The Private Equity Asset Class

Running head: The Private Equity Asset Class

The Private Equity Asset Class

Investment Rationale, Valuation Exercise & Modern Financial Techniques

Wilmington University

Student: Hedi Chaabouni

MBA Finance

Instructor: Mr. John J. Bish

February, 22, 2008

Table of Contents

Acknowledgments Page 3 / 102

Introduction Page 4 / 102

Part I- The Rationale behind Private Equity financing Page 8 / 102

Chapter 1: PE Asset Class Page 10 / 102

Chapter 2: PE Value Chain Page 17 / 102

Chapter 3: PE Strategic Power Page 31 / 102

Part II- Private Equity and Valuation Page 42 / 102

Chapter 7: PE Value Chain & Valuation Page 44 / 102

Chapter 8: PE & Value Based Management Page 47 / 102

Part III- Modern Financial Techniques & Private Equity Page 55 / 102

Chapter 9: Portfolio Theory in PE Page 57 / 102

Chapter 10: Risk Management & Financial Engineering in PE Page 62 / 102

Chapter 11: International Financial Management in PE Page 67 / 102

Conclusion Page 74 / 102

Appendixes: Cases in Emerging Markets

Appendix 1: Emerging Market Definition & Risk Profile Page 75 / 102

Appendix 2: DCF Valuation in Emerging Markets, the SPAM model Page 78 / 102

Appendix 2: A Case Study in Emerging Markets Page 92 / 102

References Page 102 / 102

Acknowledgments

I would like first to thank my finance instructors at Wilmington University who devoted time to teach me the concepts I need to become a well enlightened finance student. I especially thank Mr. John J. Bish for having taught me what the price of everything is; with his insight he gave me the keys to the secrets of finance.

I especially thank Mr. Aziz Mebarek, cofounder and managing partner at Tuninvest, a Private Equity firm with whom I made my first steps in the field in 1997 as a member of the board of a family business this investment firm invested in. With his unique insight, he inspired me and insufflated in me the passion for the Private Equity industry. He also gave me some feedback about his emerging market experience that helped me bridge the gap between theory and practice when writing this thesis.

Finally, a part of my acknowledgments goes to Mr. Majdi Chaabouni, a family member, today a top executive at a leading Arab bank in the Middle East. He is the one behind my dynamic of finance studies and English language graduate education. He taught me to go beyond my limits and passed me the passion of writing.

Introduction

In this recent time where Private Equity funds are thriving globally and becoming a very serious alternative and sometimes a «trendy» way to raise money and finance industrial operations and business acquisitions, I thought that a contribution to an open debate in a somewhat close financial industry would be an interesting and healthy endeavor for the educational and business communities. Indeed, many formal books already exist on Private Equity; they describe the investment process from A to Z and the different types of transactions that could take place in terms of timing, type and size of the company invested in.

Yet, my interest in the industry made me wander in spaces I never intended to visit. This year, when performing my MBA Finance, I first started working on some papers related to Private Equity and found that each paper was somewhat related one to the other. From this fact stemmed the idea of a thesis encompassing several related articles describing and outlining the hot topics today debated around Private Equity.

The first draft of this thesis was therefore entirely dedicated to explore what issues matter today in the industry, and what is the rationale behind PE investments. Its purpose was then to answer questions about PE specific hybrid nature, the reasons behind its phenomenal returns and the breakdown of its value chain, and how this type of investment has gained an indisputable power amid other financing tools.

But after a while and this thesis continuing germinating in my mind, I found these issues to be just a starting point and decided to push the reflection further and try to explore new fields in the industry by broadening the traditional scope of discussion about Private Equity. I had my part one for this thesis but what about the rest?

As the valuation concept and techniques are at the core of the Private Equity process I decided, with the advise of my finance instructor, to devote the whole second part to it. After all, neither value chain, nor strategic power, exists without a sound valuation process and techniques. Valuation being an important part of my finance curriculum, this academic thesis aiming also to encompass all the concepts I touched on in my MBA program, it was natural to describe and analyze this concept from the beginning.

As and when I kept touching on new subjects and topics in the finance courses I'm actually taking, many other questions arose in my mind about the structure of Private Equity. Issues like modern portfolio theory or risk management and the use of derivatives within PE funds fully retained my attention. What if a PE fund applies some of the principles of portfolio theory a mutual fund uses? And what if a PE fund starts using derivatives to hedge a stake acquired in a privately held business? Obviously, in Private Equity today, these are not conventional practices. Nevertheless, many unconventional practices in the past time became conventional today after researchers and practitioners gained footings in spaces formerly recognized insurmountable. Here came the idea of the last part of this thesis which I call the prospective technical part. Its purpose is dual: first to start a reflection on the practice by the PE industry of modern financial techniques today widely used in financial markets, and second to dig in some technical aspects Private Equity is nowadays exposed to as international investing.

Finally, an appendix part is devoted to study a specific and today topic in economy and finance, the emerging markets. The choice to tackle the emerging market issue is probably dictated by my belonging to a country and region classified as so. In this part, the emerging market definition and risk profile are reviewed, and a Discounted Cash Flow Analysis valuation technique specifically applied to emerging markets is highlighted and deeply explained.

View differently; this PE thesis is tackled through four different and complementary angles. First, the rationale driving the industry is deterred to reveal the reasons behind the value creation engine in PE; second a closer look is given to valuation and how its process and techniques impact PE process; third modern financial techniques are cited to explore new and unconventional scopes in PE daily management, and finally the merging market issue in economy and finance is highlighted. The objective of this thesis is hence to make readers better grasp the Private Equity industry practice and challenges and in the same get acquaintanced with a today hot topic on the global business place: the emerging markets.

Part I: The Rationale behind Private Equity financing

Why more and more investors allocate money to PE funds rather than traditional vehicles or securities like mutual funds and stocks? Is PE less risky than Mutual Funds? Of course not. So why this behavior? What makes wealthy individuals and big institutions accept to wait 10 to 12 years before receiving any of their returns? Why they accept to give a proxy to managerial teams to minister their funds and in the same time are keen to forgive almost all their monitoring power over these funds? The answer could only be that the investment is worth the waiting time, the lost of power and the risk taken. Ok.

So how this asset type works? What makes it different from other types of assets? And how PE creates this value today so much sought-after? What is underlying its value chain? Is there a house secret inside PE that makes it so appealing? Why PE firms and funds almost always outperform traditional groups and corporate holdings also involved in acquisitions and disposals of units, subsidiaries and other affiliates?

The purpose of this first part is to answer clearly and concisely all these questions that might come to you when dealing with the PE industry. Chapter 1 will explain what type of asset class is PE and how investors look at it against other financial assets. Chapter 2 will give an insight on the value chain sequence in PE and how value is created and cashed in through the entire investment process. Chapter 3 will delve into more strategic insight by trying to enlighten the reader on the strategic secrets of PE and what makes it outperforming traditional business management in terms of returns and value creation.

Chapter 1: What type of asset class is PE?

Definition:

What is Private Equity? «Any equity investment in a company which is not quoted on a stock exchange». Although everyone agrees on this basic definition, it is no more an exact one since an increasing convergence between the activities of private equity funds, hedge funds and property funds. Hence, let's get clearer about what is exactly Private Equity.

The most fundamental distinction in the PE industry is between those who invest in funds and those who then manage the capital invested in those funds b making investments in companies. This distinction is also defined by the terms «Fund Investing» and «Direct Investing».

Terminology:

Those who invest in funds are called «LP's», since the most common form of PE fund is a Limited Partnership; the passive investors are called Limited Partners. Whereas direct investment where money gets channeled into investee companies is the role of the PE manager called «GP» for General Partner.

The investment process may therefore be seen as two levels: the fund level and the company level, and this distinction is the difference between «fund investment» and «direct investment». In fact, each level requires its own particular modeling and analysis, and each also requires its skills.

Structure:

But how these PE funds work? Usually, a limited partnership is known as a close end fund since it has a finite lifetime typically between 10 and 12 years. This always has been the case in USA and UK but les the case in other regions. In Europe for example, much private equity investing took place through open-ended structures. These called «evergreen» vehicles were the subject of lot of criticism from the Anglo-Saxon observers who claimed that they provided little incentive to managers to force exits from their investments and that their returns could not validly be compared with LP's because typically there was no mechanism for them to return capital to investors.

Cash Flow:

PE funds are unlike ay other form of investment in that they represent a stream of unpredictable cashflows over the life of the fund, both inward and outward. These CF are unpredictable not only as to their amount but also as to their timing.

When a fund needs cash, either for the payment of fees or the making of investments, the GP will issue a «drawdown notice» sometimes called Capital Call. This will ask for a certain amount of money to be paid into a specified bank account by a certain date and will give brief details of what the money is required for.

The LP will then check that the purposes for which the money is required are valid according to the terms of the LPA (Limited Partnership Agreement) and that the amount has bee correctly calculated. It will then take steps to execute the «drawdown notice» by making the required bank transfer.

Distributions are the other side of the cash flow. Whenever a fund exits an investment by sale or IPO, then they will have to cash available to return to investors. This is usually done by a «distribution notice» which is just the opposite of a «drawdown notice», and will notify each individual investor of how much money they may expect to have transferred into their bank account, and when. Since the timing of exits is unpredictable the so necessarily is the timing of distributions. And to inject further uncertainty into the situation, a fund may actually sell its stake in a company in tranches over time.

Investment:

The most important thing to understand about the way in which a PE fund invests is that investment power is in the manager or GP hands. The LP have no voice at all in the investment process and, indeed, should not want to have since there is a significant risk of them losing their limited liability if they can be shown to have played an active part in the management of the fund.

The combination of passive investing and long fund lifetimes has made private equity a risky asset for some and has emphasized the need for extreme care and specialist skills in the selection of managers in the first place.

Fundraising:

Most PE funds tend to work to a 3-year fund cycle which means that in the third year of Fund I they will be out fundraising for Fund II, and so on.

The first step in the fundraising process should be for the PE team to sit down and plan their investment model for their next fund. This should consist of mapping out where the most lucrative returns are likely to be made, assessing how many of these investments they can secure, and thus how many are likely to be made in a 3-year period and how much money is required for them. They will then choose to raise exactly that amount of money plus a small contingency and no more.

The next stage in the process is to prepare an Offering Memorandum (sometimes called a Private Placement Memorandum) which is the legal document on the basis of which investment will take place, although the actual contractual document is of course the LPA, which will be signed separately by each investor, or made the subject of a subscription agreement, which will be signed separately by each investor.

What happens next is usually that the decision process is preceded or followed by a period of due diligences, during which the LP's team will carry out as much analysis and checks on the GP's. In practice, it is probably more accurate to say that in most cases the decision process will be accompanied by the due diligence process, since some analysis may well be done at a very early stage; on the historical financial performance for example; while the final decision may well be expressly subject to due diligence which has yet to be carried out.

The final stage in the process sees the lawyers intervening as the terms of the LPA are debated and negotiated. In reality, such is the bargaining strength of the GP's in desirable funds that little of any substance is usually conceded to LP's.

Returns:

How Returns are measured in PE and why? How may we compare them with the returns of other asset classes? These are several questions that this section will try to address.

First, what lies at the heart of how Private Equity works is the concept of the «J-curve». And this is exactly what makes PE so different from the other asset classes. Indeed, «Annual Returns» cannot be used as a guide to PE performance, whereas for most people this is the only return that matters for every other asset class.

We already said that unlike any other asset classes, an investment in a PE fund represents an investment in a stream of cash flows. Of course there are other assets which would appear to satisfy this definition like bonds, but a huge difference remains between the two assets. Because a bond has typically one cash outflow and then a series of cash inflows with the exact dates and amounts, we can calculate at any time the yield of as bond.

In a PE fund, we will rather have a series of cash outflows as money is being drawn down from the LP's, but both the timing and the amount of these outflows is totally uncertain. In the same way, there will be a series of cash inflows as the GP distributes the proceeds of investments as they are realized, but again its is completely impossible to predict in advance how much each one of these will amount to, or when it will occur. In fact, the calculation of a return in the case of a PE fund can only be made once the very last cash flow has occurred. More than that, usually the biggest inflows tend to occur at the end of the fund's life rather than in the beginning.

