Venture Capital and Entrepreneurial Finance

US Players: Banks

Also in this us, banks can invest in PE although like in europe they have many constraints, therefore it is very rare that they directly invest in PE. They usually act as either GPs or Lps in VCFs

Sudden Death Risk

-Because this investment occurs before the company is founded, the investors have to protect themselves in case the person owning the project's idea suddenly can no longer perform his or her job. -The solution to this risk is in the incubator strategy an ad hoc infrastructure in which the investor can work without worrying aboout his or her ideas being stolen.

Origination (decision making)

-PE must decide the destination of money collected Based on two diff drivers: 1. Spontaneous, as you are a PE investor and the whole system knows you just collected money and are looking for a company to invest in. This is why PE must screen a considerable amount of incoming proposal 2. Proactive activity, managers have to scout the market and find the best solution. Can be done through other players (technical commitee and advisoory board) who can also help scout the market

Expansion financing external growth money injection 2

-The PEI builds a special purpose vehicle. The SPV is an "empty box" built only for the purpose of a specific extraordinary operation. This company does not have any assets nor liabilities and equity before the operation takes place. -The PEI and the venture backed company collect money from the banking system and put the cash collected in the SPV. In this way, they will have enough capital to buy another company This option can be used in two cases: a. when a venture backed company has got a huge financial need and it does not want to further increase the amount of debt b. the company wants to keep the SPV as a seperate entity this happens when the company ddoes not want the PEI to share the gain deriving from the M&A process. In this way, the PE will not benefit from the synergies created. But: this second option is more expensive than the first one; -the pei has a minor incentive in creating synergies ( may entail that lower synergies will be created) The company has obtain financing from banks to invest in the SPV:

Fundraising: Business idea creation

-aimed at producing an information memorandum to be promoted in the market -"testing the waters" occurs before info mem. this is carried out informally among the professional network of the PE firm to asses whether it makes sense for example to invest in a specific cluster or not -After managers receive informal consensus they move to formal process -The information memorrandum has to explain the rationale of th ebusiness idea to the business community ( and to the supervisers if fundraising occurs in europe) and has to appeal to the portential audience of investors -The sucess of the involvement of an investor into the business idea is strictly linked to the reputation and to the track record of the promoter Europe: of PE firm operates in europe PE must obtain the formal approval from the supervisor and afterwards the information memorandom is turned into internal code of activity US and UK: the PE firm dors not have to obtain any approcal, information memorandum can be transformed into LPA

Content of Information Memorandum

-choice of vehicle -Target to invest (countries, secotrs, life cycle stages) -Size of vehicle and minimum amount at which the fund will be closed -corporate governance rules ( the relationship between promotors - mangers and investors) -size and policy of investment -internal code of activity/LPA -track record of the promoters-managers -Usage and size of leverage ( in the case of a non european fund) -costs

Job Selling: fundraising

-have to convince investors not only to give an opinion abut the idea but also invest in that idea. This is actualized by the letter of committment with which investors declare much they will give -this phase occurs via 1-1 meetings between promotors and potential counterparts. in other cases could be organized as a meeting with more than one investor

Rating assignment:decision making

-in this phase the PE rates and grades the dossiers of the different companies -this is fundemental to assess the level of risk and is important to understand if (and how) the PE firm has to collect funds through debt -For instance, assessing the level of riskiness and of indebtedness during an LBO in which an SPV has to be financed using debt is of primary importance If the level of risk is too high after the rating assessment the deal can not be taken further

PE players in the US

1 Venture capital Funds (VCFS or simply funds) 2. Small Business Investment Companies (SBICS) (the two institutional vehicles in the us market) 3. Banks 4. Corporate venture 5. Business angels

Distressed Financing: why would a pEI want to buy assets of a defaulted company?

1 in some cases, the pe may be a a trader of assets this means that the investment is made only to sell such asseets to a third buyer 2. in other cases he pei buys the assets because it inserts them in other venture backed companies in its portfolio The assets are bought before a court and negotiation process can be tough. Court wants to maximie the liquidity of the bankrupt company so it can pay its debts Poison pill: PEI is going to buy a valuable assets mandatorily together with another less valiable asssets or with the debt of the company

Private equity definition

1) it is a source of financing: it is an alternative to other sources of liquidity, (such as a loan or an initial public offering (IPO) for the company receiving the financing. 2)PE is an investment made by a financial institution: Private equity Investor (PEI) in the equity of a non-listed company( not a public company)

Expansion ( life cycle)

4 stage In this phase, the sales keep on growing at a very high rate. The corresponding investment of the PE is called expansion financing.

