Sweet Equity Concepts

Mastering Private Equity
by Zeisberger, Claudia,Prahl, Michael,White, Bowen , Michael Prahl and Bowen White
Published 15 Jun 2017

Private Equity—Quo Vadis Notes Acknowledgments About the Authors Glossary Index EULA List of Illustrations Section I Exhibit A: Total PE Industry Capital Deployed by Strategy Chapter 1 Exhibit 1.1 Limited Partnership PE Fund Structure Exhibit 1.2 Key Relationships GPs Must Manage Exhibit 1.3 Lifecycle of a PE Fund Exhibit 1.4 PE Industry Dry Powder Exhibit 1.5 Lifecycle of a Successful PE Firm Exhibit 1.6 PE Fund Cash Flow J-curve Exhibit 1.7 PE Fees and Carried Interest Exhibit 1.8 PE Fund Distribution Waterfall Chapter 2 Exhibit 2.1 Defining Characteristics of Venture Capital Exhibit 2.2 Start-up Development and Funding Exhibit 2.3 Global VC Investment by Geography Exhibit 2.4 Fundraising Considerations for Entrepreneurs Chapter 3 Exhibit 3.1 Defining Characteristics of Growth Equity Exhibit 3.2 Value Creation in Growth Equity Exhibit 3.3 Minority Shareholding Dynamics Chapter 4 Exhibit 4.1 Defining Characteristics of Buyouts Exhibit 4.2 Sources and Uses of Funds in a Buyout Exhibit 4.3 Buyout Valuation and Return Exhibit 4.4 Buyout Value Drivers Exhibit 4.5 PE Value-add: P2P Exhibit 4.6 PE Value-add: Carve-out Exhibit 4.7 PE Value-add: Privatization Exhibit 4.8 PE Value-add: Family Business Exhibit 4.9 PE Value-add: Secondary Buyout Chapter 5 Exhibit 5.1 Typical Turnaround Process Exhibit 5.2 Distressed Debt-to-Control Exhibit 5.3 Private Debt Substrategies Exhibit 5.4 Real Assets Project Stage Section II Exhibit B: PE Value Chain Chapter 6 Exhibit 6.1 Annual PE Deal Funnel Exhibit 6.2 PE Deal Sources Exhibit 6.3 PE Due Diligence Process Exhibit 6.4 PE Due Diligence Areas Chapter 7 Exhibit 7.1 Enterprise and Equity Valuation Exhibit 7.2 Valuing Early-stage Companies Exhibit 7.3 Valuing Mature Companies Exhibit 7.4 Valuation Football Field Exhibit 7.5 Historical Valuation Multiples of the Telecommunications Industry Chapter 8 Exhibit 8.1 Leverage, LBO Pricing and Return Exhibit 8.2 Two-stage Auction Process Exhibit 8.3 Net Debt and Target Working Capital Definitions Exhibit 8.4 Public-to-Privates as a Share of Total Buyouts Chapter 9 Exhibit 9.1 Characteristics of PE Financing Instruments Exhibit 9.2 Simple PE Investment Structure Exhibit 9.3 Complex PE Investment Structure Exhibit 9.4 Equity Vehicles in PE Investment Structure Chapter 10 Exhibit 10.1 Key Transaction Documentation in a Buyout Exhibit 10.2 Cash Flow Cover—Cash Flow to Debt Service Exhibit 10.3 Key Provisions in Equity Documentation Chapter 11 Exhibit 11.1 Core Governance Principles in a Buyout Exhibit 11.2 Active Ownership in PE Exhibit 11.3 Corporate Governance Principles in Minority Settings Exhibit 11.4 The Classic Triangle of Governance vs. Governance in a Family-owned Business Chapter 12 Exhibit 12.1 Assessing and Incentivizing Management Teams in Buyouts Exhibit 12.2 The PE Owner’s Role: Two Views Exhibit 12.3 Two-tiered “Sweet Equity” Structure Exhibit 12.4 Cash Flow and “Sweet Equity” Returns at Exit Chapter 13 Exhibit 13.1 Operational Value Creation Levers Exhibit 13.2 Operational Value Creation Support Exhibit 13.3 Standard Measures of PE Value Creation Exhibit 13.4 IVC 2.0 Value Creation Drivers Exhibit 13.5 IVC 2.0—Isolating Alpha Chapter 14 Exhibit 14.1 Responsible Investment Continuum Exhibit 14.2 ESG Evolution: From Risk to Opportunity Exhibit 14.3 Three Categories of ESG Exhibit 14.4 Emerging ESG Frameworks Chapter 15 Exhibit 15.1 Unrealized Value in PE Funds Exhibit 15.2 PE Exit Preparation Exhibit 15.3 Share of Buyout Exits by Type since 2006 Exhibit 15.4 Exit Alternatives and Considerations Chapter 16 Exhibit 16.1 PE Primary Fund and Complementary Vehicles Exhibit 16.2 Distribution Waterfall and Carried Interest Exhibit 16.3 Fund Investments Exhibit 16.4 All Capital First Waterfall Exhibit 16.5 Deal-by-deal Waterfall Chapter 17 