Hence, we need to look at the compound return over time which is the IRR of a PE fund in order to assess its performance. And it is there when we meet the famous «J-curve» phenomenon. In fact, the J-curve is produced y looking at the cumulative return of a fund to each year of its life. The first entry represents the IRR of the fund for the first year of its life; the second entry represents the IRR for the first two years, and so on. In this way, any PE fund will show strong negative returns in the early years as money is drawn down. However, as distributions start to flow back to the investor then the downward shape of the IRR curve will be reversed and there will come a year when the amount of inflows will precisely match the amount of outflows, creating an IRR of zero. This is the point when the J-curve crosses back over the horizontal axis and subsequent IRR's start to become positive and upward sloping. It is this difficulty of being able to abandon the annual returns view and look from the perspective of compound returns that makes the PE industry so different and perhaps so compelling amid the entire financial industry.

Thus, PE returns are calculated and stated not as the annual returns of any year, but as compound returns from a certain year which is the year of creation of the fund to a specified year. When looking at benchmark figures in the industry as a whole or as any part of it, the all the funds which form part of the sample that were formed in the same year are grouped together and their returns become what we call the «Vintage year return». In fact, the «vintage year» will always show the compound return of all funds formed during the vintage year, from the vintage year to the date specified. If we also look at the J-curve, we realize that at any time, the vintage year returns for the last few years meaning the most recent should be very low or even negative because they represent the equivalent of the first few years of the J-curve, at a time when even the best PE funds will show negative returns. And subsequently, the greater the number of years over which a vintage year compound return is calculated, the more robust it becomes, the less deviation there is likely to be between it and the final fund return. It is indeed meaningless to look at the performance of a PE fund in the early years; generally these are the first five years.

Now that we clearly defined the asset class and explained how it works and how its returns are viewed and computed, let's turn to the next chapter and see how the PE asset class creates value for its investors and what is the exact process of value creation for a PE fund. In other terms, let's try to mirror and understand from a sequenced process perspective, the J-curve and the compound returns of a PE fund we just touched on in this chapter.

Chapter 2: PE Value Chain

Private Equity funds are institutional and privately owned investment vehicles managed by highly skilled and multidisciplinary teams that invest equity and quasi equity, for a limited period of time, in growing businesses, usually unlisted, with potentially high returns. Since these funds make the major part of their profits when the owned stake in a firm is sold out, the «portfolio firm valuation» is the central piece for assessing the total return on investment.

Capturing indeed a «firm value» is the beacon and the final aim of every Private Equity management team. Yet, what «value» are we discussing here? There are in fact two different values: the value paid to buy the firm stake and the one received when this stake is sold out. Both values are paramount to Private Equity funds.

Yet, to better understand the meaning of these values, let's first breakdown the investment process in a specific «value chain sequence» that will help the reader go through the dynamics of «value creation» in Private Equity.

Six stages could be laid out to describe this process even if on a practical hand each of these stages could be broken down in turn in more sub stages, but we're not going to go through this detailed process since it's not the main topic of this paper. The six subsequent stages are:

1- Selection: Firm prospects are selected to form a book of potential valuable investments.

2- Pre Valuation: From the selected prospects, few would go through a complete «valuation process» since this will determine which companies would «strike a deal».

3- Due Diligences: Once the selected prospects are pre-valued, the choice is narrowed down again and the final selection would go through a complete audit (technical, financial and legal).

4- Closing: After the results of the audit, one or more companies will receive both the fund team agreement to enter in the fund portfolio for a determined period of time.

5- Portfolio Management: These portfolio firms will be actively managed by the inside managerial teams with the full support of the fund team to reach the operational and financial objectives set at the closing stage.

6- Post Valuation: When a portfolio firm has reached the objectives and goals set at the closing stage, generally after 5 years of operations, the fund team starts looking again at the new value of the firm in order to prepare the selling of the company. A new valuation is then undertaken by the fund analysts' team.

7- Exit: After a period of time, generally 5 years, the portfolio firm stake initially invested will be sold out to a strategic or a financial buyer, the fund then makes its return on investment and creates value for its shareholders.

Naturally, all the stages participate in their way to create value and generate returns for the investments undertaken:

Ø The «Selection» stage allows the funds to wisely select its prospects through an adequate fundamental and environment analysis.

Ø The «Pre Valuation» stage through a specific «financial analysis» precisely values the retained target companies.

Ø The «Due diligences» stage allows through a thorough audit of the technical/operational, financial and legal aspects of the company to alleviate the investment risk and target only healthy firms.

Ø The «Closing» stage is a check point that allows the funds to form a potentially valuable portfolio.

Ø The «Portfolio management» stage enables the firms already in the fund portfolio to reach the goals and objectives set and agreed at the «closing» stage.

Ø The «Post Valuation» also values trough a specific «financial analysis» the portfolio companies that will very soon exit the fund perimeter.

Ø The «Exit» stage is another check point that allows the funds to realize and «cash in» its returns.

Our main purpose in this paper is to distinguish through the different stages of the Private Equity «value chain sequence» what are the stages that contribute to the «intrinsic value creation» compared to the stages that don't but rather create value through «investigation and negotiation dynamics».

Hence, we came up to a simple classification here laid down in the next diagram. The «Selection», «Pre Valuation», «Post Valuation», and «Portfolio Management» stages are part of the «intrinsic valuation» process in the sense that they all contribute to the inception, determination and build up of the «intrinsic value».

Whereas the mechanisms driving the «Due diligences», «Closing» and «Exit» involving both «technical and operational expertise» and «corporate legal and financial engineering tools» that are beyond the scope of this paper, are stages that help, throughout the «investigation and negotiation process», transform the «intrinsic value» in a «real» or «strike value» that is the value agreed upon whether at the investment or at the divestment phase.

Here after is laid down a graphic that summarizes and synthesizes the concepts of the value chain process and its sequence as we explained in this chapter.

Negotiation or Strike Value

Intrinsic Value

Investigative Value

Economic Value

Check Points Value

Private Equity Value Chain Breakdown

Selection

Due Diligences

Potential Valuable Portfolio

Pre Valuation

Closing

Portfolio

Management

Portfolio Value Maximized

Post Valuation

Exit

Fund Returns Maximized

The following will be a dig in the different stages that make up the intrinsic value of the firm, which we consider the main parameter that fund managers should look at when dealing with an investment in a company and also when looking at the fund as a whole.

We absolutely don't say here that the other stages laid down in the PE value chain process are not important or less important, each stage has its own importance that is equally weighted compared to the other, because if it is no the case, there will no «chain» process, as we know in a chain each ring is equal with all the rest. These stages have also a clear impact on the «intrinsic value», whether it is the «due diligences», the «closing» or the «exit» stage because they can or increase or decrease the «intrinsic value» with the results and outcomes of the «investigation and negotiation dynamics». Our purpose in the following sections is indeed to point out how this «intrinsic value» is located and monitored through the value chain process to enable a PE fund to collect the maximum amount of intrinsic value in its portfolio thus creating the maximum wealth for its shareholders.

The «Selection» stage:

Let's now delve into our first stage and try to answer how Private Equity fund teams should select their prospects. From a «security» perspective, the proper price for a firm stock is based on a forecast of the future dividends and earnings that can be expected from the firm. This master part of the valuation process is called the «fundamental analysis».

Yet, because the prospects of the firm are tied to those of the broader economy, «fundamental analysis» must also consider the «business environment» in which the firm operates. Hence, «macroeconomic» and «industry» circumstances must be examined in order to assess the environment in which the firm involves. Briefly outlined, the «environment analysis» includes (Bodie, Kane, Marcus, 2007):

A- Macroeconomic Analysis

· The Global Economy

· The Domestic Macro economy

· Demand and Supply Analysis

· Government Policy: Fiscal, Monetary and Supply-Side policies

· Business Cycles and Economic Indicators

B- Industry Analysis

· Definition of the Industry

· Sensitivity to the Business cycle

· Sector Rotation

· Industry Lifecycles

· Industry Structure and Performance

Traditionally, the «security analyst» works out this analysis throughout the «valuation process» so that investors are well informed about the future expected returns of the stock in consideration. In Private Equity, the «investors» are the fund shareholders that gave a proxy to the fund management team to administer and manage the fund in order to reap the maximum returns allowed under the specific circumstances. Hence, fund managers should consider their private targets as «securities» or «stocks» to be analyzed prior to any investment decision. In this case, «fundamental analysis» remains the most rigorous and most reliable process to analyze an investment prospect.

Indeed, «environment analysis» due to its rigorous and orderly approach would help financial analysts in Private Equity funds apply a «market methodology» to private and closely held firms that:

- Will mitigate investment risks by deeply looking into all the financials and economics that drive a firm future value.

- Will pave the way for extracting a higher value in the future.

Yet, the exercise could seem more complex when a firm involves in an «emerging market» (see annex for a detailed definition of «emerging market») environment where economies are less efficient, less transparent and more volatile than in the «developed markets». This «asymmetry» problem in itself is sufficient to emphasize the enforcement of an aggressive «environment analysis» using all the means and tools at hand (national reports and studies, international organizations data centers and reports, central banks notes and reports...).

The fact here is that due to this high volatility, «environment analysis» should be emphasized as for a «traded security» in order to allow mitigates the incremental risks associated with the expected higher returns. But because financial and economic data are often hard to define due to the lack of transparent and exact available information, the market driven methodology would spur the managers and analysts involving in these «emerging markets» deals to keep more than an eye on the importance of «environment analysis» which in turn would stimulate more efforts and research to look at and determine what stands in and behind the economic and industrial drivers for the firm and the sector targeted.

To conclude on this part, through an adequate screening of the sectors, their industry drivers and macroeconomic factors, we came up to qualify this «selection process» as the inception stage of «intrinsic value» for a private equity portfolio. Indeed, a wary and wise choice for future investments is the start point for «value creation» in private equity funds. The following parts dealing with the next stages will say more about how «intrinsic value» is build up.

The «Pre Valuation» & «Post Valuation» stages:

In this part, our analysis will only focus on both «valuation». In other terms, the «valuation» stages will answer these two questions:

a. How these funds value businesses to find bargains for their future investments (Pre Valuation)?

b. And how they value again these investments when comes the time to sell them out (Post Valuation)?

The answer is that these funds should look every time to the «intrinsic value» or «technical value» of the firms before deciding on whether or not they should invest in the firms prospected and selected and also after having invested and managed the portfolio firms. It is only by looking at the «intrinsic value» of the firms before and after investments that the funds would maximize its opportunities to realize the required returns by its shareholders.

At the «Pre Valuation» stage, after having selected some potential targets probably involving in different business segments and different environments, the main challenge of the fund team is to decide from its prospects the right «bargains» to «strike» for. Another challenge awaits the fund team after having invested some potentially interesting companies and managed them throughout the portfolio for a limited period of time; it is the «Post Valuation» stage. At both stages, the funds analysts' teams work out the «intrinsic value» of the firms under scrutiny. From the latter analysis, some potential interesting firms start to show up in different environments and different sectors.

Now, the challenge of the fund team is to select from its prospects the right bargains to strike for. The analysts' team starts then figuring the «intrinsic value» of the firms targeted; this is what we called earlier the «valuation» stage. Many valuation techniques and models exist (e.g. DCF, Multiples & Comparables, Real Options) when the exercise is to value companies and each situation requires a specific set of tools; a framework describing each situation and what method to employ for valuation purpose exists in the financial literature; but the «fundamental discounted cash flows» (DCF) is by far the most used by the professionals and the one that best fit the valuation of closely held companies targeted by Private Equity funds.

The «Portfolio Management» Stage:

Getting into the last part of this paper, everyone agrees that the fundamental goal of a firm's financial management is to maximize shareholders wealth. This obviously applies to Private Equity funds, where as we said earlier, the ultimate goal of the fund management team is to create the maximum value for its shareholders.

