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Preface to the second editionIn 2007 the private equity industry came under intense public scrutiny including a Houseof Commons Select Committee enquiry. We published the first edition of Private EquityDemystified in August 2008 and since then the financial world has experiencedunprecedented turmoil. We have therefore taken the opportunity to revisit the accusationslaid at the feet of the private equity industry and our tentative support for the industryin the first edition of this guide with the benefit of hindsight. In summary we find thethesis that private equity created, spread or encouraged an increase in systemic risk tobe almost wholly incorrect.We argue that in contrast to the forecasts of the critics, private equity has acted to containrisk, not disseminate it; has created alignment between managers and shareholders, nota misaligned bonus culture; and provides important models for corporate governanceand risk management that have a wider applicability.Private equity has frequently and erroneously been likened to the activities of hedge fundsand other so-called ‘shadow banking system’ members by many commentators andregulators. We drew attention to the differences between hedge funds, private equity fundsand other fund types at length in the first edition and reiterate them here. We continueto encourage regulatory bodies to be mindful of the clear distinction between theseinvestment forms and encourage all commentators to emphasise this distinction to aidpublic understanding and debate.The idea of aligning interests lies at the heart of the rationale for the business model ofthe private equity industry. Where that alignment breaks down, for example as it appearsto have done in the syndicated debt market, the problems associated with excessiveleverage follow closely behind.The corporate governance regime of public companies has been widely criticised forhaving weak non-executives, shareholders who sell shares rather than actively holdingmanagement to account and bonus-based reward systems that have no penalties forfailure. The structures seen in private equity transactions often directly address each ofthese issues.The belief in the enduring outperformance of the top fund managers is widely held andhas some historical support in independent academic research. Given the excesses ofthe past few years, it seems likely that this assumption may be challenged in the future.However, it is unclear how the market will be able to adjust in the short term if therelationship breaks down.The body of academic evidence is growing rapidly, but the quality of much researchis hampered by poor data availability, for both quantitative and qualitative research.Two broad approaches have been adopted. In the first, large data sets are subjectedto econometric analysis. These studies seek to identify significant differences betweenpopulations of buyouts and non-buy-out companies. In the second approach, small scaleand detailed case studies are used to examine the themes within the academic literature.These studies are often reliant on the provision of data by private equity funds themselvesand therefore are often viewed with suspicion by critics of the industry.The academic work to date is broadly supportive of the idea of alignment that lies at theheart of the private equity investment thesis. Recent evidence particularly suggests thatperformance improvements are most marked in buyouts of divisions.Overall we have found the following core strands in the analysis:1. Alignment: private equity uses financial engineering to create exaggerated incentivesand disincentives to achieve performance gains in corporations.2. Long term: private equity funds are generally different in structure to other fund typesprimarily because they are long term and illiquid for the investors and have lowbankruptcy risk.vi Preface

3. Low systemic risk: as a result of this difference in fund structure, private equity fundsdid not contribute to the credit crunch directly and do not directly create systemicrisk in financial markets.4. Early adopters: private equity rarely creates new financial technologies but is an earlyadopter of financial innovation. Some of these financial innovations were implicatedin the credit crunch and have changed the dynamics of the market both pre- andpost-investment.5. Banking failure: banks used new innovations to change their business models andas a result incentives were changed in a way that facilitated their failure. This wassymptomatic of banking generally, not of private equity.6. Alternative asset managers: the larger private equity funds are becoming multi-fundmanagers having more than long-term private equity funds under management. Thismodel may corrupt the original private equity model based on the idea of alignmentat all levels.7. Equity illusion: management teams need to be wary of the equity illusion and focuson their cash returns not their notional equity percentage.8. Corporate governance: the model of corporate governance used in private equityis materially different to that in public companies. The rewards for success are great,the penalty for under-performance clear. Shareholders are highly active in monitoringeach investment. It can be credibly argued that the private equity governance modeladdresses many of the issues that have been implicated in the failures of publicmarket accountability.9. Distress: in distressed situations banks have the strongest hand but can only achievea turnaround in conjunction with the ongoing management of the business.Leverage does increase the likelihood of distress, but not of failure.10. Syndication paradox: wide syndication of debt has resulted in a potential paradox:Syndication is designed to mitigate risk, but once that risk crystallises the fact thatdebt is widely held makes restructuring more costly and problematic, which increasesthe risks to both the lenders and borrowers.11. Evidence: there is an extensive, but as yet incomplete, body of peer-reviewed academicresearch regarding the impact of private equity. This research is broadly supportiveof the hypothesis that private equity has, in aggregate, a positive influence on theeconomy by facilitating and accelerating restructuring, with all the pain that that maycause at an individual level.12. Outstanding questions: the high levels of borrowing seen in the past decade mayresult in an increase in failures in buyouts. The number of funds in existence mayreduce as some fail.John GilliganMike WrightMarch 2010Preface vii

