Private Equity and Venture Capital in Europe_2 pptx

He specializes in corporate fi nance with specifi c attention to private equity and venture capital, SMEs and family fi rm fi nancing, and corporate banking.. Because this type of business h

About the Author

Stefano Caselli is a Full Professor of Banking and Finance at Bocconi University

where he is Director of the Masters of International Management for CEMS He is the Head of Executive Education Custom Programs, Banks and Financial Institutions Division at SDA Bocconi School of Management He specializes in corporate fi nance with specifi c attention to private equity and venture capital, SMEs and family fi rm

fi nancing, and corporate banking He is the author of several books and tions on these topics and serves as a strategic consultant to many fi nancial institu-tions and corporations

PART

1

General

There is evidence that investing in the equity of companies started during the Roman Empire However, the fi rst suggestion of a whole structured organization that funded fi rms to improve and make their development easier was found dur-ing the fi fteenth century, when British institutions launched projects dedicated

to the increase and expansion of trade to and from their colonies

Modern private equity and venture capital have been around since the 1940s when it started to be useful and essential for fi nancial markets and a fi rm’s development Financing fi rms by private equity and venture capital has become increasingly more important, both strategically and fi nancially

Because this type of business has been around so long, together with ferences between fi rms and fi nancial markets, one worldwide defi nition and classi fi cation for private equity and/or venture capital does not exist However,

dif-CHAPTER

Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals

it is clear that a broad defi nition does exist: private equity is not public equity because it includes the investments realized from the stock market

In the third part of this book, various defi nitions are formulated based on the operation, the stage of the fi rm’s life cycle, the operator’s approach, and the type of support

Institutionally , private equity is the provision of capital and management expertise given to companies to create value and, consequently, generate big capital gains after the deal Usually, the holding period of these investments is defi ned as medium or long

This defi nition, even if very broad, cannot be applied to the real world, because operators ’ national associations (i.e., NVCA, EVCA, BVCA, AIFI), or central banks interpret the defi nition according to the countries in which they operate For this reason, many defi nitions still exist According to the American version, venture capital is a cluster of private equity dedicated to fi nance new ventures Therefore, venture capitalists fund fi rms during their initial phases or look for sources to expand and develop the activity of the fi rm, whereas private equity operators fund fi rms at the end of their fi rst/fast growth process

The European defi nition proposes that private equity and venture capital are two separate clusters based on the life cycle of the fi rm Venture capitalists provide the funding for start-up businesses and early stage companies, whereas private equity operators are involved in deals with older fi rms Different from the American defi nition, the European defi nition does not consider the expan-sion phase (the phase after the beginning and the start-up) as a part of venture capital, but more of an autonomous subcategory

Although there are differences in defi nition, private equity and venture tal create a strict relationship between the investor and the entrepreneur This is

capi-a unique chcapi-arcapi-acteristic not found in capi-any other fi ncapi-ancicapi-al institution This is capi-uted to the typical characteristics of private equity and venture capital fi nancing schemes:

Modifi cation of shareholder composition

Knowledge and non-fi nancial support

Predefi ned time horizon of the investment

Private equity and venture capital investment are used to invest in equity; for this reason, operators specializing in these kinds of deals may decide on the

fi rm’s strategy and day-by-day management This participation, or the admission

of a new subject among the original shareholders, generates a metamorphosis in the decision process Additionally, a modifi cation in the stability and symmetry

of the organization and its consequences among original shareholders may be noted

The operation of private equity and venture capital is not limited to simple money provision; the fi nancial support comes from managerial activity consist-ing of a series of advisory services and full-time assistance for fi rm development For young fi rms or a new business idea, cooperation with fi nanciers is very important, because reputation, know-how, networking, relationships, compe-tencies, and skills are the non-fi nancial resources provided by private equity and venture capital operators Although diffi cult to measure, these resources are the real reason for the deal and important for fi rm growth