But how shareholders wealth and value are created in a business? The answer is that when a firm makes an investment that will return more than the investment costs in today`s value. Said differently, a firm is constantly expanding its operations through capital investments to finance new projects and the underlying new assets. These new capital assets make the production capacity of the firm. These investments will also determine how efficiently the firm will operate and how profitable it will be in the future.

In real life, as a firm has more than one project in its «project portfolio», its management is always confronted with a crucial choice: what projects should be undertaken now and what projects should be delayed? As these projects are typically expensive, their implementation will determine the competitive position and the long term survival of the firm in the marketplace. Hence, no one can doubt that deciding on what, when and how it costs to implement a specific project could be absolutely critical for a firm future health. Facing this decision, the firm management should therefore be at the same time prudent and wise without losing insight on the opportunity costs if a project is not undertaken. In another words, these decisions are highly challenging.

That's when financial «capital budgeting» should become the «science» for the managers faced with these challenges. Indeed, several methodologies are at hand when dealing with capital budgeting, although we can safely state that the «Net Present Value» (NPV) discounted cash flow (DCF) model is the most achieved technique in modern finance. The NPV of a capital expenditure in a specific project is the present value of all cash inflows, including those at the end of the project's life, minus the present value of cash outflows. The NPV rule is to accept a project if NPV > 0 and to reject it if NPV < 0 (Eun and Resnick, 2007).

Additional methods exist (IRR, Payback, Profitability Index...) for analyzing capital investments and each of them can provide pieces of information for decision making, but the NPV is considered to be superior when dealing with capital budgeting decisions.

Turning back to our firm management faced with this decision making process, we can safely assume that if a firm «projects portfolio» is prioritized according to the NPV rule that is the first project that will be undertaken is always the one with the higher NPV, the firm management is taking the right and wise decisions regarding its expansion aiming to maximize the shareholders value. Said differently, if a firm undertakes its capital investments according to the NPV rule, it means that it has prioritized its expansion stages and «disciplined» its «growth» in order to achieve the highest shareholders wealth.

Let's just translate all this methodology to Private Equity funds. If the fund management team is actively involving in the management of its portfolio firms with a unique goal that is maximizing its shareholders value, then the fund managers should accompany and support the whole portfolio firms' management to adopt this «disciplined growth» by obeying to the NPV rule. The aggregate result would be a maximization of the fund portfolio value.

A diagram presenting the portfolio «intrinsic value» maximization mix in a Private Equity fund is laid down in the next page.

Maximization of the Fund Total

Intrinsic Value

Portfolio Intrinsic Value Maximization Mix in Private Equity

1^st: Prospects Selection via Environmental Analysis

3^rd: Portfolio Management through Capital Budgeting & Disciplined Growth

2^nd: Firm

Pre Valuation using DCF

Chapter 3: The Strategic Power of Private Equity

To address the issue of what drives the strategic power of PE funds and understand what is behind the phenomenal returns of the major PE funds, albeit the early negative returns we touched on when we explained the J-curve phenomenon in Chapter 1, I tried to take ground on two articles recently released on the September 2007 «Harvard Business Review». These articles are totally independent one from the other, yet I kept asking myself whether the first could feed the latter and reciprocally and found out after thought that these two articles combined will form an excellent source of knowledge for our current issue.

Indeed, the first article named «The Strategic Secret of Private Equity» is dealing with the strategies Private Equity firms deploy to achieve high returns on investments, the latter named «Rules to Acquire By» depicts a methodology to abide by for groups of companies and corporations seeking to expand and grow using external acquisitions. Obviously, the basic common ground between these two articles is the fact that both Private Equity funds and Corporate groups are engaged in a permanent process of external acquisitions. Yet, their in-house alchemy differs and so are their returns and successes.

Through the analysis of both cited articles, I will attempt in this chapter to give an insight about the «strategic power» of Private Equity funds by comparing them to common corporations and private groups. The fact is that usually, corporate groups are also constantly involving in acquisitions processes. So by comparing the respective practice of PE funds and Corporate groups when dealing with acquisitions, we will give an insight on what drives the dynamics of both toward success or failure, and try to find out if one category could learn from the other.

In the first cited article, Felix Barber and Michael Goold, both directors at the «Ashridge Strategic Management Centre» in London, attempt to give a strategic insight on the powerful «Secret» Private Equity firms use and in some cases probably abuse to dramatically increase the value of their investments.

The question is why Private Equity firms achieve high growth and correlated high returns in the businesses they acquire whereas Corporate groups barely digest their acquisitions and wait a long term before experiencing acceptable returns?

Many well known reasons could answer this question (Barber and Goold, 2007):

- Both Private Equity firms' Managers and Portfolio Businesses Operating Managers receive high incentives,

- An aggressive use of leverage and debt which provide both financing and tax advantages,

- A clear focus on cash flows and margins improvements,

- A freedom from restrictive public companies regulations being private and often closely held entities.

But the fundamental reason behind Private Equity skyrocketing growth and returns is something else. The driver for such encountered successes is more mechanical and less financial than usual practitioners could observe. Indeed, Private Equity industry thrived in the mid-way between «pure financial investment firms» and «pure operational management businesses». This pivotal position to refer to a mechanical term makes the major reason for Private Equity blurring success. Let's just think about this a few moments. Is there another type of investor that holds this strategic position amid the financial and business community? In my opinion, the answer is obviously negative.

The authors qualify this phenomenon as Private Equity funds «standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. That strategy, which embodies a combination of business and investment-portfolio management, is at the core of Private Equity's success». The Venn diagram here after presented, reveals the «Hybrid Nature» of Private Equity firms.

Investment Portfolio Management Firms

Operational Management Businesses

Private Equity Firms

However, this «Buy-to-Sell» strategy could not be fully implemented by Corporate groups that acquire businesses with the intention to integrate them into their core operations creating synergies for a long term run. In the meanwhile, and as Private Equity track records show, the «Buy-to-Sell» strategy is perfectly matching when the purpose of the investment is to make a one-shot, short to medium term value creation.

For that, buyers must take the ownership and control of a target company, often one that hasn't been aggressively managed and so is currently underperforming or an undervalued business with potentials not yet apparent. In such cases, after the changes necessary to achieve transformations and drive up the firm value have been implemented (usually around 5 years), it makes sense for the buyer to sell out the business and turn over to new opportunities following the same line fashion.

In fact, records also show that Corporate groups, usually public companies, still holding to their acquisitions even after value creation changes and transformations occurred, are somewhat diluting the terminal value and final return of their investments by forgiving to sell out businesses at the apex of their value.

Both practices are indeed justified by the different ways Private Equity funds and Corporate groups work and also by the manner their respective shareholders perceive their buying activities.

First, PE funds are obligated by their shareholders to sell out the portfolio businesses and liquidate the entire assets of a fund within its lifetime; therefore acquired businesses remain under pressure to perform. Whereas as Corporate groups shareholders expect long term synergies (sometimes in vain!) and operational integration that will sustain the total shareholders value in the future, the businesses belonging to their portfolios don't get immediate attention from top management whether they are well or under performing and thus reflexes to immediately restructure, sell out or take on other strategic actions are not triggered in a timely manner as do Private Equity funds, always on the hot spot.

This in turn leads to another reason for the insolent performance of the Private Equity industry. Because, Private Equity structure requires a rapid turnover of businesses due to the limited life of the funds, the result is that PE funds gain strong and fast knowledge of buying, transforming and selling businesses that few Corporate groups develop. Perhaps the nature of Private Equity top managers has also something to do with that, whereas Private Equity partners as former investment bankers are keener to trade, most Corporate groups top mangers have operational and line background and are so more comfortable to manage that to buy and sell.

Now, after having discussed all these differences, the question is what should Corporate groups do and change to narrow down if not overcome the outperforming Private Equity industry?

The authors give a tangible answer by proposing two distinct strategies:

1- Adopt the same Buy-to-Sell framework

2- Take on a Flexible Ownership strategy

Rapidly explained, the first point could be implemented by overcoming a corporate culture of a «Buy-to-Keep» strategy embedded in the nature of Corporate groups. It also requires that a Corporate group develop new resources or shift them, hire new skills and change some of its structures to adopt Private Equity oriented approach. This strategy should also be explained to shareholders which beliefs can be qualified as somewhat traditional; in that case, both the board and the top management need to argue the new approach of the Corporate group portfolio of businesses. This can be easily expressed but highly challenging to implement and achieve.

In contrary, the «Flexible Ownership» means that a Corporate group could hold on acquired businesses as long as these can add significant value by improving their performance and continuing their growth, and then can dispose of them once it is no longer the case. In fact, if a Corporate group decides to hold on to an acquired business, it can give it a competitive advantage over Private Equity funds which must sometimes forgo substantial over returns they could realize if they would keep on the investment for a longer period of time. «Flexible Ownership» is likely to lure most industrial and services holdings with fewer synergies between subsidiaries, Corporate groups could keep businesses with potential long term core synergies or transform and sell units with no longer more synergies yet with a sustainable go-alone strategy. Following the «Flexible Ownership», Corporate groups should also be wary about keeping businesses after corporate top management could no longer contribute to create more value. In a sense, the latter comment embodies the «gauge» that indicates when and whether a business should be kept, transformed or sold.

Taking ground on all what we explained here up, let's now find out what the second article provides as insight for the present discussion. This article deals with the outstanding success of Pitney Bowes, a US company that experienced 70 external acquisitions in six years!!

Pitney Bowes is a US multinational firm specialized in providing mail stream solutions that allow companies to improve and integrate all the activities essential for business communication, the company operates in 130 countries with a current turnover of $5.7 billion.

The author, Bruce Nolop, an Executive Vice President and CFO of the company, is arguing that success or failure from an external acquisition process is due to the mere fact that some companies have figured out how to do it right, and other don't.

The problematic laid out here is the fact that much recent studies revealed that the «impulse to buy other businesses is a sign of weakness, that corporate cultures don't mix, and the majority of acquisitions simply fail». Yet, on the flip side, the records show that world's most successful companies rely heavily on acquisitions to achieve their strategic set of goals and objectives.

So the question is: who is right? As a part of an answer to this question, Bruce Nolop tried to bring up and share the experience of his company in the subject, through a fairly set of basic rules that could apply to most companies.

Here are his key guidelines:

- Rule 1; Stick to Adjacent Spaces: This approach means pursuing development on logical extensions of a company's current business mix, which can be taken on incrementally.

- Rule 2; Bet on Portfolio Performance: This rule emphasizes the fact to manage acquisitions as a portfolio of investments introducing diversification and all the technical rules applied to asset management in terms of risk analysis, liquidity and expected returns.

- Rule 3; Get a Business Sponsor Involved: Acquisitions processes should be sponsored by inside business leaders who establish and maintain strong working relationships with the new management teams to smooth their entry into the buyer culture and operating procedures.

- Rule 4; Be Clear on How the Acquisition Should be Judged: Distinguish between acquisitions that will perfectly fit into a business or a market the buyer is already in, and acquisitions that takes the buyer into a new business space or activity. Both types should be treated and appraised differently, the second is naturally more difficult and entails more risks that the first.

- Rule 5; Don't Shop When You Are Hungry: On a strategic level, «Hungry» means that the business is missing an element that the management feels it urgently needs. However, this does not have to translate into impulsive acquisition.

In fact, whether or not this set of rules perfectly matches other companies, the main lesson applies to all businesses: acquisitions should be managed as a «process». As all business processes, this one should be documented, practiced, improved and mastered. Said differently, it means laying down the «complex chain of actions typically involved in an acquisition, paying attention to what can go right or wrong at different stages, standardizing effective approaches and tools, and continually improving these approaches». «This aims to create more smart and efficient buyers, discipline the unit managers about which companies should get into an acquisition pipeline, and help keep away from apparent tempting deals that turn out to be in fact disappointing. This also ensures that the acquisitions completed would finally make more strategic, business and financial sense».