Mature age ( life cycle)

5th stage This is the moment when sales growth is stable. The PE investment is called replacement

Early Growth (life cycle

This is the third stage This represents the moment when the company starts its growth. In the professional world, this is known as "the financing of the day after" The PE investment is eary growth financing Part of the venture capital subsample

Expansion financing External Growth

A company grows via external growth when it plans to grow by acquiring another company (M&A) in order to enhance the level of sales and exploit the synergies coming from this operation. This path is much more complicated than the internal growth and it may be undertaken by an adult company to enter a new market The role of the PEI: the investory has to sustain the M&A and in this case, they not only have to provide the venture backed company with the money necessary, but they also have to: a. screen and scout the market b. support the negotiation witht he potential target c. provide the venture backed company with money d. support the M&A process (also from a legal and fiscal point of view) e. Legal and taxation support f. the integration process after the operation d-f= hands on approach

Closed end fund players: Closed end funds

A fund is a seperated amount of money, given by the investors, managed by the asset management company This amount of money can be used to invest into financial assets or in other assets such as real estate, gold, etc A fund can be open end of closed end, where the distinction is driven by two parameters: -the maturity (fixed or not) -The amount of money to invest (fixed or not) THESE FUNDS CAN NEVER USE DEBT closed end funds have a fixed maturity and a fixed amount of money to invest

Closing

After all steps concluded closing stage starts - a successful closing occurs when the PE firm is able to collect all the money necessary to begin the PE activity and this was possible thanks to both the reputation and the purpose of th einitiative -A pure closing occurs when the PE firm is not able to collect the whole money in the fundraising stage. such is the casee whe managers dont have a robust netowrk.

Screening: decision making

After origination screening starts -In this phase about 90% of dossiers collected in origination will be eliminated (100/10/1 rule in startups) -Screening is done by the managers together with the technical committee -The output of the screening is a very small number of dossiers which the PE firm can further investigate and study deeply

Closed end fund Extra time

After the end of the closed end fund there is the possibility to use up to three years of extra time. PE tends to have low liquidity, and as such sometimes an AMC does not have the whole liquidity it would need to pay off investors right away. When the fund finally comes to an end, the AMC valuates the fund and spreads this value among all the investors coherently with the amount of tickets bought by each investor in the beginning of the fund

Closed end Funds

An investment made through closed- end funds consider a two level system involving two different institutions: -asset management company (AMC) -Closed-end fund -the closed end fund is a seperate entity that invests money for a pool of investors

Stock options for the inventor ( startup financing)

Another way to reduce the risk the business plan is not accurate and reliable is to grant the inventor some stock options. In this way the entrepreneur will also enjoy the profitability of the company

Closed end fund getting to time N

At time 3, the investors have to entirely have injected all the money equivalent to their tickets. So after the three years, the AMC keeps on investing until the end of the fund. In fact, some investing activity can have already taken place before time 3 but, not using the entire amount. The length of the fund can be defined by the AMC, as long as it is shorter than 30 years. Usually 90% of the funds have a maturity of 10 years. For AMC 10 years is a maturity enough to make two investments: 1. year 0-3: first investment 2. year 3-5: exit from the first investment 3. Year 5-7: second investment 4. Year 7-10: exit from the second investment

Why should a company choose PE over a bank?

Because the need for extra money comes with other needs which can be accomplished with one of the four benefits seen. There may be the need for the PE network or the need to build a good reputation

Closed end fund: fundraising

Before launching any activity, the AMC needs approval by the authority, where the approval depends on three criteria: -The size of the fund -The value of every ticket -The investment target Once the approval is granted the AMC has a maximum of 18 months to collect all of its money Generally, 4-5 months is the average time taken by an AMC to collect the whole capital that will be invested. As a matter of fact, if the AMC does not collect money before the time allowed, they usually stop beforehand, otherwise they would lose their reputation In fact, 50% of the funds all over europe do not manage to get ot time 0.

Corporate Governance Deals

CG deals just like PIPE do not derive from financial needs of the company The PEI invests in a company to manage the redesign of the corporate governance. These operations occur particulary when there are problems in the management succession. In the case of corporate governance deals there is a reputational risk, rather than a financial one.

Approach of PEI

The PEI can either be a majority or minority shareholder depending on which it is, Hands On: the investor provides the support a company requires under the forms of the four benefits seen and in addition they operate together with the entreprenuer Hands off: The investor provides the support the company requires in the forms of the four benefits seen but the PEI does not give any additional support

Closed end Funds in europe

Closed end funds are the most important vehicle in europe for PE. Their length is fixed, meaning that the investors can invest in the beggining and divest in the end of the fund The liquidity is no problem for the investors nor the AMC. For this reason closed end funds are the perfect tool to undertake a pe investment Typically, the average size of a fund is 100-300 million and this amount is divided into tickets an investor can buy. Each ticket typically has a value of 1 million For instance, if the amount of money of the fund is 100 million and each ticket is worth 1 million , the fund needs 100 investors

Distressed Financing

Contrary to replacement financng, distressed financing is a very common deal for PEI and it occurs when a company is completey dead. This may look a bit contradictory to the other clusters of PE in ehich the main goal of a PE deal is to finance a company finding itself in the need of money THe aim of PEI is not in fact to meerely finance the company, rather to buy the relevant ( and valuable) assets of the company in this case: patents brands contracts equiptment

Crowd Funding

Crowd funding has become very important and widespread nowadays. it is a brand new and digital way of collecting money. Different players can launch their own financial needs and make a call on the internet to collect money through their platform. PE and VC can be done through crowd funding: for companies who are in the very early stages of their life, they launch a call on the market to raise money Because this is a very recent approach we can not say the certainty whether this tool works or not for startups

