 The venture-backed company does not pay any interest expenses to the PEI

 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.

Why Would a Company Need PE?

1. Certification Benefit: Due to the long screening phase before deciding to invest in a
company, if the PEI finally does choose 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 company’s brand.
2. Network Benefit: The PEI can give the company a very strong network, in terms of suppliers,
customers and banks therefore multiplying its possible contacts.
3. Knowledge Benefit: 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
4. Financial Benefit:
Seed:

 Most risky
 Idea development/r&d oriented
 3 golden rules:
o 100/10/1 RULE: The investor has to screen one hundred projects, finance ten of
them and be lucky (and able) enough to find the one successful one.
o 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 longerpreform his or her job.
o Size of the market:

Startup:

 Initial operations started

 need of cash derives from the necessity to buy the necessary equipment to start business
o Put option: This tool is used to sell back to the entrepreneur 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.
o COLLATERAL: This is a pledge for the investor over some valuable assets of the newly
founded company and this is usually used together with the put option.
 o STOCK OPTIONS FOR THE INVENTOR: In this way the entrepreneur will also enjoy the
profitability of the company. Another way to reduce the risk the business plan is not
accurate and reliable is to grant the inventor some stock options.
o 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 business
(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.

Early Growth

 started generating sales

 Need of cash derives from the necessity to buy inventory and to sustain the gap existing
between cash flow and money needed.
 Cash flow is still negative, but not as much as in the previous stages of life of the company.

Characteristics of VC

 high level of risk

 hands on approach
 very deep knowledge of the field

Expansion Financing

Internal Growth: when it plans to grow “by itself.” This means that investments in fixed assets and in
working capital will be made. 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.

External Growth: plans to grow by acquiring another company (i.e. carry on an M&A) in order to
enhance the level of sales and exploit the synergies.

Two ways of M&A

1. PEI gives money to venture-backed company and they carry out M&A and give the profit
from synergies to the PIE
2. Creation of SPV by PIE to collect money from the banking system and put the cash collected
in the SPV
 a. When the 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 separate entity, this happens when the
company does not want the PEI to share the gain deriving from the M&A process.
c. SPV is more expensive than 1st option

Replacement

 Mature age
 A company needs replacement financing when it wants to face strategic decisions linked
either to governance, status, or corporate finance decisions.
 There are three kinds of operations belonging to this cluster. These deals do not derive from
the arise of need of money of a company.
o LBOs:

The target company usually has: • Relevant Cash Flow • Low D/E ratio • Assets that
can be easily be sold on the market

Private Investment in Public Equity

the profit mechanism is still not related to the stock exchange. This deal is not done with trading
purposes. The purpose is to buy a minority stake and then to sell it to another potential
shareholder at a price not based on the stock exchange (which usually is three - four times bigger).
This stake has to be big enough to become the biggest shareholder.

CG 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 particularly
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.

Vulture Financing

The financial aid coming from the PEI is used to launch a survival plan. Very risky also

 Restructuring financing (or turnaround): the company is facing a crisis, but is still alive. The
need of financing derives from the settlements of debts with banks and with suppliers. At
the same time, money can be used to re-launch the business. These strategic needs make
the PEI not only a financer for the troubled company but also an advisor. Because the risk is
very high due to the strategic nature of the role of PE, the investor is a majority
shareholder: there is a very strong hands-on approach and this needs a majority stake in the
equity of the company. it is very difficult to find a PEI investing in such deal, it is more of an
investment banking activity.
 Distressed financing: it occurs when the company is dead. The aim of PE is not in fact to
merely finance the company, rather to buy the relevant (and valuable) assets of the
company like Patents, Brands, Contracts, Equipment
Why would a PEI want to buy the assets of a defaulted company? 1. In some cases, the PE
may be a trader of assets. This means that the investment is made only to sell such assets to
a third buyer. 2. In other cases, the PEI buys the assets because it inserts them in other
venture-backed companies in its portfolio.
The assets are bought before a court, and the negotiation process can be tough between
the court and the investor. As a matter of fact, it is a desire of the court to maximize the
liquidity of a company when it goes bankrupt, so that it can pay off its debts. Sometimes the
court implements the “poison pill.” This means that the PEI is going to buy a valuable asset
mandatorily together with another less valuable assets or together with a debt of the
company.