Does this process-oriented acquisition strategy developed by Pitney Bowes Company and here laid out answers to the previous question about how could Corporate groups compete in the area with Private Equity firms? I'm pretty much sure that readers will find out on their own.

In fact, although the majority of already known cases highlight a segmentation of strategies for the Private Equity funds and the Corporate groups, each one could learn from the other by adopting the outsider line of work if and when the case appeals so.

Private Equity could hence benefit from a «Buy-to-Hold» strategy for portfolio firms that still show high growth and more value creation in a longer term (more than 5 or 6 years) to end up with a much high profitable sell out of the business.

Corporate groups could in turn reap profits from a «Buy-to-Sell» strategy and sell out or spin-off businesses that have reached successful transformations in a limited time fashion, avoiding in the same time to consider such «divestments» as «strategic errors».

Part II - Private Equity & Valuation

Before unveiling what our chapters are about, I couldn't find more interesting words than those of Luis E. Pereiro to introduce the toughness of the issue in his preface of «Valuation of Companies in Emerging Markets» (Wiley, 2001):

«Valuation is the point at which theoretical finance hits the harsh road of reality. You may be one of the many managers, advisors, or researchers faced with appraising the economic value of a new investment project, a merger, an acquisition, or a corporate divestment. You may have attended formal finance courses; you may even hold an MBA or an MFA; and still you are puzzled and frustrated when you attempt to implement the elegant theories of corporate finance in real life valuation exercise. This is hardly surprising, for financial theory and practice have formed an easy partnership that often ends in dissolution. On one side, of this partnership are the academics, who have their sophisticated risk-return models; on the other side the practitioners, who stand by their expertise in crafting real-life acquisition deals. The professional appraiser sits uneasily between the two groups, often being squeezed uncomfortably by both. All the while, the crucial problem - how to sensibly and plausibly value a real asset- remains at best only partially solved.»

After reading these words, I guess the tone is set up for what will follow. How the PE industry deals with the valuation of companies is a tremendous issue. In this part, we will not be able to dig into the details of the valuation techniques but rather point out how the industry tackles that.

Hence, the first chapter will give an insight about how PE funds deal with the valuation of companies across their «value chain»; whether at the pre acquisition or at the post acquisition stage (chapter 2). It will also point out what are the practices of PE funds regarding valuation as a daily management issue.

The second chapter will rather emphasize the notion of «Corporate Value creation» and the so called «Value Based Management», and stresses the standpoint of PE funds toward these notions and concepts.

Chapter 4: Private Equity Value Chain & Valuation

Before delving into the core of this chapter, we need to quickly explain where PE funds conduct their business, in other words, what are the domains where PE funds thrive.

PE funds as we said earlier are hybrid vehicles sitting between classical corporations and asset management investment funds. This is also the case from the standpoint of their acquisitions. Indeed, PE funds have two targets of firms:

1- Closely held companies, non publicly traded stocks

2- Publicly held and traded companies

A simplistic definition would say that usually the PE funds involving in the acquisition of the first type of companies are called «Venture Funds» and «Generalist Funds»; whereas those involving in the second type of companies are called «Buyout Funds».

Venture & Generalist Funds have a clear exposure to early and growth stage companies thus almost always invest in closely held corporations; whereas Buyout Funds have more exposure on traded stocks in the way that they structure their deals to extract the publicly held company from the stock market and make it go private with the Buyout Fund as the main shareholder.

This being presented, we can assume that these two types of PE funds have different practical approaches to how to appraise their targets but remain convergent regarding the financial techniques and models used for that. Hence, we will not present in this chapter their differences but rather the common ground in valuation between them.

Usually, in developed countries and markets, the valuation of public or closely held companies is a precise endeavor: the classical models of corporate finance must be considered and adapted when dealing with real-life valuations. In the US, considered the most efficient financial market, the use of well established frameworks such as the CAPM, the arbitrage pricing theory (APT), or the real options, poses serious challenges to the practitioner. No agreement exists among academics and practitioners concerning many crucially important issues, issues as basic as deciding on the market risk premium to be used, whether an option is truly embedded in a real asset, or how precise the multiple method is compared to DCF analysis. This demonstrates how perilous is the appraisal exercise for professionals dealing with real assets, which is our case for the PE industry.

Now, for the PE funds, and according to the «Value Chain» we described in chapter 2, we can safely confirm that the most important valuation exercise concerns the «Pre Acquisition» stage, what we called «Pre Valuation». Obviously, before taking the last decision to put money in a company, the fund should be profoundly aware about the exact value of this company. Since the investment will be carried out for a period of about five years, the «Pre Valuation» will be the masterpiece of the transaction process. We need to keep in mind to understand this, that the PE fund doesn't know well the company at the Pre Acquisition stage, sometimes neither its specific products, nor its top management. The issue evolves differently at the Post Acquisition stage, when the PE fund had the time to better know the firm, its core business and its management style.

Obviously, the Post Acquisition will also require a new valuation of the portfolio company after a number of years in the fund portfolio, but this will be a «light» version of the «Pre Valuation» mission. So rather than the «Pre Valuation» which involves a precise and thorough deployment of the «Valuation Process», the «Post Acquisition» will be more or less a monitoring of the value appraised at the Pre acquisition stage.

Now that the differences between the Pre and Post Valuation highlighted, let's set a framework for this «Valuation Process». The one that will be presented here after is more suited for the Venture &n Generalist Funds and their closely held early and growth stage companies than for the public companies targeted by Buyout Funds. Although, the differences are sometimes thin, we preferred to focus more on the closely held companies case and the inherent practices of the Venture and Generalist PE funds, and less on the Buyout Funds practices that target public listed companies since there is plenty literature for valuation of public stocks here in the US and also because this thesis is more about private equity in the sense of privately held companies by opposition to publicly held companies.

Chapter 5: Private Equity & Value Based Investing

Is there a room for «Value-Based Investing» in the PE industry? To answer this question, let's first rapidly define the concept.

The notion was first introduced by Columbia Professor Benjamin Graham in his classic «Security Analysis» text where he developed a method of identifying undervalued stocks, meaning stocks whose prices were less than their intrinsic value. This became a cornerstone of modern value investing. Also, Graham approach was to focus on the value of assets such as cash, net working capital, and physical assets.

But this approach has since evolved under the philosophy of investor super guru Warren Buffet. Indeed, Buffet modified that approach to focus also on valuable assets such as franchises and other intangible assets that were unrecognized by the market at that time. Here are the principal elements of Buffet investment philosophy:

1- Economic reality, not accounting reality: Financial statements prepared by accountants conformed to rules that might not adequately represent the economic reality of a business.

2- The cost of the lost opportunity: Buffet compared an investment opportunity against the next best alternative, or the marginal best alternative in more economic words; that is the «lost opportunity».

3- In value creation, time is money: Buffet assessed intrinsic value as the present value of the future expected performance and that book value is meaningless as an indicator of intrinsic value.

4- Measure performance by gain in intrinsic value, not accounting profit: The gain in intrinsic value could be modeled as the value added by a business above and beyond the charge for the use of capital in that business. It is a measure that focuses on the ability to earn returns in excess of the cost of capital.

5- Risk and discount rates: Discount rates used in determining intrinsic values should be determined by the risk of the cash flows being valued. The more the risk, the higher the discount rate. The conventional model for estimating discount rates was the CAPM, which added a risk premium to the long term risk-fee rate of return. Buffet developed a philosophy against Beta in computing the cost of capital by arguing the fundamental principle: «it is better to be approximately right than precisely wrong».

6- Diversification: Buffet disagreed with conventional wisdom that should hold a broad portfolio of stocks in order to shed company specific risk.

7- Investing behavior: Buffet believes that investment behavior should be driven by information, analysis, and self-discipline, not by emotion, fashion or «hunch».

8- Alignment of agents and owners: Buffet believes that to do the best investment, one should think that he is investing his own money.

Now that «Value-based investing» as Graham and Buffet conceived it, do PE funds believe in it? Apply it? And is it applicable to PE transactions.

My answer is yes. In my opinion, the majority of Venture, General and Buyout PE funds follow the philosophy of value based investing. And I do believe that PE among other asset classes is the one that embodies at best the lessons we had from Graham and Buffet.

If I go along the eight points developed by Buffet and listed here above, I would confirm that yes PE funds are good in «value-based investing» at an exception of one criterion: the use of time as a valuable asset in «value-based investing». Indeed, because of the timeline defined in the LPA's, PE mangers are almost obligated to return all the proceeds from divestments in a time fashion that do not exceed 10 years. This make them often forgo a valuable part of the excess returns a portfolio company is making but selling under time strain. Their strategic power of «buy-to-sell» as we explained in chapter 3, is good at making phenomenal returns, but also bad at making the «maximum returns» an investment can bring.

The concept of value based investing was first developed to address the investment behavior in the US stock market by institutional, private, and mutual funds investors. Yet, there is something that strikes me if I go back to my private industry and small business experience. All the principles here up exposed and developed by Buffet also perfectly apply to small businesses, in the way that they are common sense of wise and aware entrepreneurship. So if the concept applies to publicly traded stocks, closely held companies like those in PE funds portfolio, and also to small businesses as I mentioned here, does this signify that the concept is transversal and universal? I believe yes. Even if a valuation exercise applies to the most sophisticated investment opportunity in Wall Street, I really believe that a valuation process based on «value-based investing philosophy» is a common sense of how to do business wisely and not following emotions or fashions. In that sense, valuing GE or a Delaware based small business follow the same principles, even if the proportion of data to collect and the tasks to undertake hugely differ in terms of volume; in that case it is more a matter of scale than of valuation philosophy.

Back to PE, Robert F. Brunner, a Distinguished Professor at Darden Business School, University of Virginia, presents a case study in his book «Case Studies in Finance - Managing for Corporate Value Creation» (Mc Graw Hill, 2007) that deals with a growth stage Private Equity investment. The reflection process held by Louis Elson, Managing Partner at Palamon Capital Partners, a generalist UK based PE fund, when dealing with the acquisition of TeamSystem S.p.A., an Italian based accounting and payroll software company, perfectly matches what we described as the «Value-based investing» philosophy. Here are some extracts illustrating our opinions.

Palamon Investment Process:

Palamon's investment process began with the development of an investment thesis that would typically involve a market undergoing significant change, which might be driven by deregulation, trade liberalization, new technology, demographic shifts, and so on. Within the chosen market Palamon looked for attractive investment opportunities, using investment banks, industry resources, and personal contacts.

About TeamSystem S.p.A.:

TeamSystem was founded in 1979 in Pesaro, Italy. Since its founding, the company had grown to become one of Italy's leading providers of accounting, tax, and payroll management software of small-to-medium-size enterprises (SME's). Led by a cofounder and CEO Giovanni Ranocchi, TeamSystem had built up a customer base of 28,000 firms, representing a 14% share of the Italian market.

Palamon's search generated the opportunity to invest in TeamSystem S.p.A. In early 1999, before Palamon's fund had been closed, Elson had concluded that the payroll servicing industry in Italy could provide a good investment opportunity because of the industry's extreme fragmentation and constantly changing regulations. History had shown that governments in Italy adjusted their policies as often as four times a year. For Palamon, the space represented a ripe opportunity to invest in a company that would capitalize on the need of small companies to respond to this legislative volatility.

Industry Profile:

The Italian accounting, tax, and payroll management and software industry in which TeamSystem operated was highly fragmented. More than 30 software providers vied for the business of 200,000 SME's with the largest having 15% share of the market; TeamSystem ranked number two with its 14% share. All of the significant players in the industry were family-owned companies that did not have access to international capital markets.

Analysts predict that two things would characterize the future of the industry: consolidation and growth. Consolidation would occur because few of the smaller companies would be able to keep up with the research and development demands of a changing industry. As for growth, experts predicted 9% percent annual growth over the period 1999-2002. That growth would come primarily from increased personal computer penetration among SME's, greater end-user sophistication, and continued computerization of administrative functions.