Deal Making

Deal making means setting up the contracts between the investors and the company in which they find the right balance between the need of money of the company and the expectation of IRR and capital gain for the PE investors Finding the right balance is not easy and the whole process is based on 3 pillars: 1. Targeting 2. Liability profile 3. Engagement

Decision making

Decision making is the capability to understand the market and to pick the right opportunities 1. origination 2.screening 3.valuation and due diligence 4.Rating assignment 5. Negotiation 6.Decision to invest As the process goes on, and the PE goes towards the decision to invest, both costs and commitment of the PE firm increase -Decision making process involves all players: the management company, the technical committee, and an advisory company -The path is sequential and the PE needs a green light in every step to move on to the next one

The certification benefit

Due to the long screening phase before deciding to invest in the venture backed company, in a way, that confirms the very high quality of the company's accounts. This can give a sign of great health of the company and this high quality can be used as a kind of promotion for the venture backed companys brand

Early Growth Financing

Early growth financing is the financing of the first phase of growth of a new company that has started generating sales. -The entreprenuers and the founders need of cash derives from the necessity to buy inventory and sustain the gap existing between cash flow and money needed. In this phase, the cash flow is still negative, but not as much as in the previous stages of life of the company. -The risk is still high for the PEI since it is investing in a very young company and when they make the injection, they do not exactly know how the company will turn out. In this phase, there is a very hands on approach. If the PEI thinks that the company is based on a good idea, but the business plan is not adquate, it helps rewrite the business plan --> knowledge effect. For this reason the PEI usually has a high amount of shares in the equity of the company. On average this financing occurs up to the end of the first three years after the startup stage. In this kind of investment, the PEI may also not have any protections due to the high stake in the equity of the company and to the adoption of the hands on apprach.

Exiting

Exiting concerns the decisions to sell the equity owned in the portfolio vision. For this to happen the PE has to identify another shareholder in which they sell their stake of the company. becuae the liquidity is very low, finding a counterpart is not easy This is the most important phase, because it is only with the exiting that the PE is able to exit the investment and generate a capital gain ( IRR for the PE investor)

The network benefit

The PEI can give the company a very strong network, in terms of suppliers, customers and banks therefore multiplying its possible contacts

Closed end funds: rules for the fund

General rules internal code of activity Investment Policy

Negotiation (decision making)

Negotiation is not based on deal design, but it is the negotiation with the entreprenuer to calculate the number of shares a PE owns and the stake to which they correspond in terms of equity -In this phase the PE understands if there is room for an external shareholder

Crisis (life cylce)

In the end, when ( and if) the company comes across its decline, in this case the PE investment will be very hard and it is called culture financing.

The European Union Format

In the european union there are two directives regulating PE activity and, at the same time, they regulate the entire financial system in the European union: The banking directive The financial services directive behind these directives lies the idea that the financial institution becomes active, there must be an approval by both the local and central authorities Within this format there are three players that can be a pei 1. banks -in europe they are universal and they can provide any kind of financial service 2. Closed-end funds -they have an ad hoc structure and they are the most suitable player that can be a PE investor 3. Investment Firms

New trends in PE

Innovation in the instruments and mechanisms of financing is very important in PE 1) private debt funds 2)Crowd funding 3) venture philanthropy 4) special purpose acquisition companies (SPACs)

Investing

Investing is the mission of the eqiuity investment vehicle to create value for investor through scouting, screening, the choice, the managing and the exiting of ventures from when they decide to invest, managers have two problems: one the one hand, they have to valuate the company in which they invest; and on the other hand, when managers and GPs decide to invest they have to negotiate the mechanisms supporting their management of the company. If the decision of the investment is made, the managerial process enters another phase: the management and monitoring phase

PE players in Europe: Investment Firms

Investment firms in europe are regulated by the banking directive and can undertake the same activity as banks with the exception of collecting money h through deposits. According to the regulation they comply to, there are two kinds of investment firms Type 1 Investment firms: They do not have any specific constraints to manage their activities and the supervision impact is quite soft. They do not undergo any regulatory capita rules Type 2 investment firms: They face the same constraints set for banks and for them the supervision impact is hard. In this case, all investments undertaken by the firm entail a regulatory ccapital as if they were banks in europe most widespread type is the second type The role of the two kinds of shareholders is necessary to replicate, in the investment firm the relation existing between an AMC and the investors within closed end funds A-shareholders: act as an AMC. They are renumerated with the management fees and with a yearly carried interest ( it is computed every year because the investment firm does not come to an end, unlike closed end fund) B-shareholders: Act purely as investors and cannot influence the managment of the investment. They are renumerated with the difference between the profits and the carried interest given to A shareholders There may be at least two reasons to use investment firms to invest PE -investors may want to leverage ( closed end funds cannot use debt) -A small group of investors may want to create a captive vehicle and they do not want to compl to very strict regulations. Such is the example of the so called "family offices" a group of family members who want to invest their own money

