematically, as the sweet equity is not associated with loan notes, the ordinary equity that the PE house and anyone else invests in loan notes is diluted by the amount of the sweet equity. Over the period of the investment, the cash generated by the target may be used to service and often pay down (or amortise) the bank debt, and sometimes the loan notes. However, most of the loan notes and the balance of the bank debt (often the majority of that) are repaid at exit (ie when the shareholders sell their stakes). As the returns on the bank debt and loan notes are restricted to the repayment of the principal plus any unpaid, but accrued, interest or coupon any excess growth in value accrues to the ordinary shares very much like how equity value accrues to house owners who use mortgages. From the PE house perspective, it would like to invest in the highest returning lowest risk situations as they have the most chance of delivering the best returns. Good returns lead to good carry and good
HOW PRIVATE EQUITY INVESTS The vast majority of buy-outs are largely funded through loan notes from PE houses and bank debt. Bank debt attracts an interest rate that is paid periodically, and loan notes attract a coupon (really an interest rate). Typically this is between 8% and 12%. The coupon can be paid but is most normally rolled up into the principal or paid by the issue of further notes, typically referred to as ‘PIK’ (Payment in Kind) notes. The balance is funded by a thin sliver of ordinary equity. All these funds are invested into a new company (often referred to as ‘Newco’) which is formed to make the acquisition of the target. The loan notes and ordinary equity are sourced from the PE house, often the vendors and invariably the management team. The element of ordinary equity and loan notes sourced from the PE house is referred to as the ‘institutional strip’. The vendors and the management team often roll over a proportion of their value crystallised in the target because of the buy-out into loan notes and associated ordinary equity alongside the incoming PE house. If the proportions and the terms are broadly the same, they are said to have invested in the institutional strip. Management will invariably be asked to invest in the venture from their own resources, even if they have no value in the target. This is so all stakeholders have ‘skin in the game’. The ownership proportions of Newco are determined by the value of target, the relative amounts of funding being provided (bank debt, loan notes, vendor role and management investment) and negotiation. There are no hard and fast rules, but the more
Made with FlippingBook HTML5