AcknowledgementsThis report has benefited immeasurably from the support and positive criticism of anumber of people, including anonymous reviewers and colleagues within both PKF andThe Centre for Management Buy-out Research at Nottingham University. Chris Ward,Deloitte, Chairman of the Corporate Finance Faculty from 2004 to 2008, not only sawthe need for a report, but has tirelessly reviewed many drafts with an eye for both detailand the big picture second to none, giving far more of his time than we could haveexpected and he could have anticipated when we first started. Richard Green, AugustEquity; Barry Lawson, Bridgepoint Capital and Jon Penfold and Terry Awan, Deloittesimilarly gave of their valuable time and, in the absence of any tangible reward, weoffer them our thanks. Without Robert Hodgkinson and especially Katerina Joannouof the ICAEW the report would never have seen the light of day. Thanks also to DebbieHomersham, Philip Chamberlain, Caroline Kearns and Richard Anning of the ICAEWand Nick Toyas of NT&A. All errors and omissions are entirely our own responsibility.viii Acknowledgements

About the authorsJohn Gilligan is a Corporate Finance Partner in PKF (UK) LLP. He has worked in theprivate equity and venture capital industry for over 20 years. He started his career in 1988at 3i Group plc as a financial analyst. He joined what is now Deloitte in 1993 and was apartner from 1998 to 2003. He is a Special Lecturer at Nottingham University BusinessSchool and has also taught at Cranfield University Business School.He has a degree in economics from Southampton University and an MBA in financialstudies from Nottingham University.Professor Mike Wright has been Professor of Financial Studies at Nottingham UniversityBusiness School since 1989 and Director of The Centre for Management Buy-outResearch since 1986. He has written over 25 books and more than 300 papers inacademic and professional journals on management buy-outs, venture capital, habitualentrepreneurs, corporate governance and related topics.He served two terms as an editor of Entrepreneurship Theory and Practice (1994–99) andis currently a joint editor of the Journal of Management Studies. He holds a BA (CNAA),MA (Durham), PhD (Nottingham) and an honorary doctorate from the University ofGhent and is the winner of the Academy of Management Entrepreneurship DivisionMentor Award 2009.Contact detailsJohn GilliganPartnerPKF (UK) LLPFarringdon Place20 Farringdon RoadLondon EC1M 3APUKTel: 44 (0)20 7065 0241Email: John.Gilligan@uk.pkf.comMike WrightCentre for Management Buy-out ResearchNottingham University Business SchoolJubilee CampusNottingham NG8 1BBUKEmail: mike.wright@nottingham.ac.ukandRotterdam School of ManagementErasmus University RotterdamBurgemeester Oudlaan 503062 PA RotterdamPO Box 1738300 DR RotterdamThe NetherlandsTel: 44 (0)115 951 5257About the authors ix