Closed end fund players: investors

Investors put money in the funds and from that moment when they do that, they automatically lose any right to have a tailor made investment, Their investment will be managed by the AMC together with the other money belonging to the fund. When they invest, they recieve a certificate with the value they invested in the fund. Typically investors are: -high net worth individuals -Banks -Insurance companies -Pension funds -Corporations -Governments

Venture Capital

Is a very specific case of PE. It is the investment in the very early stages of a companys life

Leverage Buyout

LBO is very commonly used, especially in the Anglo-Saxon world, where they account for 45% The role of an investor is not only to finance the company but to identify the target company that the venture backed company has to buy at 100%. 1. When the PEI identifies the potential target, the PEI itself creates an SPV of which it becomes the full owner (ie 100% shareholder) 2. The PEI collects money up and highly leverages the SPV up to a ratio of 90% debt and 10% equity 3. The SPV recieves a huge amount of cash through which it is able to purchase the target company 4. The SPV buys the target company either through a negotiation process or through a hostile process and through an IPO on the stock exchange. The aggressiveness of the operation depends on the level of debt used by the PE to buy the target company. 5. The PE fully owns the target company After the new acquisition, the PE will sell the target to another company

The economic mechanism of an AMC

Over the life of the investment, the AMC receives two different kinds of remunerations 1 management fees 2 carried interest

Private Investment in Public Equity

PIPE is a investment made in a company listed in a stock exchange. Even though the investment is made in a public entity it still belongs to the PE world: the profit mechanism is still not related to the stock exchange This deal is not done with trading purposes. The purpose is the buy a minority stake and then sell it to another potential shareholder at a price not based on the stock exchange ( which usually is threee- four times bigger) This stake has to be big enough to become the biggest shareholder To make this deal work the PEI has to understand the small amount of shares which is necessary to be the owner of the company. For this reason these deals can become very aggressive

The knowledge benefit

The PEI can transfer knowledge to the company: -Soft knowledge: the capability to manage the business Hard knowledge: the specific-field knowledge of a business, this applies particularly to high-tech or pharmaceutical industries With this knowledge, an investor can even carry the company through very hard and difficult steps, such as a merger and acqui The PEI plays the role of an advisor and mentor

The difference between PE and Investing in a Public Company

Pricing: Public- the price is driven by the market, either upward or downward Private- The price is the result of negotiation process which can be both easy and hard Liquidity: Public- Liquidity is very high. Whenever an investor wants to sell shares of the public company there is always a buyer Private- Selling the shares is not easy. No stock exchange, finding a new shareholder can be hard and time consuming. Monitoring: Public- When trading on the stock exchange, there is always a very high level of proctection for the shareholders, regardless of their stake in the company. Private- The shareholders (The PEI) have to protect themselves and the values generated by the company. All of the rules will be stated in a formal agreement.

Asset Management Company (AMC) (closed end funds-euro)

The AMC is a financial institution It can host many funds at the same time (they can be both closed and open-end) and it can manage financial services as defined by the financial services act ( personal management of savings, dealing, brokerage, advisory) FInancial institution approved and supervised by the local authority, whose task it is to manage the fund The AMC shares some characteristics with a consulting company. In fact, it is not a financial institution but a cluster of people advising. There are AMCs owned by banks, private individuals (boutiques of PE) and the government There are no constraints in terms of shareholders, except for the commitment the AMC must own in every fund, which must be equal to 2%

SBIC

SBIC were created through the small business investment company act of 1958. They are considered the beggining of the PE development in the US because they were created to stimulate the VC market It is a legal entity in which one of the two shareholders must be a US Public Admin, while the other shareholder can be any kind fo shareholder ( it is usually a bank, corporation, or individual) The public admin who holds 50% of the company is a pure investor it cannot manage company, the non public admin investor has the duty and right to manage the investments and the whole company. Both shareholders receive a mangement fee, but the profit distribution ( calculated with the carried interest approach) is asymmetric: the us PA will get the renumeration up tp a threshold stated in SBIC agreement, whereas extra profit generated through the investments belongs to the other shareholder, Losses are equually distributed 33% of debt can be borrowed from the federal reserve system at a very low and fixed rate which is set yearly Capital gains and other rev. are free from tax, taxation starts with the distribution of earnings. This "free from tax" vehicle can not be implemented in the EU because of the rule of "non-states aids" This mechanism is very popular in the us, becuase with a partner belonging to the public administration some investors feel they can invest in even riskier deals. SBICs are considered among the best models of PPPs (public private partnerships)

Startup Stage ( life cylce)

Second stage This is when the business actually starts. For this phase, the PE investment is called startup financing. Part of the venture capital subsample

Seed Financing

Seed financing is the most complex and riskiest activity among the PE investments. It is the investment in an idea or in a research and development project, it is very industry oriented: -usually deals with the biomedical, IT and pharmecuitical industries/sectors. -Under seed financing the uncertainty of the project is high because the investor has to trust the idea of the entreprenuer. This is why the managerial role is very limited There are two levels of risk: 1. The capability for the idea to generate an output 2. If there is an output: does this output have a marketability?