The Transaction:

After TeamSystem pas performance and the sate of the industry, Elson returned his attention to the specifics of the TeamSystem investment. The most recent proposal had offered EUR25.9 million for 51% of the common shares in a multipart structure that also included a recapitalization to put debt on the balance sheet.

Valuation:

To properly evaluate the deal, Elson had to develop a view about the value of TeamSystem. He faced some challenges in that task, however. First, TeamSystem had no strategic plan or future forecast of profitability. Elson only had four years of historical information. If Elson, were to do a proper valuation, he would need to estimate the future cash flows that TeamSystem would generate given market trends and the value that Palamon could add.

His best guess was that TeamSystem could grow at 15% per year for the next few years, a pace above the expected market growth o 9%, followed by a 6% growth in perpetuity. He also thought that Palamon's professionals could help the CEO improve operating margins slightly. Lastly, Elson believed that a 14% discount rate would appropriately capture the risk of the cash flows. That rate reflected three software companies' trading on the Milan stock exchange, whose betas averaged 1.44 and unlevered beats averaged 1.00.

The second challenge Elson faced was the lack of comparable valuations in the Italian market. Because most competitors were family-owned, there was very little market transparency. The nearest matches he could find were other European and U.S. enterprise resource planning (ERP) companies and accounting software companies. Looking through the data, Elson noticed the high growth expectations (greater than 20%) for the software firms and correspondingly high valuation multiples.

Risks:

Elson was concerned about more than just the valuation, however. He wanted to evaluate carefully the risks associated with deal, specifically:

- TeamSystem management team might not be able to make the change to a more professionally run company. The investment in TeamSystem was a bet on a small private company that Elson hoped would become a dominant, larger player. Its CEO had successfully navigated the last five years of growth, but had, by his own admission, created a management group that relied on him for almost every decision. From conversations ad interviews, Elson concluded that the CEO could take the company forward, but he had concerns about the ability of the supporting team to deliver in a period of continued growth.

- TeamSystem was facing an inspection by the Italian tax authorities. The inspection posed a financial risk and therefore could serve as a significant distraction for management.

- The company might not be bale to keep up with technological change. While the company had begun to adapt to technological changes such as new programming languages, it still had some products on older platforms that would require significant reprogramming. In addition, the Internet posed an immediate threat if Team System's competitors adapted to it more quickly than TeamSystem itself.

Finally, Elson wanted to make sure that he could capture the value that TeamSystem might e able to create in the next few years. Exit options were, therefore, also an important consideration

Part III - Applying modern financial techniques in Private Equity

This last part is the one I describe as the «most technical» part. Indeed, the three themes I want to introduce here are all very important because these are the cornerstones of modern financial theory, yet they are also very technical and sometimes they imply many mathematical concepts that are somehow difficult to grasp or to dig in, as it is the case for the financial risk management discipline.

My goal here is not to unveil details about these techniques, this is nor my level of knowledge, neither my purpose. My goal for this thesis is to understand how PE funds deal with these financial techniques when they are confronted to such issues, and for sure they are. I also want to give to the reader an insight about the different practices PE funds use when it comes to face such financial issues in their daily managerial duties.

Divided in three chapters, this part starts by explaining the stand of PE funds toward financial risk management. Then, it will move to a more contemporary issue by giving some thoughts about where modern portfolio theory lays out when dealing with asset management funds in the Private Equity class. Lastly, we will touch on how PE funds structure their business and deal with their issues when it comes to play internationally; in other terms, do they follow and abide by the concepts of international finance or do they have their own practices in the international marketplace?

Also, I want to add that all this part is basically stemming from my own experience along head the PE industry in Tunisia, North Africa, where I spent more than 8 years working besides the PE industry and also inside. So all the analyses and conclusions in these three chapters are my own thoughts and insights about the stands of the industry toward these financial disciplines. Hence, my view could not be exactly the one that a US student will have, but I'm almost sure that the differences would be quite thin since the PE practices all over the world tend to be the same and imposed by a sort of a common body of knowledge and practice.

Chapter 6: Risk Management in Private Equity

Since I started this graduate finance program, my view was turned to the Private Equity as a financial theme so that I get all the finance disciplines I learned applied to it. I was sure from an academic point of view, that this will help me grasp the different concepts I was taught by thinking how the PE industry will behave in such or other discipline. I finally created my own case study on a rolling basis. And when came the latter course of Derivatives and financial risk management, I immediately asked my self this question: how do PE funds deal with this issue when facing different kind of risks?

Let me first lay out immediately one concept that will be helpful for the rest of the discussion. We already explained in part I and II that PE funds manage portfolios of privately held companies. Hence, there is an immediate question to ask when the financial risk management discipline: do PE funds manage risk on a fund level, which I call «direct level» or do they manage risk on a portfolio company level, which I call «indirect level»; or do they manage risk either way meaning on a «direct» and «indirect» level?

The Indirect Level:

On a portfolio company level, it is obvious for me that the executives of the company are managing risk when they are facing it. Maybe the level of sophistication in risk management depend on the size, the business and the market where the company is, but we can be safe in saying that every good management will try to minimize the risks associated with the global operations of the company if the financial market where the company is supposed to act in does allow the execution of risk management transactions such as derivatives instruments.

The Direct Level:

Now on a direct level, the question is more interesting. Do PE funds manage risk associated with their portfolios of companies on a consolidated level? In my opinion, no, I really never heard or remarked a PE fund managing risk on a global portfolio basis, yet this might exist, I simply saying here that I don't believe this is a common practice.

So, my sub consequent questions are why they don't do so and should they?

Well, I do think that PE funds executives as asset managers have an eye on the risks associated with holding those assets for a predetermined period of time. But I do think also that due to the fact that the portfolio companies are not public companies, they have already avoided » the market risk associated with the stock price, and then they narrowed down the risks to a non market one, or as it is called to an «unsystematic» risk compared to the «systematic» market risk.

Now that they have only «unsystematic» risks to manage, how can we break down these risks so that we can have a more in-depth insight into the question. I'll breakdown the unsystematic risks faced by the PE portfolio companies into four categories of risks: Forex risk, Commodity risk, Interest rates risk, and Credit risk.

As we said earlier, on a «direct level», a wise management will surely undertake to manage these four risks by:

- For the Forex, Commodities and Interest Rate risks: entering into forwards, options, futures or swaps contracts to sell, buy, take an option or exchange currencies, commodities or cash flows.

- For the Credit risks: giving a collateral pledge to creditors and/or setting up a «sinking fund» to ensure debt reimbursement.

Now let's change our perspective again to an «indirect level». Do PE funds manage these four unsystematic risks on a global portfolio basis? If the answer is yes, how do they manage those risks? And if the answer is no, how do they monitor those risks?

Since the answer is more no than yes, I believe that the best way to manage and monitor those risks on a global fund basis is to take benefit from the portfolio companies' quarter reporting by asking the top management to prepare a specific annex detailing their exposure to those four risks at the end of each quarter. Then the PE managers can sum up those risks by category for the entire portfolio and determine an aggregate exposure of the fund for each category of risk. A further step would be to include the point in the quarter board meeting with the companies top executives and discuss how the company is measuring and hedging those risks.

I really do not think it is feasible and reasonable for a PE fund to directly manage these risks stemming from its portfolio companies as consolidated positions. First, it will be hard to cover a consolidated position by one or a structured instrument, since the consolidated position is constantly and simultaneously moving in two directions. Second, the companies are probably already taking positions to hedge their inner risks, so a consolidated position would be a double action, and a hedge on a hedge could result in zero results. Third, the PE fund would be hedging quarter by quarter because it follows the reporting schedule, and thus will not be as close as the company to the periodically shifts in the risk exposures that only a company could manage on a daily basis.

Finally, there is another way how PE funds behave to deal with those unsystematic risks associated within their portfolio companies. It is not a financial technique or methodology, but rather a «legal» methodology or a series of «legal techniques» that are embedded in the most important document of an acquisition deal: the «Shareholders Agreement».

This document is crafted by highly experienced legal professionals on behalf of the PE fund and encompasses all the legal rules and actions that a PE fund could undertake if the portfolio company won't meet the expectations fixed or will behave in a way that PE funds disapprove. The shareholders agreement is also designed for other purposes such as to fix the company executives compensation or other remunerations for the PE fund, but certainly the most important part in this document is devoted to the circle the structure of the «exit» from the company invested in. By including coercive actions yet legally permitted, the PE fund can quit the company at anytime if it has been decided so. This exit is also accompanied by a series of financial decisions that tend to protect the PE funds for their investment in any circumstances and in such a case I consider the «legal tool» as an excellent technique of «hedging risks».

Chapter 7: Portfolio Theory in Private Equity

When we think about an investment fund, we immediately think «portfolio». And a series of questions arise in my mind:

- What is the typology of the portfolio in terms of risk and return?

- What are the constituents of the portfolio? Ad how many?

- What is the impact of the constituents' nature on the performance of the portfolio?

- How these portfolio constituents have bee selected? And why?

- How much time these constituents will be kept in the portfolio? And why?

If I summarize those questions, I'll be right in the Portfolio Theory core considerations. That's why this chapter deals with this discipline. My intention here is not to get in the details of «modern portfolio theory» and the way of thinking of its originators and masterminds such as Sharpe or Markowitz. My purpose here is to unveil how the PE industry stands from the perspective of portfolio theory when it sets up its funds. For sure they consider a risk return pattern but do they build a model that underpins this pattern? In another terms, are the investment decisions linked on to another to stick to this certain pattern, or are they independent and in such case the pattern is just a target yet there is plenty of flexibility for whether to reach or not this target.

Again, as we discussed in the previous chapter about «risk management», and from my experience, I never heard or met a PE fund that applies «portfolio theory» in the strict sense of the term. Yet, the basic principles of portfolio theory are indeed followed in terms of diversification of assets and portfolio risk decreasing.

Let's first define «Modern Portfolio Theory» (MPT) and mention for which investment vehicles does it apply the most to draw some differences and answer why PE funds don't use modern portfolio theory in a strictly manner but rather some basic principles.

MPT proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.

MPT is generally applied by «Mutual Funds» investing in big caps on the markets and aiming to bring income and retirement solutions to individual and institutional investors wishing to invest revenues or excess liquidities for a certain period of time and for specific purposes.

In fact, the main difference between PE funds and Mutual Funds (especially with big caps focus) is because they only invest in non public and closely held companies. Therefore, they don't deal with «market risk» or «systematic risk» associated within the publicly listed companies; again remains the «non market» or «unsystematic risk» to deal with for the PE funds.

But, PE funds and MF resemble in the way they deal with the «non market» and diversifiable risk. Indeed, «modern portfolio theory» being the way to construct «optimal portfolios» in terms of «risk-return» couple using «diversification» as a main tool to reduce «non market risk» and in consequence drive down the return as an immediate answer to satisfy the principle of «the less the risk the less the return» in an efficient financial market; the PE funds will also focus on constructing optimal portfolios using diversification and reduce the «unsystematic risk» associated with the failure of one or several companies, yet without forgoing an excess return.

Let me explain a bit more this point. Whereas MF invest in public companies considered at mature life stage (especially big caps MF), PE funds rather invest in non public and closely held companies considered more in a development or growth stage or sometimes in what we call in the PE jargon a «turnaround» stage meaning a shift from a core business to another. Growth companies are more likely to realize excess returns than any of the mature companies. That's why when investing in growth and development stage companies, PE funds have a highest probability of making excess returns than MF do.

Then, we can understand that increasing the number of portfolio companies in a PE fund will not decrease the probability of making astonishing returns because each stand alone company has a high probability of making those returns which is not the case for MF especially those investing in big caps. Hence, increasing the number of companies or investing in different industries will decrease the risks of the portfolio but will not decrease the probability of excess returns since each company has the capacity to achieve those returns. This last point also involves the experience of the PE fund team, because the more seasoned the team, the less the probability that the company won't meet the expectations in terms of returns.