List of figures, tables and findings1. The private equity marketFigure 1.1:European private equity: new fund commitments, new investment18Figure 1.2:Number and value of UK private equity-backed buy-outs greater than 10m18Figure 1.3:Private equity-backed buy-outs above 10m as a percentage of UK takeover activity 19Figure 1.4:Average value of UK private equity-backed buy-outs ( m), above 10m19Figure 1.5:Buy-outs over 100m share of UK market value by value (%)20Figure 1.6:Buy-outs over 100m share of UK market by number of transactions (%)20Figure 1.7:UK public to private buy-outs: number and value23Figure 1.8:Buy-outs in receivership: number and value25Table 1.1:Major UK private equity houses and their predecessor firms17Table 1.2:Largest UK buy-outs21Table 1.3:The world’s largest buy-out bids22Table 1.4:Estimate of the world’s 25 largest private equity funds (by capital committed) 2007 22Findings 1.1: Does corporate governance in public to private deals differ from other listedcorporations before buy-out? The academic evidence242. Who are the participants in a private equity transaction?Figure 2.1:Participants in a leveraged buy-out28Figure 2.2:Structure of a typical private equity fund29Figure 2.3:Global private equity investment bn 200736Figure 2.4:Global private equity funds raised bn 200736Figure 2.5:Funds raised by country of fund manager 2007 (exc US)37Figure 2.6:Investment bn by country 2007 (exc US)37Figure 2.7:Evolution of EVCA/KPMG index of British tax and legal environmentfor private equity 2003–200839Figure 2.8:Illustrative relationship between fund size and fee income39Figure 2.9:Changing CGT rate to higher rate taxpayers on business assets 1998–200842Figure 2.10: Full members of the BVCA 1985–200744Figure 2.11: BVCA members joining/leaving the BVCA by year: 1985–200744Figure 2.12: Investors in private equity/VC funds by type of investor 2002–200645Figure 2.13: Geographic origin and country of management of European funds raised in 2006 46Figure 2.14: Return to mid-large buy-outs: distributed versus unrealised value47Figure 2.15: Valuation decision tree48Figure 2.16: The J curve: cumulative cash flow and total return after fees and beforecarried interest51Figure 2.17: Realised and unrealised value per 1.00 invested51Figure 2.18: Distribution of returns to mid-large buy-outs funds: total value per invested52Figure 2.19: Distribution of returns to mid-large buy-out funds: cash distributed per invested 52Figure 2.20: Schematic of CDO/CLO/SIV56Figure 2.21: Flow of risks from original lenders through securisation to bond markets57Figure 2.22: Illustrative advisers to a transaction59Figure 2.23: Taxation general schematic62Figure 2.24: Divestment proceeds by type of exit63Figure 2.25: Write offs by value and % of total divestments (excluding loan andpreference repayments)64Figure 2.26: UK exit numbers by type of exit64Figure 2.27: Secondary buy-outs by number and value65Figure 2.28: Average time to exit: private equity-backed buy-outs over 10m by year of exitin the UK6731Table 2.1:Key differences between private equity and quoted equity fundsTable 2.2:Key differences between private equity and trading groups of companies32Table 2.3:Key differences between private equity and hedge funds33Table 2.4:Selected other activities of the world’s largest private equity investors (as at 2008) 35Table 2.5:Reconciliation of BVCA membership from 1985–2008x List of figures, tables and findings43

Table 2.6:Top 20 fund of funds in recent global private equity 200745Table 2.7:Pooled returns in larger buy-outs 1996–200647Table 2.8:Investee company compliance to the Walker Guidelines68Table 2.9:Private equity firm compliance with the Walker Guidelines68Findings 2.1: Do investors earn superior returns? The academic evidence53Findings 2.2: Do private equity and buy-outs adversely affect employment?The academic evidenceFindings 2.3: Do private equity and buy-outs adversely affect wages? The academic evidence6161Findings 2.4: What is the impact of private equity on human resources management?The academic evidence62Findings 2.5: What are the effects of private equity on debt holders? The academic evidence63Findings 2.6: What are the effects of private equity on taxation? The academic evidence63Findings 2.7: Do private equity deals involve the short-term ‘flipping’ of assets?The academic evidence66Findings 2.8: What is the extent of asset sales and refinancing? The academic evidence67Findings 2.9: Do the effects of private equity continue after exit? The academic evidence673. Evaluating, structuring and restructuring a private equity investmentFigure 3.1:Equity value, enterprise value and asset value72Figure 3.2:Types of financial instrument: risk and reward73Figure 3.3:The basic building blocks of financial engineering74Figure 3.4:Outline structure of a leveraged buy-out75Figure 3.5:Relationship between length of loan, interest rate and multiple of free cash flow(in an equal payment fully amortising loan)78Figure 3.6:Illustrative security value of a failing company’s assets78Figure 3.7:Impact of capital holidays of various lengths on the cash requirement of loans(seven-year loan)79Figure 3.8:Margins on tranches of senior debt (basis points above LIBOR)81Figure 3.9:Illustration of the restructuring into a propco/opco structure84Figure 3.10: Schematic illustrating banking covenants87Figure 3.11: Percentage of UK buy-outs ending in receivership: by value rangeand vintage year89Figure 3.12: IRR versus time of exit at various exit multiples91Figure 3.13: The limits of the most common restructuring options98Table 3.1:Calculation of enterprise value and equity value72Table 3.2:Creating a hierarchy of financial instruments by varying risk and reward75Table 3.3:Stylised comparison of security in a retailer and a manufacturer79Table 3.4:IRRs calculated at varying exit years and varying exit multiples oforiginal investment90Table 3.5:Multiple of money calculated at varying years of exit and IRRs91Table 3.6:Impact of varying yields on the capital gain required to generate an IRR of 25%92Table 3.7:Largest private equity-backed receiverships93Findings 3.1: Does higher leverage lead to increased likelihood of failure?The academic evidenceFindings 3.2: Where do buy-outs get the cash to pay down the debt? The academic evidence8285Findings 3.3: To what extent to do private equity deals involve strategies to grow the business?The academic evidence86Findings 3.4: Do private equity deals and buy-outs have adverse effects on investment andR&D? The academic evidence86Findings 3.5: What proportion of buy-outs fail? Industry data89Findings 3.6: What do secured creditors recover? The academic evidence90Findings 3.7: Has the debt-equity ratio been increasing in private equity deals? The evidence93Findings 3.8: To what extent are managerial equity, leverage and private equity boardinvolvement responsible for performance changes? The academic evidence94List of figures, tables and findings xi