SPACS

Special purpose acquisition company. SPACS were born around ten years ago in the US and the idea was so succesful that they started to operate in europe 3-4 years ago. They basically are an "empty shell" a form of SPV 20% of the SPV vehicle is held by the promoter, the company is listed in the stock exchange so that they can collect the other 80% of the equity. The SPAC can collect money only to do one investment: to buy another company If the SPAC succeeds it will merge with the target company, otherwise the investors will get their money back as this is a "one shot vehicle"

Start up Financing

Start up financing is the financing of a new company starting its own initial operations. -The entreprenuers and founder's need of cash derives from the necessity to buy the necessary equiptment to start (equiptment, inventory, building) the business. In this kind of financing the risk is still very high, leading to a high level of protection for the investor. The level of risk depends on the fact that the PEI is betting on a business plan. Because the investor is neither a non-profit organization nor a high net worth individual, there are several ways in which this can occur

Restructuring Financing

The company is facing a crisis, but is still alive. The need of financing derives from the settlements of debt with banks and with suppliers. At the same time, money can be used to relaunch the business, therefore in some cases money can be used to buy further assets or invested to redesign the business plan The company needs the stratefic support from PEI These strategic needs make the PEI not only a financer for the troubled company but also an advisor Because risk is so high the investor is a majority shareholder, very hands on and needs a majority stake in company Very difficult to find PEi invesring in such a deal because difficult and risky, more of an investment banking activity

Closed end funds : rules for AMC

The existence of this "double level" is necessary to analyze the (very few) rules both for the asset management company and for the closed end fund - the same all over europe the choice of a short albeit well organzied system responds to the need to better regulate a country specific financial system For the AMC the set of rules: Minimum requirements to operate Governence rules management rules the rules are verified by the country supervisor, checking over the whole life of the AMC

Expansion Financing

The expansion financing takes place in the fasted phase of growth of a firm to consolidate its position in the market The investment is only used to sustain the (reducing) gap existing between cash flow and money needed. In this phase, the level of risk is moderate (and it mostly depends on the business) because the trend of development of the business is well known In this cluster the stake held by the PE is not usually very high. The expansion financing deals are about the growth of a company In an adult company, growth can be 1. Internal (or organic) 2. External -according to the growth a company finds itself in, the role of the PEI changes

The financial benefit

The financial benefit is generated through the injection of cash in return for shares of the venture backed company. The increase generates the following effect on the cost of capital: increase in equity --> increase in rating--> positive effect on the cost of capital If a companys needs at least one of the four benefits then PE is the only choice; if not there are other sources of financing, each suitable for the life stage where the company has that specific need.

Fundraising

The first activity of fundraising is included in the managerial process even if this activity starts before the vehicle is launced. The fund raising activity is devoted to promote the business idea of the new vehicle of equity in order to find money It is in fact a very preliminary activity ( in closed end funds this acitivity occurs before time 0) occuring before the actual starting of the investment. In thec case of the closed end funds this takes 1.5 years whereas for VCF this phase takes 1 year If managers are able to collect the whole investment and they are able in this way to get to time 0, the legal entity starts its acitvities and then the other three acitvities ( investment, managing and monitoring,, and exiting ) start.

Due Diligence and Valuation (decision making)

This phase is the analysis of the business plan which starts right after the screening phase -it takes a very long time, therefore PE should only do it for a very narrow number of companies -This phase is dedicated to exclude the proposals that do not make sense for an investor -The outcome of due diligence is a small number of proposals which it makes sense to undertake the rating assignment for

Relationship between the PEI and venture backed company

The investor gets shares of the equity of the company in return for the inflow of cash. A company needing money for a certain and clearly identified reason; • The company collects money with the issuance of equity on the private market, the company does not pay any interest expenses to the PEI; • The newly issued shares will be bought by the PEI; • The professional investor will not only become a shareholder but will contribute to the management of the company. The smaller the company is, the larger the contribution of the PEI in the business management will be; • The professional investor will create profit only through the generation of capital gain, i.e. exiting from the investment by selling shares to someone else on the market

100/10/1 Rule (seed financing)

The investor has to screen 100 projects, finance ten of them and be lucky and able enough to find one succesful one -The activity is risky that you must invest on much more than one project. The investor needs to invest a huge amount of money. The "psychological threshold" is one billion euros. -by the time the investors find the winning project they will have lost much of their beginning investment

Size of the Market (seed financing)

The investors usually invest in the markets they know the best. -Despite this, in some cases, the idea may be a good one without a market willing to buy it -Such is the case in which the investors look for venture philanthropy, set up by non-projfit institutions with the investors themselves.

The life cycle of a company importance

The life cycle of a company is important in two ways: 1. to understand if a company can use PE to accomplish its needs 2. And to identify the different kinds of PE investment and the right one -There are six life stages

Decision to invest ( decision making)

The managers (the GPs or the directors in an AMC in europe) have to convince the whole board of the PE firm if it is worth to invest in that specific company The decision of investing does not mean to invest immediately in the company, rather it sets the beginning of the second part of the investing phase: deal making

Collateral (start up financing)

This is a pledge for the investoru over some valuable assets of the newly founded company and this is usually used together with the put option.