Private equity and venture capital agreements always defi ne length and exit conditions for fi nancial institutions Even though funding institutions are active shareholders and engaged in company management, they are not interested in taking total control or transforming their temporary participation into long-term involvement Venture capitalists and private equity operators, sooner or later, sell their position; this is the most important reason for defi n-ing this type of investment as “ fi nancial ” and not “ industrial ” The presence of

a predefi ned time horizon for the investment makes private equity and ture capital useful for fi rms wanting quick development, managerial change,

ven-fi nancial stability, etc

AND ENTREPRENEURIAL FINANCE

What is the difference between corporate fi nance and private equity fi nance (or entrepreneurial fi nance)? This is a very interesting question and the answer is not as easy as it may seem The question can be answered in two different ways: institutionally and environmentally (see Figure 1.1 )

Corporate fi nance, which is the most traditional way to fund fi rms, is more standardized, less fl exible, and focused on debt Expected returns are lower and linked to the costs that fi nancial institutions incur while collecting money from savers The reference point for the valuation (i.e., costs, feasibility, etc.) is the whole company, independent of funded sources Another interesting point

is the fi nancial institution’s unwillingness to participate in the fi rm’s decision framework

Private equity fi nance is very fl exible and the expected returns are higher (non-fi nancial resources must be paid) than corporate fi nance It is characterized

by a medium to long time horizon, higher options available for the fi nancial tution’s exit strategy, and by its high profi le in the decision process The focus of private equity fi nance is the potential growth path of a company

insti-1.2 Main differences between corporate fi nance and entrepreneurial fi nance

The institutional approach, even though it is able to distinguish between porate and entrepreneurial fi nance, does not consider the environment companies face when they contemplate private equity as a fi nancing option The environmen-tal approach does consider the environment and the situation faced by entrepre-neurs during the fi nancial selection process Some aspects of the environmental approach are the same as the institutional approach, whereas some aspects better explain the consequences of entrepreneurial fi nance

The elements in the following list distinguish private equity fi nance from porate fi nance using the environmental approach

Interdependence between investment and fi nancing decision

Managerial involvement of outside investors

Information problem and contract design

Value to entrepreneur

Legal and fi scal ad hoc rules

Reference point for

Collateral

Usually real estate No guarantees or agreement between

company and financier

Target return Spread over the financial

costs of funds collections

High or very high, consisting of capital gain realized at exit moment

5/7 years

Financial institution

With the institutional approach, private equity fi nancing does not fund the whole company In this scheme of fi nancial and non-fi nancial support, a specifi c project the entrepreneur needs to fi nance is targeted Because of this, a strong and effective interdependence between the fi rm’s investment and fi nancing must exist and must continue during the entire length of the deal

Private equity operators and venture capitalists provide fi nancial and

non-fi nancial sources This generates the involvement of third parties (external investors) in the decision process and/or company management It must be emphasized that only in private equity fi nance is there a decisive participation

in the fi rm’s administration

The third issue seen in the environmental approach is that private equity operators support fi rms on risky projects This increases conventional informa-tion problems occurring in all fi rm fi nancing schemes These problems lead to

a lack of standardized agreements, so a special settlement is signed for every funded project

The strong interdependence among companies and fi nancial institutions erates problems in wealth and value distribution too As private equity fi nan-ciers became shareholders, a strong co-participation between the entrepreneur’s desires and the fi nancial institution’s purposes exists Private equity fi nanciers support fi rms with their skills, competencies, know-how, etc Because this cre-ates value for funded fi rms, the investor allows the entrepreneur to take value from the funded idea In most cases, without private equity or venture capital-ists, fi rms would not be able to develop projects

The special legal and fi scal framework for the investor and/or vehicle used

to realize the deal is the last factor that sets private equity fi nance apart from venture capital It will be shown throughout the following chapters that the pri-vate equity industry, because it simultaneously acts as entrepreneur/shareholder and fi nancier, needs special treatment regarding taxes and legal frameworks to develop and carry out investments

In the private equity business, relationships between entrepreneur, holders, and external investors are intertwined In large deals within large cor-porations there is a clear convergence between the entrepreneur (and many times, his family) and the shareholders This modifi es the traditional perspec-tive of corporate fi nance in which shareholders and managers are two separate blocks with different goals and tasks

This is particularly true for venture capital The smaller the fi rm or the earlier the life cycle, the more likely the entrepreneur is the shareholder and the manager This makes it easier for the deal to be realized, developed, and carried out