Exhibit 17.1 PE Fundraising Process Exhibit 17.2 PE Fundraising Timing and Success Exhibit 17.3 PE Fund Term Sheet Chapter 18 Exhibit 18.1 PE in an Institutional Investor's Portfolio Exhibit 18.2 PE Target Allocation by Investor Type Exhibit 18.3 LP PE Portfolio J-curves Exhibit 18.4 LP PE Portfolio Evolution Exhibit 18.5 PE Fund Performance Quartiles by Vintage Year Exhibit 18.6 LP Fund Manager Selection Process Exhibit 18.7 LP Ballooning PE Portfolio Chapter 19 Exhibit 19.1 Evaluating PE Fund Performance Exhibit 19.2 Gross Performance Statistics Exhibit 19.3 Net Performance Statistics Exhibit 19.4 Performance Comparison: IRR versus MIRR Exhibit 19.5 Global PE versus Public Market Returns Chapter 20 Exhibit 20.1 Winding Down a PE Fund Exhibit 20.2 Options to Address Tail-end Funds Exhibit 20.3 Lifecycle of a Zombie Fund Exhibit 20.4 Unrealized Value Held in 2005–2008 Vintage Funds Chapter 21 Exhibit 21.1 Overview—Ways to Market Exhibit 21.2 Breakdown of LPs by Current Co-investment Activiy Exhibit 21.3 LP’s Perceived Benefits of Co-investing Exhibit 21.4 GP’s Perception of Offering LP Co-investment Rights Chapter 22 Exhibit 22.1 How LPE Vehicles Generate Revenue Exhibit 22.2 LPE Firm (LGP) IPO and Use of Proceeds Exhibit 22.3 LPE Fund (LF) Chapter 23 Exhibit 23.1 PE Risk for Limited Partners Exhibit 23.2 Global PE versus Public Market Range of Returns Exhibit 23.3 Idiosyncratic Risks Posed by PE Funds Exhibit 23.4 PE Risk for General Partners Chapter 24 Exhibit 24.1 PE Secondaries Annual Market Volume Exhibit 24.2 Limited Partnership Secondary Transaction Exhibit 24.3 Secondaries Market Pricing (Average High Bids) Exhibit 24.4 Direct Secondary Transaction Exhibit 24.5 Structured Secondary Transaction Exhibit 24.6 Total Return Swap Secondary Transaction Chapter 25 Exhibit 25.1 PE Industry AUM by Region Exhibit 25.2 PE AUM as a Percentage of Public Equity Market Capitalization Exhibit 25.3 Ten Largest Global Listed Companies by Market Capitalization Exhibit 25.4 PE Industry AUM by Fund Size Exhibit 25.5 Private Capital AUM by Strategy LIST OF CONTRIBUTORS Our distinguished Guest Authors made time to share their experiences and at times critical comments, thereby adding a practical perspective to our writing.

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Exhibit 12.3 Two-tiered “Sweet Equity” Structure The implications of this incentive structure are best illustrated through various business scenarios and possible outcomes at exit—a downside case, a base case, and an upside case. We assume a holding period of five years, with a varying amount of bank debt remaining on exit. After five years, the balance due to preferred shareholders amounts to €491.2 million, consisting of principal (€305.0) and annual dividend proceeds (€186.2). The cash flows and returns generated in the three scenarios are shown in Exhibit 12.4. Exhibit 12.4 Cash Flow and “Sweet Equity” Returns at Exit As shown, a well-structured management compensation plan can deliver significant upside to management teams if and when they deliver on a PE firm’s base case return (in our example roughly 2.5 times invested capital) or outperform the set target.

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With managers participating in a buyout as owners, a PE fund’s goal of maximizing financial return is thus shared by those in charge of executing the fund’s investment plan and managing the day-to-day operations at the portfolio company. While the structure of these compensation plans magnifies management’s potential returns on the upside, it comes with risks. A management team’s “sweet equity” and stock options produce a return several multiples of that realized by the PE fund, should an investment perform as planned. However, in the case of a poorly performing business, management’s co-investment is at risk of being wiped out, as their equity stake is often subordinated to that of the PE fund.