PE in Europe and US
Europe (excluding the UK) can be taken as one very big country with many family businesses
and PE can help them to develop. PE players support generational change: again, a different
way to do PE

Acronyms:
VCF Venture Capital Funds
VCM Venture Capital Method
VCT Venture Capital Trusts
PPP Public-Private Partnerships
QSBS Qualified Small Business Stock
 SA surplus (non-operating) assets
SBIC Small Business Investment Companies
PEX Participation Exemption
NFP Net Financial Position
EVCA European Venture Capital Association
CG deals Corporate Governance Deals
CEF Closed-End Fund(s)
CFt Cash Flow at time "t"
AIFM Alternative Investment Fund Managers

Regulation of PE Investments:
1.The European Union format: regulated by a Directive of the European Union
 The Banking Directive: regulates banks and investment firms
 The Financial Services Directive: closed-ended funds
 AIFM Directive: closed-ended funds
2.The Anglo-Saxon format: regulated by US and UK laws.
In the Anglo-Saxon world, PE is not a financial service (as it is in Europe), rather it is an
entrepreneurial activity. In the end, in the Anglo-Saxon format, there is no supervisor.

The European format has been adapted and is now used in, Brazil, and Russia, and others;
whereas the Anglo-Saxon format is also used in India and Australia.

What is an AMC?
The AMC is a financial institution, whose task it is to manage the fund. 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 (i.e., personal management of savings,
dealing, brokerage, advisory). AMC must own in every fund, which must be equal to 2%.

What is fund?
A fund is a separated 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.

What are closed-ended funds? illiquid

The closed-end fund is a separate entity that invests money for a pool of investors. Closed
end funds have a fixed maturity and a fixed amount of money to invest. Their length is fixed,
meaning that the investors can invest in the beginning 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. Closed-end funds are the most important
vehicle in Europe for PE. Both open and close-ended funds can never use debt.

Rules for the AMC:

Minimum requirements to operate
Governance rules
Management rules

Rules for the Fund:

 General rules
Internal code of activity
Investment policy

Closed-End Fund: Lifetime of a Fund

1. Fundraising: AMC needs the 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 as a maximum 18 months to collect the 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. In fact, 50% of the funds all over Europe do not
manage to get to time 0.
2. Draw Down Period: AMC has the possibility ask the investors to deposit a percentage of
their commitment (e.g. 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.
3. 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.
4. After the end of the closed-end fund there is the possibility to use up to three year 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 the 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.

How the AMC is remunerated over the fund’s lifetime?

1. Management fees: AMC receives every year from closed-end funds. 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. Management fees
must be precisely calculated for they have to cover: Operating costs • Remuneration of the advisor
helping the AMC in the consulting activity • Remuneration of the technical committee

2. Carried interest: Usually, the fixed percentage ranges between 25-30%. Maximizing the carried
interest is the ultimate goal and desire of an AMC. It is computed only at the end of the closed-end
fund’s life cycle.

CARRIED INTEREST = % x (Final IRR – Hurdle IRR)

Amount to managers = committed capital * carried interest

Without catch-up: The carried interest is computed on the difference between the final IRR and the
hurdle rate. • With catch-up: The carried interest is directly computed on the final IRR

Banks: For regulatory reasons, it is very rare that a bank invests directly and become a PEI. Banks
usually invest in closed-end funds to ultimately participate to some PE activities.

Investment Firms:
A-shareholders: act as an AMC. They are remunerated with the management fees and with a yearly
carried interest (it is computed every year because the investment firm does not come to and end,
unlike the closed-end fund).

B-shareholders: act purely as investors and cannot influence the management of the investment.
They are remunerated with the difference between the profits and the carried interest given to A-
shareholders.

Why 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
comply 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.

(Note: remember that closed-end funds can not leverage). The fact that a fund can leverage makes
it a hedge fund, entailing a higher risk-return combination than the one in Europe.

US

1. Venture Capital Funds (VCFs or simply, funds): most popular PE instruments in the US. The legal
entity supporting a VCF is called the limited partnership (LP). An LP is the legal entity with the
mandatory presence of two different groups of shareholders: The Limited Partners (LPs) must own
99% of the equity of the LP, whereas the General Partners (GPs) must own 1% of it. This is set by US
law. Limited Partners are solely 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. Even though the holding stake is different. The functioning of a fund is regulated
by a Limited Partnership Agreement and it is made by GPs and LPs, where the content is very similar
to the one of the internal code of activity, except for the parts referring to debt policy. The only
difference with the fact that in Europe, it is a code, therefore in case of a legal battle they go before
a Supervisor. On the contrary in the US it is a contract, then they go before a Court.

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 can be enjoyed if you do not operate in the US, as long as
the VCF is in the US.
2. Small Business Investment Companies (SBICs): 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 of shareholder
(it is usually a bank, corporation, or individual). The Public Admin that holds 50% of the equity of the
company is a pure investor: it cannot manage the company. On the contrary, the non-public admin
investor has the duty and the right to manage the investments and the whole company. Both
shareholders receive a management fee, but the profit distribution (calculated with the carried
interest approach) is asymmetric: the US PA will get the remuneration up to a threshold stated in the
SBIC Agreement, whereas the extra profit generated through the investments belongs to the other
shareholder. Losses are equally distributed. This mechanism is very popular in the US, because with
a partner belonging to the Public Administration, some investors feel they can invest even in riskier
deals. SBICs are considered among the best models of PPPs (Public-Private Partnerships).