Actually, we stressed the notion of MF investing in big caps because some MF behave like PE funds in the sense that they invest in small and mid caps not yet in the mature stage, hence with an important growth potential. In this case, their stance to MPT is the same than PE funds, but those MF are just different because they are open-ended not closed-ended funds.

Also, in a PE fund, risks are very high but so are the excess returns. This is actually the «financial model» of any PE fund and also partially explains the reasons why PE funds don't follow MPT in the strict sense. By being able to make growing and sustainable Cash Flows in their portfolio companies, PE funds could offset the unsystematic risks associated within those companies by selling at an opportune time and capturing the returns «today» based on the future growth and cash inflow of their companies.

The second part of the discussion regarding PE funds and MPT consists in the philosophy of investing regarding PE and MF funds. Whereas the MF (especially big caps MF) generally adopt a «buy-to-hold» strategy and don't try to time the market; PE funds rather adopt a «buy-to-sell» strategy that is independent from the financial market. Therefore, MF's look at their portfolio with a timetable that is different from the PE funds timetable. MF's try to enhance the «risk-return» function by acting «marginally», meaning that they change their perimeter to push the frontier of their portfolio to a better «risk-return» curve; whereas PE funds act «globally» (and don't push marginally) to create ad hoc an optimal portfolio that fit the best their risk-return target.

Hence, in terms of modern portfolio theory consideration, there is less need for the PE funds to apply the theoretical concepts of risk-returns models to achieve optimal portfolios than for the MF's. In reality, PE funds don't have risk-returns models, as we described here, they only target an excess return rate measured by the IRR of the fund and try to reach it by first selecting good prospects and second helping the executives reach the forecasted objectives.

Chapter 8: International Private Equity

I cannot conclude this thesis without tackling the issue of international exposure within PE funds. Nowadays, for a PE firm to succeed, or even to get a chance to succeed amid a fierce competition of deal hunters and makers, a PE management firm must have a broader exposure than its domestic market. Beyond the competition, another factor plays an important role here: the already international exposure of the companies where PE funds are investing.

Like all the previous parts and chapters, this issue could be a big endeavor to undertake in regard to a thorough analysis, and as said previously, it is not the purpose of this thesis to dig in the details of the issue. The goal here is just to bring to light a subject that became paramount to focus on for PE firms. Hence, I will just explain how important some international finance concepts are for international PE firms and try to do my best to answer a common question for all the topics here exposed: are PE firms already tackling the issue?

The frame of this chapter is derived from the book of Eun & Resnick, «International Financial Management» (Mc Graw Hill, 2006). I will obviously not touch on all the topics reported by the book but rather select two important concepts that are the most relevant to this chapter as a personal assessment. These concepts are:

- Foreign Exchange Exposure and Management

- International Portfolio Investment

Foreign exchange exposure and management:

We all know that as the nature of business becomes international, and this is the case for more and more companies even small ones because of a more globalized world economy, many firms are exposed to the risk of fluctuating interest rates. In fact, changes in exchange rates may affect the settlement of contracts, cash flows, and the firm valuation as a whole. It is thus important for the firm executives to know the firm's foreign currency exposure and properly manage this exposure.

Actually, we already touched on this subject in chapter 6 when we discussed how PE funds deal with the «financial risk management» of their portfolio firms. So by discussing this international finance part, we have the chance to dig more in its dynamics. In fact, when investing in firms with international exposures, PE funds are immediately faced with a dilemma that is paramount to them: how this international exposure will affect the cash flows and the value of the fund portfolio firms?

Since PE funds are professional investors in non public companies, their number one concern is the value of their investments. Yet, this value is affected by the international activities of their portfolio companies. So what do they do to manage this risk and should they act differently?

In chapter 6, we already exposed the notion of «direct level» and «indirect level» and we've also given some advices to how this risk should be monitored. We're not therefore going to repeat this discussion. We will rather explain in more details the nature of this risk. In fact, it is conventional to classify foreign currency exposures into three types:

- Transaction exposure

- Economic exposure

- Translation exposure

Translation exposure can be defined as the sensitivity of «realized» domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Since settlements of these contractual cash flows affect the firm's domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure.

Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm's value. Changes in the exchange rates can have a profound effect on the firm's competitive position in the world market and thus on its cash flows, capital structure and cost of capital.

Translation exposure refers to the potential that the firm's consolidated financial statements can be affected by changes in the exchange rates. Consolidation involves translation of subsidiaries' financial statements from local currencies to the home currency. Translation involves many controversial issues, because resultant gains or losses represent the accounting system's attempt to measure economic exposure ex post; and does not provide a good measure of ex ante economic exposure.

For PE funds, my view amid this trilogy is to let the company manage «transaction» and «translation» exposures as we slightly discussed the matter in chapter 6, although the PE fund should quarterly monitor those exposures in the board meetings; yet the PE fund should manage by itself the «economic exposure» since the fund is the party that has the more to lose if the portfolio firms lose value.

There are two ways to do that for a PE fund:

1- Directly manage this risk by geographically diversifying its investments in different regions that tend to behave not exactly in the same economic trend (For example: invest in developed countries and in emerging markets) so that the currencies moves tend to offset one another hence decreasing the PE fund portfolio overall risk. Said differently, PE funds should «negative economic correlation» between the different regions or countries where they invest.

2- Directly manage this risk on a stand alone basis, meaning that the PE fund should manage each portfolio company economic risk by exiting the one that has lost a certain level of value already defined by a threshold.

In any case, parallel to the management of this risk, the PE fund should also monitor the economic exposure of the fund by looking quarterly to the transaction and translation exposures of the entire portfolio.

International Portfolio Investment:

We will try in this paragraph to see how we could translate the theory of international portfolio investment from a security and financial markets perspective to a PE funds holding non public companies.

From a financial market perspective, it is clear that security prices in different countries don't move together very much. This suggests that investors may be able to achieve a given return on their investments at a reduced risk when they diversify their portfolio holdings internationally rather than domestically. In fact, investors can reduce portfolio risk by holding securities that are less than perfectly correlated; we already know from the financial management principles that the less correlated the securities in the portfolio, the lower the portfolio risk.

In fact, international diversification has a special dimension regarding portfolio risk diversification: security returns are much less correlated across countries than within a single country. This is so because economic, political, institutional and even psychological factors affecting security returns tend to vary a great deal across countries, resulting in relatively low correlations among international securities. In addition, business cycles are often asynchronous among countries, further contributing to low international correlations.

Yet, relatively low correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically. And the magnitude of gains from international diversification in terms of risk reduction depends on the «international correlation structure» which from an empirical base strongly suggests that international diversification can sharply reduce risk. In fact, the empirical studies (Solnik, 1974) show that as the portfolio olds more and more stocks, the risk of the portfolio steadily declines, and eventually converges to the «systematic» and non-diversifiable risk. Systematic risk refers to the risk that remains even after investors fully diversified their portfolio holdings.

Now to push the discussion further, let's move from the «international diversification» to the «optimal international portfolio» selection by considering not only the risk factor but the returns associated as well. We know that investors are willing to assume additional risk if they are sufficiently compensated by a higher expected return. We are here again in the «portfolio theory» analysis we touched on in chapter 7, at a difference that introduces internationalization as a factor of diversification to reduce risk and push toward an optimal risk-return frontier.

Here, the gains from holding international portfolios could be measured in two different ways:

1- The increase in the Sharpe performance measure, which is given by difference in the Sharpe ratio between the optimal international portfolio (OIP) and domestic portfolio (DP): ÄSHP = SHP (OIP) - SHP (DP), with ÄSHP representing the extra return per standard deviation risk accruing from international investment.

2- The increase in the portfolio return at the domestic-equivalent risk level, which is measured by the difference in return between the domestic portfolio DP and the international portfolio IP that has the same risk as the DP. This extra return ÄR accruing from international investment at the domestic equivalent risk level, can be computed by multiplying SHP by the standard deviation of the DP that is: ÄR = (ÄSHP)(ó DP)

Now if we try to translate all the above discussion to a non market point of view, does this analysis apply to PE funds investing in non public and closely held companies? Does international diversification reduce the risk of their portfolios? And are PE funds looking for an optimal portfolio when they are selecting international prospects?

My answer is for sure yes. Yet, when thinking and trying to stick to all these concepts, PE funds are not applying the mathematics of «international portfolio theory» compared to other international equity markets investors like international mutual funds because PE funds do not have the market historic data available for them to construct an optimal portfolio. Their process is more driven by experience and hunch to make an international deal decrease risk or increase excess return to their portfolio. Even sometimes, the target is both decreasing risk and increasing excess return by investing for example in mature industries by in a developing or emerging country; which is in opposition to other market investors for which the outcome from such diversification sticks to the rule of thumb «the less risk, the less return» (see chapter 7 for this discussion).

Conclusion

Summarizing the purpose of this thesis, I'd say that it will enable the reader to understand:

- how the Private Equity industry is shaped as a financial asset first,

- how «value» is spotted, tracked and created in the process,

- what «strategic» leverage is behind the phenomenal success of Private Equity,

- how the Private Equity inside players are considering and dealing with the concept of «corporate value» and what is and what should be their approach

- and finally, what is the standpoint of the Private Equity industry toward modern financial techniques such as Risk Management and Portfolio Theory and their extent on an internationalized front.

I promptly know that the inputs brought up by this thesis will not trigger a revolution inside this financial industry, yet I'm convinced that some parts of this work are somehow challenging and will make some readers, if there are, deeply think abut the issues outlined and consider a new perspective in the way they deal with the daily job.

On a personal side, this thesis was for me a unique occasion to dig, link and synthesize all what I learned at the frontiers of Business, Management and Finance knowledge.

Appendixes: Cases in Emerging Markets

Appendix 1: Emerging Market Definition & Risk Profile

1- Emerging Market Definition

The expression «Emerging Markets» is used to describe a national economy that is (Pereiro, Luis E., 2002):

1- Attempting to order its national accounts, privatize state owned companies, and deregulate economic activity.

2- Rapidly dismantling barriers to foreign trade and investments, thereby quickly increasing its share in the world economy.

3- Being flooded by foreign capital, technologies, and new, advanced managerial practices, as multinational corporations enter its territory.

4- Undergoing a profound change in the structure of entire industries and individual companies based on a jump in productivity, thereby pushing firms to approach international standards of competitiveness.

5- Reporting a growing rate of activity in mergers and acquisitions, joint ventures, and large scale corporate reengineering and divestments.

6- Experiencing a growing, more active and fairly sophisticated stock market.

7- Expanding influence to other neighboring economies, which in turn, start to open to the World.

8- Stabilizing its political system, from autocratic regimes to liberal, democratic rules, and increasing public interest in solving the most pressing social problems.

2- Emerging Market Risk Profile

v Risk design principles for companies in emerging markets:

· Hedge risks that are not specific to the organization.

· Beware the effect of decision-making under uncertainty.

· Allow two-way communication with emerging market operations and be

prepared to hear the truth.

· Link risk management with performance assessment.

· Structure risk approach to reflect the business model.

· In general, manage risks at their source.

v Key risks in emerging markets:

§ Developed market view:

ü Political

ü Currency or treasury

ü Compliance (laws & regulations)

ü Trade credit or customer insolvency

ü Market or competition

ü Operational

ü Supply chain

ü Workforce

ü Pricing

ü Security

ü Fraud, bribery & corruption

ü Financial reporting

§ Emerging market view:

ü Market or competitive

ü Currency or treasury

ü Political

ü Compliance (laws & regulations)

ü Pricing

ü Trade credit or customer insolvency

ü Workforce

ü Tax

ü Operational

ü Transactional

ü Supply chain

ü Technology

Appendix 2: DCF Valuation in Emerging Markets, the SPAM model

The three-step Stackable Premiums and Adjustments Model (SPAM) is Luis Pereiro extension model to less efficient arenas than the practices used by US financial appraisers when valuing privately held companies.

Stage 1 of the model introduces adjustments that should be made to cash flows of companies operating in volatile markets.