1.2 Main differences between corporate fi nance and entrepreneurial fi nance

Firms need funding during sales development, which occurs during different stages for each fi rm The drivers that measure the fi rm’s need for funding are investment, profi tability, cash fl ow, and sales growth These four variables are strictly linked together, and should be evaluated from a long-term perspective These four variables/drivers represent the stage the fi rm is in, which helps fi nan-ciers defi ne their strategy

Analyzing the four drivers, typical stages of the fi rm used to classify fi nancial needs can be identifi ed There are six different stages:

6 Crisis and/or decline

These stages impact the four drivers — investment, profi tability, cash fl ow, and sales growth — used when analyzing fi nancial needs and equity capital demand of a fi rm as seen in Figure 1.2

During the fi rst stage, the entrepreneur has to cope with development, the length of which depends on the business features and the entrepreneur’s com-mitment The objective is to defi ne the most convenient structure for the project’s progress In this phase, sales do not exist and profi tability and cash fl ow are negative due to the presence of compulsory investments such as the completion of informa-tion memorandum, costs for legal and fi scal advisory, engineering development, etc The start-up stage consists of company creation and launch of fi rm activity During this period, sales start, but the trend is not solid enough to support costs incurred by sizeable and substantial investments related to the acquisition of pro-ductive factors Consequently, cash fl ows and profi tability are strongly negative The next stage, early growth, occurs just after start up Investments have been made and the fi rm’s current needs are related to inventory, rather than working cap-ital; the revenues realized by the company are increasing There is a rise in profi t-ability and cash fl ow, even though they remain negative However, the whole trend

is positive and stable and the negative value is slowly becoming greater than zero

The next stage is rapid growth The investments needed are the same as the early growth stage In this period, sales are increasing but the growth trend is negative and cash fl ow and profi tability are positive and increasing

After the rapid growth stage, there is a period of maturity and fi rms enter the mature age phase The sales growth tends to zero while profi tability and cash

fl ows level off During this phase, investments are not just related to inventory and/or working capital but the replacement of ineffective or unused assets also must be taken into account The last of the six stages is the crisis or decline phase During this period, sales, profi tability, and cash fl ow fall and the fi rm is unable to decide what investments should be completed to overturn the decline These stages create a demand for fi nancial resources measured by the net cash fl ow produced by the fi rm Demand for fi nancial resources is satisfi ed by different players with different tools ranging from debt capital to equity capital

PERSPECTIVE

Private equity operators and venture capitalists are just a sample of the groups

in the fi nancial system They represent one of the various options that neurs consider to fi nance their business At the same time, entrepreneurs must think about profi tability, investment needs, sales growth, and cash fl ow to fi nd the right counterparty

entrepre-1.4 The map of equity investment: an investor’s perspective

Development Focused on the acquisitions

of productive factors

acquisitions of productive factors

Strongly negative

Strongly negative

Starting

Early

growth

Limited to the inventory financing

Negative but reducing

Negative but reducing

Positive and increasing

Rapid

growth

Limited to the inventory financing

Positive and increasing

Positive and increasing

Positive but decreasing

Mature age Focused on the inventory

or on the replacement

End of increasing

End of increasing

Getting to zero

Crisis or

decline

Not possible to be identified

Falling down Negative Falling down

FIGURE 1.2

The characteristics of the four drivers in a fi rm’s six different stages

Many potential investors are considered from both a debt and an equity perspective:

Founder and family

3 How long before the fi rm is able to repay the equity investor?

The fi rst question determines the size of resources required by the fi rm and the amount of resources that the fi nancial institutions have to satisfy this need The greater the amount the fi rm requires, the greater the size, reputation, and skills of the counterparty The second question ascertains what sort of fi nancial resources the fi rm needs; for example, venture capitalists and private equity operators tend to participate with equity, whereas banks are focused on debt At the same time, the founder and the family equity investment in the fi rm or trade credit institutions only propose debt The third question defi nes the time hori-zon and the capability of investors to wait and remain confi dent in their deals The answers to these questions help to defi ne profi les of investors with dif-ferent levels of risk tolerance, chances to invest in equity, and the ability to sup-port a shorter or longer payback period The different profi les are related to different risk – return combinations and time horizons ( Figure 1.3 )

FIGURE 1.3

The relationship between risk – return profi le and characteristics of the investment