Carried Interest

The second source of remuneration for the AMC is made up of the carried interest. -maximizing the carried interest is the ultimate goal and desire of an AMC It is computed only at the end of the closed end funds life cycle Carried Interest= % * (Final IRR-Hurdle IRR) IRR: it is a discount rate that equals the investments with the present values of the future returns of such invesments The carried interest is the spread between the final IRR and a hurdle (aka threshold) IRR multiplied by a fixed percentage Usually, the fixed percentage ranges between 25-30% the hurdle rate ranges between 7-8% This means that at the end of the fund, the AMC will receive a carried interest if and only if the final IRR is larger than 7-8%.. The carried interest formula is also called the waterfall mechanism This mechanism can be used either with or without catch up, where the choice to calculate IRR one way or the other is up to the AMC and must be agreed in the internal code of activity -without catch up: the carried interest is computed on the difference between the final IRR and the hurdle rate -with catch up: The carried interst is directly computed on the final IRR

The US financial market

The us financial market is driven by common law and great importance is covered both by local courts' work and by the federal court's work. Some federal acts have created a general framework for the financial sytem. This framework is not basd on financial institutions but on relevant financial activities The pillars are represented by: -discipline on stock exchange and securities -corporate governance rules -discipline for insurance and pension funds -general rules for banks

Why would a company need PE?

The venture backed company wants to enjoy some direct and indirect benefits that a company can exploit when financed by a PEI. -Certification benefit -Network benefit -Knowledge benefit -Financial benefit

US Players: Business Angels

They are PE investors without any professional skills. Example of such could be foundations, universities and individuals They can also be high net worth individuals, charities, and foundations and in this case can benefit of the QSBS rule (Qualifirf small business stock) this means that if they invest in PE and at the end of the investment the capital gain is immediatley invested in another private company under the form of PE taxes are not paid, this is a huge incentive for PE investments They are mostly active in venture capital, mostly with seed and startup financing

Uk Players: Local PPPs

They are not as popular as they are in the US within SBICs. They operate at a local level and they do not have to comply to certain rules, rather they have to comply to local laws

US players: Corporate Ventures

They are not proper legal entitites rather they are a division or a department of a corporation which wants to invest in venture capital. The only aim of the Cv is to run seed and start up financing The investment is done to promote R&D outputs patents and unlike in VCFS the aim is not to generate IRR but to enhance the value for the corporation

Debt Raising

This phase only occurs if the fund is based in UK or US Debt raising is job selling too, but with a diff perspective in whihc the goal is to sell a prokect to a comminuty of financers -debt raising is strongly related to the repuatation of both the promotr and of the investors ( good signaling effect) in fact this step is difficult for each counterpart ( investors and bansks) because no on wants to make first move

Put Option ( start up financing)

This tool is used to sell back to the entreprenuer the shares the investor bought. This tool is quite dangerous: it assumes that if the business plan does not work, the founder will still have money to pay off the PE. For this reason, the put option may be used together with a second tool...

Closed end fund: lifetime of a fund

When presenting the lifetime of a closed end fund, some milestones must be set. In its lifetime the following moments are the most important -time 0 time 3 time n -0.5 (where N is the end of the fund) time N+3 -1.5-->0=fundraising 0-->3 = draw down period 3--> N-0.5= Getting to time N N-0.5--> N = getting to time N N-->N+3= extra time

Venture Capital Trust

UK Venture capital trusts were introduced in 1997 and have had a great success in the Uk market. Started in the UK but now it is a format used in india and australia They are based on the concept of the UK trust A trust is a very old british institution and it is an entity, not a company. The trust was birn in the first place for succession issues, as a matter of fact through this mechanism the owner ( called the settlor) does not have to mangage the assets, for a third player will do it ( the trustee) and that is fully liable. In case the VCT has a maturity at the end of the VCT the owner gets back the assets belonging to the trust In terms of PE trusts want to combine retail investors with PE activity ( unlike with closed end funds) Gps create a trust with a a term ( the vcf term) and they seet a portion of their assets in the trust which they use as a collateral to show the LPs the commitment in the management of the fund Investors become the settlers, whereas a managment company becomes the trustee. The trust does not own any assets rather it just has the cash injected by the investors used to make VC investment Every time investors invest in trust, they receive a certificate listed in the stock exchange; this ensures to investors a high level of liquidity the trust is like an empty box that does not publish any financial reporting The investors trust the reputation of the trustee A trust can invest in listed securities, but at least 70% of the cash collected among the retail investors must be used to invest in non listed companies in the end fiscal incentive are granted to the investors

Venture Capital Funds (UK)

Uk VCFs are not built under the European scheme of closed end funds but are legal entities operating like LPs in the us limited partners are private investors, banks, pension and insurance funds, and corporate investors and they are allowed to leverage A UK fund must have a set maturity of 10 years same as us