Stage 2 presents a wide array of conceptual frameworks to compute the cost-of-equity capital. And because the use of the traditional CAPM is highly controversial in emerging markets, the included variants are restricted to those that have been specifically adjusted to deal with such economies. Non-CAPM based models, which do not use betas as the risk factor, are also included.

Stage 3, some recommendations are made as to which and how unsystematic risk adjustments should be made to stock value, as a function of the condition of the shareholding appraised and the method used for computing the cost of capital in the first stage of the process.

Typically in «developed countries» such as the U.S., financial professionals use DCF following two steps:

1- The cost of capital is computed via the Capital Asset Pricing Model (CAPM) as if the target were a public company, the firm value (both equity and debt) is estimated via a DCF-based fundamental valuation, either by using the weighted average cost o capital (WACC) as the discount rate, the equity value is finally computed by subtracting debt from firm total value.

2- In the second step, the equity value is adjusted for unsystematic risk factors such as differences in size, control, and illiquidity, usually found between quoting and non quoting companies.

The second step is indeed necessary because the first implicitly assumes the appraiser is valuing a stock minority position in a large, quoting company; this assumption is based on the fact that the data used for CAPM calculations derive from comparable large, public companies, which are by definition, trading minority positions in the capital markets. But when the target under valuation is instead a small, control shareholding in a non quoting company, unsystematic risk must be introduced to adjust the value of its stock.

Step 1: Modeling Cash Flows in Emerging Markets

In emerging economies, the DCF presents hard challenges to the appraisers. Indeed, both cash flows and the discount rate need to be properly adjusted to take into account the specific features of the «developing markets».

First, three types of adjustments should be applied to the cash flows (CF) of companies operating in these «emerging markets»:

1- Adjustments for overcompensation (Salaries vs. Dividends)

2- Adjustments for over expensing (Personal vs. Corporate spending)

3- Adjustments for currencies (Exchange risk and Inflation)

Step 2: Modeling the Cost of Capital in Emerging Markets

The second step following the CF adjustments is to determine a «discount rate» as an «opportunity cost» expressing the minimum cost of capital that an investor requires from a specific investment project. The investor will undertake the project when the free cash flows (FCF) generated by the project, discounted at this rate, create value over and above the initial investment (also see next part about Capital Budgeting).

Hence, the cost of capital (CC) is a factor of prime importance when valuing companies using DCF method. An overestimation of CC may lead to rejecting good investment opportunities with a probable potential source of «economic value» for the future, whereas an underestimation of CC may drive the investor to undertake value-destructive projects. Defining the CC is therefore a delicate and effortful task.

The most used technique in DCF is the free cash flows to the firm (FCFF) that requires a weighted average of both the cost-of-equity and the cost of debt or WACC. Since the cost of debt is not very difficult to obtain via the market rate of a marginal debt issuance or loan contract by the operating firm; the challenge remains how to determine the cost-of-equity that is the minimum rate of return shareholders require for an investment.

In modern financial theory, it is assumed that the cost-of-equity (let's call it CE) of a quoting company reflects the risk that investors perceive in it; if investors are risk-averse they will require a larger return when the risk perceived is larger. This behavior is embedded in the CAPM method when computing the CE:

CE = Rf + Beta * (RM - Rf) + RU

where Rf is the risk free rate and RM is the market average return, Beta is a measure of the volatility of the company's shares to the market return, and RU is a component that accounts for effects no explained by the other terms of the equation. The term (RM - Rf) is called the «market risk premium», the product of Beta and the market risk premium is the «systematic risk premium» of the shares under analysis and partly explains the returns that move systematically with the market. The RU factor arises from the so-called «unsystematic risk» and encompasses the effects of all variables affecting share value and that do not move in the same direction as the market.

Yet, two major conditions that exist when trading «financial assets» in the developed and efficient markets are not normally present when trading «real or closely held assets» in the emerging markets: diversification and efficiency.

First, diversification is imperfect when a single or only a handful of acquisitions is made in a market where only few interested buyers ad sellers are operating; this is the case in majority of the deals in emerging markets. Imperfect diversification, in turn, generates unsystematic risk, and the traditional CAPM, as explained earlier, has not been structured to deal with this condition. Unsystematic risk is particularly important in emerging markets, where the dominant transaction is the «small and non quoting company». Most transactions in practice correspond to private assets where private risk plays an important role in defining the firm value.

Second, the final price of a transaction is not a transparent reference determined by financial analysts, it is rather a blend of different viewpoints from a small group of entrepreneurs, strategic investor or Venture Capital and Private Equity firms' negotiating the deal.

Finally, practice shows that even among financial professionals, the existence of efficiency is truly questionable in emerging markets for many reasons, among them (Pereiro Luis E., 2002):

- Emerging stock markets tend to be relatively small,

- The importance of stock markets in emerging markets is also small,

- Emerging stock markets are highly concentrated,

- Market and cost of capital information is scarce, unreliable and volatile,

- Data series are extremely short,

- Very few comparable companies are available.

Hence, to mitigate the drawbacks of the use of CAPM for the determination of the CE in emerging markets, specific adjustments should be applied. Luis E. Pereiro suggested five CAPM-based and two non-CAPM based models to cope with the difficulties and constraints faced in the emerging economies. The non-CAPM based models are basically models designed to take out Beta coefficient from the CAPM in order to avoid the use of beta approach in emerging markets that are highly volatile, with betas not correlated with returns when computed against the world market.

The CAPM based models are:

- Global CAPM Variant: uses global market parameters into the CAPM equation,

- Local CAPM Variant: uses local market parameters and country risk premium into the CAPM equation,

- Adjusted Local CAPM Variant: adjusting the previous model by avoiding the double-counting of the «macroeconomic country risk» by correcting the «systematic market risk premium».

- Adjusted Hybrid CAPM Variant: this model calibrates the «global market premium» to the «domestic market» through the use of a «country beta».

- Godfrey-Espinosa Model: it is and ad hoc «beta model» that adjusts Beta to deal with CAPM in emerging markets.

The Non-CAPM based models are:

- Estrada Model: this model better reflects the partial integration under which many emerging markets operate by using a «downside risk» as the risk measure as opposed to «total risk».

- Erb-Harbey-Viskanta (EHV) Model: this model is designed for economies without a stock market by using the credit-risk rating-based model.

Now that these models are presented and partially explained, the challenge remains what model to choose since each variant will naturally lead to a different value for the cost of equity. What can be verified is that the CE depends strongly upon the volatility generated by both the «country risk premium» and the «market risk premium». Non-CAPM based models on the other hand give higher values the CAPM-based models; this may be due to the fact that they are capturing a portion of «unsystematic risk».

In fact, there is no right model to choose or to recommend, the appraiser is solely responsible for which model fits his preferences. If a CAPM based model is used, the selection of the specific variant should undergo two decisions:

1- Deciding the true degree of integration between the local financial market and the global market.

2- Deciding on the reliability and usefulness of data available for the target country.

For the first decision, the literature recommendation is to use a «Global CAPM» when strong financial integration is perceived, and to use a «local CAPM» when the domestic market is partially or nonintegrated with the world market. For the latter case, the «local adjusted» version is preferred over the single «local CAPM» because of the double-counting of «country risk».

For the second decision, the appraiser should gauge the usefulness and availability of the historical domestic market data series to be used as a reference in the forecasting process. When series are considered to be short, or incomplete, or when the market is expected to be very volatile in the future, the appraiser may opt to use data from the global market and adjust for the country risk as the 2 last models suggest («adjusted hybrid CAPM» and «Godfrey-Espinosa» models).

Otherwise, if the appraiser doesn't trust the use of Beta as a risk measure, he or she may use the Estrada or EHV models. The available suggestion here is to apply the Estrada model to markets where a local sock exchange exists and the EHV model where it doesn't.

Finally, the analysts' team may consider that the different models provide a «range» of values for the CE; hence the team can compute a «synthetic value» as a combination of the different models instead of choosing a «single value» derived from a single model.

Now, once the CE is determined, the WACC can be computed using these three parameters: Proportion of Debt to Equity (D/E), the Cost of Debt and the Corporate rate Tax (usually both Cost of debt and tax are computed using the «marginal» values).

Step 3: Modeling the Unsystematic Risk

To be able to model the unsystematic risk (UR), the following questions should be answered:

- How important is UR in company valuation and why isn't it popular among academics and practioners alike?

- What are the specific drivers of unsystematic company risk?

- How is UR computed by U.S. practioners?

- What is the size of the private company risk adjustment for non US markets, and how can this adjustment be computed in an emerging market?

- How are UR adjustments transformed into risk premiums to be introduced directly into the discount rate?

In fact, diversification is usually imperfect in the world of real assets. For many Corporate Finance deals such as M&A's or Private Equity transactions involving closely held companies, money is allocated to a single or just a few investment projects; this creates a component of «unsystematic» or «idiosyncratic» or «private» risk which affects positively or negatively the company value. Such risk can be introduced as a premium or discount into the discount rate, or simply as a straight adjustment (decrease or increase) to the final stock value computed via the DCF analysis.

Computing the UR is an indeed an intricate task for the appraiser. Academics have not yet developed a full set of models to tackle the issue, simply because the CAPM mind-set ignores it by design. As a result, most practioners resist dealing with UR, yet this matter cannot be pushed aside because there is empirical evidence that shows UR may greatly affect company value. In fact, it can diminish by about half the company value of US firms, and more than that in emerging markets! Said differently, «unsystematic risk» may have a larger impact on firm value than «systematic risk».

In the US, UR is composed of three different value-affecting drivers:

- Company size

- Shareholding size

- Shareholding liquidity

The Size Effect:

Practioners do recognize the influence of size on value and adjust it accordingly. Alternatively, the influence of size on value can also be estimated as the spread between the bank rates at which smaller and larger firms may take a loan.

Control Premiums:

A majority shareholding is less risky than a minority one, since the former carries several control and restructuring privileges than the latter does not. As a result, a minority interest is worth less than a control interest. In other words, the former trades at a «minority discount» or, alternatively, the control interest carries a «control premium» over the minority interest.

Illiquidity discounts:

The shares of a quoting company are more liquid than those of a non quoting firm, as they can be rapidly and easily traded in the stock market, with considerable certainty on the realization value and with minimum transaction costs. Illiquidity risk translates into a discount on the price at which shares of a private company are sold compared to the selling price of shares belonging to a public and similar company.

In the non US and Emerging markets, if we assume that CAPM based methods, by definition, capture systematic or undiversifiable risk only, the analyst choosing one of the variants in this subset of models must apply any adjustments for size, control, and/or illiquidity, depending on the condition of the stock under appraisal.

On the contrary, the Estrada and EHV models certainly capture some portion of unsystematic risk.

However, in both models, data on returns come from the stock market where, by definition, only minority shareholdings of quoting companies are traded. It is reasonable to assume that the models are already capturing the size effect (plus any other unsystematic factor), with the exclusion of control and illiquidity effects. Hence, only control and/or illiquidity adjustments must be applied when using these models.

Once the analyst has selected which unsystematic risk effects apply, he or she must decide on the method to combine them. Directly adding discounts may lead to overestimating risk, since effects may be correlated with each other; ad a straight addition may double-count risk. So what is the solution? In fact, the double-counting of UR effects may in practice be at least partially countered by multiplying (instead of adding) them. The reason is that a multiplicative combination gives a lower value than the straight addition sum would give.

Now, all these adjustments must be transformed into Risk Premiums. Hence, instead of applying size, control, and illiquidity adjustments to the stock value, the analyst may prefer to introduce unsystematic risk straight into the DCF discount rate. The implied risk premium corresponding to a specific unsystematic risk adjustment can be computed as follows:

1- Obtain the present value of the company via a DCF analysis.

2- Subtract debt to obtain stock value.

3- Apply the unsystematic risk adjustments to stock value.

4- By trail and error, find out which risk premium (discount), added to the discount rate, and produces the stick value found in the previous step.

An iterative method such as this is necessary because the premium (discount) in the rate implied by a specific final decrease (increase) in stock value is a function of the cash flow structure.