4. A detailed worked example of a leveraged buy-outFigure 4.1:Actual and forecast sales and profit104Figure 4.2:EBITDA and operating cash flows105Figure 4.3:EBIT: profit bridge107Figure 4.4:Sources of funding109Figure 4.5:The funding package analysed by funding requirement, security available,source of funds, detailed financial insturment and type of financial instrument109Figure 4.6:Profit: EBITA, EBIT, NPBT110Figure 4.7:Difference between interest accrued and interest paid112Figure 4.8:Cash flows: before and after finance costs112Figure 4.9:Forecast values of interest cover and cash cover113Figure 4.10: Forecast security cover114Figure 4.11: Taxable profit and accounting profit are different116Figure 4.12: The book value of assets is different to the tax written down valuebecause of capital allowances117Figure 4.13: Calculation of goodwill118Table 4.1:Operating profit projections104Table 4.2:Actual and forecast operating cash flows105Table 4.3:Profit bridges106Table 4.4:Funding requirement107Table 4.5:Sources of funding108Table 4.6:Illustrative financing structure110Table 4.7:Summary of projected consolidated profit and loss account after funding111Table 4.8:Reconciliation of interest charges112Table 4.9:Summary of cash flows after funding113Table 4.10:Summary of projected consolidated balance sheets114Table 4.11:Alternative balance sheet presentation115Table 4.12:PIK debt and the equity illusion115Table 4.13:Restatement of profit for tax purposes in a typical company116Table 4.14:Calculation of goodwill117Table 4.15:Enterprise value and equity value at exit120Table 4.16:Allocation of net equity value121Table 4.17:Projected share of exit enterprise value by investor121Table 4.18:Reconciliation of the relative effects of operating performance and financialengineering on equity value at exit in years 2 and 3121Table 4.19:Split of proceeds on exit122Table 4.20:Projected returns (IRRs) by participant (exit year 3, PE 12)122Table 4.21:Private equity investor blended returns: sensitised by year of exit and exit P/E ratio 122xii List of figures, tables and findings

Executive SummaryObjective of the reportThis is the second edition of Private Equity Demystified – An Explanatory Guide. In the firstedition we sought to contribute to a debate about the private equity industry by clarifyinghow the industry works. We provided a summary of the findings of a review of approximately100 peer-reviewed academic papers which have examined aspects of the private equityindustry over the past 25 years. This was the most comprehensive review of academicresearch in this area ever undertaken.Since we wrote the first edition, there has been unprecedented market turmoil and financialdistress across the global banking system. The analysis in this second edition expands on someof our earlier discussion in the light of this t

The first edition of Private Equity Demystified -An Explanatory Guidewas published in August 2008, as the first report to be issued under Financing Change, the thought . 2.9.5 What do private equity investors have to do to comply with the guidelines? 69 3 Evaluating, structuring and restructuring a private equity investment 71 .