Private Debt Funds

Vehicles used in private debt are the same as in private equity ( investment firms, closed end funds..) the only difference is that the investment is made in private debt This new instrument is becoming more and more popular lately for two reasons 1) In europe there is an increasing tendency among companies to collect debt. Companies do not want to do so anymore with banks but through the market. For the companies listed this is easy: they issue bonds on the market. however in europe most companies are not listed SMEs 2) PE already knows how to deal with the fundraising when the company is a private one

Venture Capital Funds

Venture capital funds are the most popular PE instruments in the US regardless of the name, theycan operate in every PE deal. The legal entity supporting a VCF is called the limited partnership (LP) An LP is one of the typical structures to create a company is the US, whereas common organizational forms are: sole proprietorship, partnership, limited liability partnership, limited partnership, s corp, c corp THAT MEANS PE INVESTMENT IS CONSIDERED A BUSINESS ACTIIVITY AND NOT A FIANNCIAL ACITIVITY AS IT IS IN EUROPE

Vulture Financing

Vulture financing takes place in the final stage of a companys life cycle, when it enters its decline phase or worse, a crisis Money is used to sustain the financial gap generated from the decline of growth. The financial aid coming from the PEI is used to launch a survival plan. Due to the life stage, this activity is very risky even though the level of risk also depends on the sector of the ventured backed company. for this reason the PEI needs to fully understand indsutry company operates in There are two deals included: 1. Restructuring financing (or tunraround) 2. Distressed financing

Venture Philanthropy

When PE vehicles invest only in businesses generating a string social social impact, this is called venture philanthropy In these cases the mechanisms are the same as in other forms of PE except for the fact that both investors and the management company accept to get a lower level off profits in terms of capital gains, carried interest, and management fees

Investing, Managing and Monoritoring, and exiting

When the fundraising phase comes to an end, the other three phases start In the ordinary activity the managers have to decide the investment policies and the investment target; at the same time they manage and monitor the company in which the investment is made; and at the same time, they have the exiting issue; that is they have to understand when and if they will be able to exit The exiting moment is in the end the reason why managers do PE activities

Expansion Financing Internal Growth

a company grows via internal growth when it plans to grow "By itself" This means that investments in fixed assets and in working capital will be made. The role of the PEI: the investor needs to provide money to the venture backed company in order to buy/ and or sustain the procurement of working capital and to purchase new assets. Because this kind of deal is not difficult for a PEI, the offer is very wide and there is a very high number of investors providing this financing This kind of financing can be an alternative to a loan

Managing and Monitoring

activities concern the involvement of the vehicle in the selected ventures. These two acitvities have to ensure the creation of value value and to control the opportunities for the financed venture When in this phase, the PE is a shareholder because the PE decided to invest in the VBC The managers have to support and sustain the company in the ordinary activity for managing and monitoring to be succesful the last phase has to come

Investing: managerial process

after the money has been collected by the PE firm, the phase of investing activity can start -investing activity is the core private equity business and the main way to develop the business idea for the managers on the investors behalf 1. Decision making: The activity of valuation and selection in which the PE has to assess whether the investing activity makes sense 2. Deal making: the activity of negotiation of the contracts by which the PE firm can invest and actively participate in the company. These contracts include, for instance, the calculation of the shares the investor has to buy, the corporate governence rules

LP (vcf)

an LP is the legal entity with the madatory presence of two different groups of shareholders The limited partners (LPs) must own 99% of the equity of the LP, whereas the General Partners must own 1% of it. This is set by US law Limited Partners: are soley investors. They do not manage the company and are limitedly liable to the extent of their investment General Partners: are the managers of the company and they are fully liable for the LP liabilities, this means that in the worst case scenario they lose everything. Comparison with europe: Lps are like the investors in closed end funds. GPS are like the AMCs in closed end funds Liable fund=hedge fund makes a higher risk return combination than the one in europe The functioning of a fund is regulated by a limited partnership agreement and it is made by GP and LPs where the content is very similar to internal code of acitivity except for part reffering to debt policy Difference is that in europe it is a code therefore in the case of a legal battle they go before a supervisor vs in the US its a contract so they go before a court GPs want to protect themselves due to full liability which is why Gps are usually a management company and operates via limited liability partnership working like an AMC in europe, GPs want to be protected but LPs do not want them to be too safe, which is why the assets of the LLP will be a collateral of the debt of the VCF Limited partners are typically banks, insurance companies, pension funds, private investorsetc success of limited partnership is due to simple scheme of fucntiong and tax transparency The us government decided to have a tax law with specific reference to PE. THis entails that if in any US state there is a PE investment, taxes =0% provided that : -the fundraising lasts 1 year -the maturity is 10 years -the maximum extra time is 2 years in all other cases, investors pay taxes, these benefits are there if you dont operate in us as long as vcf is in the us

Closed end fund: draw down period

at time 0, the fundraising phase comes to an end In this period the AMC has the possibility to ask the investors to deposit a percentage of their commitment (ex 10%) The time is set at 3 years, because collecting all the capital from the investors will take much more time than it does in capital markets In the time going from time 0 and the third year, the closed-end fund has to cash in all the money previously subscribed by the investors, who can also deposit their investment with installmetns