Alternatively, Arzac (.....) has suggested a formula for determining the implied illiquidity risk premium, which has been expanded to cover all three components of UR (size, control, and illiquidity):

UR rate premium = d * (k - g) / (1 - d)

Where d is the discount on the stock value, k is the DCF discount rate, and g is the cash flow growth rate.

At this point, the relevant conclusion is that whatever the computational method used, the implied risk premium for a closely held company may be substantial. Indeed, it is UR that may explain large cost of capital values (from 30% to up) in private companies. As an illustration of that, the average Venture Capital fund may diversify away only part of unsystematic risk (maybe size and/or control) by making a portfolio of carefully chosen acquisitions, but it cannot avoid the marketed discounts imposed by the private and non quoting nature of companies the fund is entering to as a shareholder.

Computing a Synthetic Company Value:

Using different variants for computing the cost of capital will naturally lead to different discount rates, and these in turn will generate a set of alternative values for the same company. The analyst may hence opt for estimating a singular, or «synthetic» company value from that set.

Also, using multiple value scenarios is an effective way to visualize the «downside» risk involved in any project. Downside risk is the maximum monetary loss expected in an investment situation and its probability of occurrence, or simply, the inability to achieve a monetary goal above zero. In that case, the investor should consider three different scenarios: optimistic, expected, and pessimistic. Each scenario is then modeled after a carefully selected set of assumptions on the operation of the business, and each set defines a specific cash flow. In fact, a substantial empirical evidence suggests that investors and managers should carefully consider the «downside risk» when making investment decisions.

Finally, the analyst may opt for one of the following variants:

- No Synthesis: the analyst reports the value of each scenario but does not attempt to combine them.

- Assume Centrality: the analyst assumes the «most» likely scenario is the one that counts, and used the value corresponding it as the synthetic value.

- Compute the Average: the analyst computes the simple average f values for the three scenarios.

- Compute the Median: The analyst computes the median value of values.

- Probability-weighted scenarios: The analyst estimates subjective probabilities of occurrence for each scenario, and used them as weights to compute a synthetic value.

See exhibits here after annexed for the illustration of the steps for a Buy/Sell deal using a DCF Valuation involving in an Emerging Markets.

Appendix 3: Case Study in Emerging Markets

Here is the sequence that we will follow for this exercise:

a- Model the cashflows for the planning period and for the terminal period.

b- Adjust cashflows for overcompensation, over expensing, and currency corrections.

c- Define the discount rate via a CAPM or a non CAPM based method and compute the present value of the company.

d- Apply the corresponding unsystematic risk adjustments, dependant on the method used for computing the cost of capital.

e- Report a final company value.

The purpose of this case study is to give a comprehensive and detailed valuation f a closely held company operating in a transitional market. The idea is to show the types of challenges that may arise in a real-life valuation exercise.

The Company:

Quimicos del Sur (QDS) is an Argentine closely held company that manufacture industrial inorganic chemicals.

Valuation Purpose:

TMA Chemicals, a private US chemical manufacturer, offers to buy a majority shareholding in QDS. The purpose of the valuation exercise is to determine the market cash value of a majority shareholding comprising 70% of the common stock of QDS. This value will be used as a starting point in the negotiation leading to the sale of the majority of QDS stock to TMA through a private transaction.

QDS Net Sales were $21.5 million for the last year.

Data Normalization:

The first step in the valuation exercise is to gather relevant financial information for the company, data that reveal the fundamentals of the business (Growth, Profitability, Indebtedness, and Liquidity) that ultimately impact the value of the company's equity.

Financial data should also be normalized to allow consistent comparisons with other companies. A close look a QDS financial statements show that the owner-manager salaries are 30% more than the average amount paid to professional managers in similar positions in similar medium-sized chemical firms in the country. Other distortions are also corrected adding back estimated over expenses and overcompensations to the P&L statement.

Search for Comparable Companies:

QDS is a non quoting company, therefore we could use as references the values investors pay for the stock of quoting companies that re similar to QDS, then we could value-adjust those figures for unsystematic risk to capture the closely held condition f QDS.

It should be apparent that the first candidate to be compared with the company is TMA, the potential acquirer. However, TMA is also closely held company whose market value is not publicly available.

Here, the experience dictates that in any valuation for which an ideal quoting comparable does not exist, a portfolio of comparables should be assembled, which will reasonably reflect, on average, the profile of the target company. In the search for comparables for QDS, the following criteria will be used:

- Operates in similar industries

- Has a similar product portfolio

- Has a similar customer portfolio

- Has a similar scale (sales or assets)

- Has a similar financial and performance structure

- Was profitable in the last year

- Operates in Argentina or USA

- Is operating normally (not under financial distress or threat of liquidation)

The core business of QDS is the production of inorganic commodity chemicals in addition to some specialty organic-based chemicals. Using the Standard Industry Classification (SIC) codes, we'll search for Argentine and US comparables in Bloomberg's and Hoover's financial databases looking for at least 10 profitable companies with sales of less than $2.5 billion in last year. Note that in the US case, chemical giants such as Dow Chemical are deliberately excluded because it is far away from the scale of QDS, and while we will be adjusting for size at the end of the valuation exercise, it is recommended to use the smallest (for U.S. standards) comparables that can be found.

The only publicly held Argentine comparable found is Atanor which net sales were $154 million for the last year.

The other suitable comparables found for QDS in the US are:

- Albemarle Corporation (ALB): Net sales $845.9 million

- Church & Dwight Co. (CHD): Net sales $730 million

- Georgia Gulf Co. (GCC): Net sales $857.8 million

- Great Lakes Chemical Co. (GLK): Net sales $1.45 billion

- Hawkins Chemical, Inc. (HWKN): Net sales $95.5 million

- KMG Chemicals. Inc. (KMGB): Net sales $36.4 million

- Mineral Technologies, Inc. (MTX): Net sales $637.5 million

- NL Industries, Inc. (NL): Net sales $1.05 billion million

- OM Group (OMG): Net sales $507 million

- Tor Minerals International (TORM): Net sales $11.6 million

Comparability Check:

The most important highlights are:

- At $29.1 million in assets and $21.5 million in sales, QDS is clearly much smaller than both the US median ($838.8 million; $683.8 million) and the Argentine benchmark ($228.1 million; $154 million). This problem will be solved later by carefully applying corrections for size later in the process. Note also that within the US based firms, KMG Chemicals and TOR Minerals have a scale similar to that of QDS.

- QDS's Return on Assets and Return on Equity are lower than the US industry median, but higher than the Argentine comparable.

- QDS is less leveraged than the US and Argentine industry medians (D/E=0.67 versus 1.01 and 1.20), while having a larger liquidity (2.93 versus 2.38 and 1.08).

Valuation Plan:

QDS status is characterized by the following features:

- No real option is generated by a reserve of exploitation rights.

- It's ongoing.

- It's established.

- It is being appraised to be sold to a strategic investor.

- It uses a mature or established technology.

- It operates in an emerging market.

- It is non quoting.

- It is planning to sell a majority shareholding position.

- It is small, both in terms of sales and assets.

A quick look to the chart (.....) shows which valuation techniques better fit QDS. The company will be valued using two main methods:

- DCF, to compute an «intrinsic» value. Based on management forecasts, a DCF and will be modeled and discounted to the present by using an appropriate discount rate.

- Comparable company and transactions multiples, to compute an «extrinsic» value for the company. Multiples will be based on the stock price of quoting comparable companies, and the transaction prices of the sale of controlling positions of comparable companies in both Argentina and the USA. (This pat of the valuation will not be included in this case study since the topic of this Section is about DCF valuation)

Unsystematic risk adjustments should be applied properly to the values computed via both methods.

Discounted Cash Flows Valuation:

QDS free cash flow will be discounted at an adequate WACC. Since, we will be working at the «company» level and not the «shareholders» level, the present value of the free cash flows so computed will be equivalent to the «Market Value of Invested Capital» (MVIC) of QDS. Only one cash flow scenario will be computed.

For computing the WACC, the beat factor (unavailable for QDS since it is a non quoting company) will be estimated from the betas of comparable companies. An «unlevered» beta (the beta of a company after subtracting out the impact of its debt obligations, It is calculated by dividing the levered beta by [1 + (1 - tax rate) x (D / E)]) will be computed for the portfolio of Argentine-US comparables and «relever» it via the future target of D/E ratio expected by the QDS management.

In addition, the WACC will be computed using four CAPM based versions: Global, Local, Adjusted Local and Adjusted Hybrid; this will render four different MVIC of the company.

Four values of companies will be then determined by subtracting company debt from MVIC; they will correspond conceptually to the stock value of a minority position in a large quoting comparable company, since references used to compute the WACC came from this type of benchmark.

Then, the equity values will be adjusted to account for unsystematic risk (the small firm, majority non quoting nature of the target company).

Finally, a synthetic equity value will be obtained for QDS.

Modeling the Free Cashflows:

The FCF have been modeled under the following assumptions:

- The growth in sales fluctuates between 4.5% and 5.5%, reflecting management expectations on future economic conditions.

- Gross profit as a percentage of sales climbs from 21.3% to 23% in next year, due to productivity improvements realized after the investments made up the previous years. This ratio is about 16.2% for the US industry and 12.1% for Atanor.

- Interests paid by the company will be about 4% of sales.

- Depreciation is expected to at 8% of sales. This ratio is between 4% and 9% for the US industry.

Calculation of Beta:

The first benchmark comprises sector betas for the chemical industry in the US, they render a median value of 0.66. However, it is preferred to do an exercise of maximum approximation by using a small group of maximally similar companies, those defined as true comparables in a precedent paragraph. The median beta for this group is 0.35. As for the local comparables, Atanor, it has an unlevered beta of 0.40 against the local stock market, and of 0.30 against the US market.

QDS management estimates a future D/E ratio of about 0.55 for the company. Relevering beta with D/E, four different beta values are obtained, one for each CAPM model.

Cost-of-Equity Capital:

The results of cost of equity calculations under each CAPM model fluctuate between 8.2% and 17.8% dependant on the variant considered.

Computation of WACC:

The computation of the WACC as a function of its proportion of debt, the cost of debt, and the corresponding corporate tax rate fluctuates between 7.3% and 13%.

Computation of MVIC:

First, the PV of the company is calculated for the planning period of 5 years using the WACC figures obtained. But because the company is still valuable beyond the 5 years, a terminal value is computed assuming the free cash flow of the last year planned will sustain perpetually beyond that year. No growth of the cash flow is assumed, since QDS competitive environment is expected to prevent the company from extracting extraordinary returns in the terminal period. Based on this assumption, the MVIC of QDS oscillates between $14.9 million and $27.3 million.

Calculation of Stock Value and Unsystematic Risk Adjustment:

To compute QDS stock value, debt will be subtracted from the alternative MVIC values. The stock value then fluctuates between $3.3 million and $15.7 million. But this range of values reflects how much a minority stock position is worth in a large quoting company that is systematically similar to QDS, and our goal is to value a majority position a a small, non quoting company; therefore, we should adjust for unsystematic risk: for size, control and illiquidity. These three elements must be accounted for, because we have used CAPM-based models for determining the cost of capital.

An assumption suggests that a combined unsystematic risk discount for Argentina is of 56%, which implies multiplying stock value by the coefficient 0.44.

Under this assumption, adjusted stock value for QDS oscillates between $1.4 million and $6.9 million.

Synthetic Company Value:

A simple average will be used to compute a synthetic value for QDS. Note that this method assigns equal importance to the four CAPM based methods used; an analyst who has no faith in market integration could, instead, assign a greater weight to the local CAPM or the adjusted local CAPM models.

Using a simple average, QDS stock is worth: $3.4 million

Since stock is composed of 1,362,000 ordinary shares, share value will be: $2.5 per share.

Finally, since QDS's management plans to sell 70% of its stock to TMA Chemicals, such portion will be worth: $2.38 million.

See exhibits here after annexed for the detailed data, calculations and steps of this case study.

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