Development ( Life cycle)

first stage of the life cycle The life cycle starts with development. It is the moment in which the founders start to create and try to develop the business idea. The corresponding investment of the PEI is seed financing. Part of the venture capital subsample

PE Players in Europe: Banks

in europe banks are universal: they can undertake any kind of financial activity except for the following ones: collective asset management acitivity insurance activity non financial activities However banks can hold equities of AMCs, insurance companies and non financial firms when a bank wants to directlyy invest in the private equity of a company (whether it is listed or non), not only does it have to follow very strict constraints and rules but it is necessary for the bank to set aside a lot of regulatory capital, due to the strict regulation constraints imposed on banks by BAsel II and III. This means that the capital gain obtained through the investment can be counterweighted by the regulatory capital it has to set aside. For the reasons mentioned above it is very rare that a bank invests directly and become a PEI banks usually invest in closed end funds to participate in PE activities Banks only invest if there needs to be an urgent intervention to save a company in a certain industry pr area or if the venture backed company is of particular importance

The Managerial Process of Private Equity

is the day to day activity of the managers managing the nvesment made by the investors 1) fundraising 2) Investment Activity 3) Managing and Monitorung 4) Exiting for each phase there is also a different contribution coming from the managemtn themselves, the advisory and the board of directors

The taxonomy of the formats

local players: the perimeter of the investment is within the country of origin of the PEI itself: (a US PEI investing in the US only is a local player). must apply the legal framework of the country of origin of the investor Global players: the perimeter of the investment is outside the country of origin of the PEI itself can opt for one format or antoher one according to the needs of their portfolio.

Management Fees (AMC)

management fees correspond to the amount of money an AMC receives every year from closed end funds closed end funds are the vehicles generating: -revenues in the form of capital gains -dividents coming from other companies in which the investment is made -losses, in case the deal is not succesful The management fees is a fixed percentage of money calculated on the value of the closed end fund in the beginning of the fund itself For instance in the case of a closed end fund being worth 100 million bearing management fees at 2%, every year the AMC receives 2 million from the fund The management fees must be precisely calculated to cover: -operating costs -remuneration of the advisor helping the AMC in the consulting activity -remuneration of the technical committee The percentage of the management fees is in fact computed with the capital budgeting approach. That means that it is computed replying to the question: is the amount enough to properly cover all expenses The reply is in fact not the percentage per se rather it stands in the absolute value of these fees -if AMC is owned by a bank all above costs will be easily covered, if not covering these costs can be tough

Fundraising - Managment

managers have to convince th investors of their idea: the investors will remain in that project for a long time Fundraising Steps: -managment company has to sell the proposal launched to the market -proposal is a business idea that leads to the creation of a vehicle to invest in PE to produce value that will be spread among the promotors managers and investors -Fundraising is a selling game in which reputation, mutual trust, and love for risk are the pillars -success of fundraising depends on the reputation of the management company Fundraising steps ii: 1) business idea creation 2) job selling 3) raising debt 4) closing

PE Players in the UK

mechanisms similar to us uk financial market is driven by common law and great importance is played by the courts 1. Venture capital funds (VCF 2. Venture capital trusts (VCT 3. Banks- same as us 4. Business angels- same as us 5. Local PPPs

The formats of PE

regardless where a deal occurs, there are two formats, each having its regulation and players: 1. The european union format: This format is regulated by a directive of the european union 2. The anglo-saxon format this format is regulated by US and UK laws -Using one of the two formats does not necessarily mean that the deal occurs in the area of the format the european format has been adopted and is now used in brazil and russia, the anglo saxon format is now used in india and australia

Replacement Financing

replacement financing takes place in the mature age of a company and the role of the PEI is that of replacing an existing shareholder. A company needs replacement financing when it wants to face strategic decisions linked either to governance, status, or sorporate finance decisions. The level of risk is moderate and linked to the quality of the strategic process that has to be put in place. There are three kinds of operations belonging to this cluster: 1. Leveraged buyout (LBO) 2. Private Investment in Public Equity (PIPE) 3. Corporate Governance Deals (CG) These deals do not derive from the arise of need of money of a company

Balance between money and shares

the PEI needs to find the right combination between not losing all its investment (such is the case when the PE owns 95% of the equity) and not having any say in the management of the businesss ( such is the case when the PEI owns 2% of the equity) -for instance, for the investor the right balance would be owning 48% of the company. -In such case the PEI would have the right to lead the company but the founder is the owner of the company

The Anglo-Saxon Format

the main difference between the two formats is the idea that each has of PE. In the anglo saxon world, PE is not a financial service ( as it is in europe), rather it is an entreprenurial activity this idea means that when talking about PE in the anglo saxon world, the regulatory framework is made up of: common law + Ad hoc fiscal rules + special regulations for the pe world in the end, in the anglo saxon format there is no supervisor

Expansion financing external growth, money injection 1

the pei invest in the venture backed company, from which it gets shares and the company has to get enough money to carry out the M&A deal. If the process is succesful the venture backed company and target company will merge Pros: the venture backed company will merge with the target company and the company will benefit from the synergies Cons: The venture backed company is going to give the investor a portion of the synergies created