3. Banks : very rare that they directly invest in PE. They usually act as either GPs or LPs in VCFs.

4. Corporate Venture: They are not proper legal entities, 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.

5. Business Angels: 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 (Qualified Small Business Stock). This
means that if they invest in PE and, at the end of the investment, the capital gain is immediately
invested in another private company under the form of PE, taxes are not paid.

UK:

1. Venture capital funds (VCF) : UK VCFs are not built under the European scheme of closed-end
funds but are legal entity operating like LPs like in the US

2. Venture capital trusts (VCT) : the owner (called the settlor) does not have to manage the assets,
for a third player will do it (the trustee) and that is fully liable to manage In case the VCT has a
maturity, at the end of the VCT the owner gets back the assets belonging to the trust. GPs create a
trust with a term (the VCF term) and they set 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 management 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. 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. Every time investors invest in trust, they receive a certificate listed in
the stock exchange; this ensures to investors a high level of liquidity. Retail investors can purchase
shares in venture capital trusts that are traded on major exchanges like the LSE. This allows investors
to take part in the growth of smaller, private, up-and-coming businesses indirectly. The government
exempts these trusts from corporate taxes on capital gains that arise from their investments. They
also provide investors with certain tax benefits

3. Banks

4. Business Angels

5. Local PPPs
New Trends in PE

1) Private Debt funds : 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) Crowd Funding: 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. Different players can
launch their own financial needs and make a call on the internet to collect money through their
platform.

3) Venture Philanthropy: When PE vehicles invest only in businesses generating a string social
impact, this is called Venture Philanthropy. In these cases, the mechanisms are the same as in the
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.

4) Special Purpose Acquisition Companies (SPACs): 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.” In creating a SPAC, the founders sometimes have at least one acquisition target
in mind, but they don't identify that target to avoid extensive disclosures during the IPO process.
(This is why they are called "blank check companies." IPO investors typically have no idea about the
company in which they will ultimately be investing). SPACs seek underwriters and institutional
investors before offering shares to the public. The funds SPACs raise in an IPO are placed in an
interest-bearing trust account. These funds cannot be disbursed except to complete an acquisition
or to return the money to investors if the SPAC is liquidated. A SPAC generally has two years to
complete a deal or face liquidation. In some cases, some of the interest earned from the trust can
serve as the SPAC's working capital. After an acquisition, a SPAC is usually listed on one of the major
stock exchanges.

Advantages of SPACs:

 a company can go public through the SPAC route in a matter of months, while the
conventional IPO process is an arduous process that can take anywhere from six months to
more than a year.
 owners of the target company may be able to negotiate a premium price when selling to a
SPAC because the latter has a limited time window for making a deal. In addition, being
acquired by or merging with a SPAC that is sponsored by prominent financiers and business
executives can give the target company experienced management and enhanced market
visibility.

Risks:

 leap of faith that its promoters will be successful in acquiring or merging with a suitable
target company in the future. The reduced degree of oversight from regulators, coupled
with a lack of disclosure from the typical SPAC, means that retail investors run the risk of
being saddled with an investment that could be massively overhyped or occasionally even
fraudulent
  Returns from SPACs may be well below expectations when the initial hype has worn off.
Strategists at Goldman Sachs noted in September 2021 that of the 172 SPACs that had
closed a deal since the start of 2020, the median SPAC had outperformed the Russell 3000
index from its IPO to deal announcement; but in the six months after deal closure, the
median SPAC had underperformed the Russell 3000 index by 42 percentage points.2 As
many as 70% of SPACs that had their IPO in 2021 were trading below their $10 offer price as
of Sept. 15, 2021, This dismal performance could mean that the SPAC bubble that some
market experts had warned about may be in the process of bursting.

Why Would a Company Go Public Through a SPAC and Not an IPO?

To save time and money. Going public through an IPO is a lengthy process that involves complex
regulatory filings and months of negotiations with underwriters and regulators. This can deter a
company's plans to become publicly listed, especially during periods of heightened uncertainty (such
as the pandemic years of 2020 and 2021), in which the risk of investors giving its IPO a frosty
reception is much greater.

WEEK 3

MANAGERIAL PROCESS

1. Fundraising: The fund-raising activity is devoted to promote the business idea of the new
vehicle of equity in order to find money. In the case of the Closed-End Funds this takes 1.5
years, whereas for VCF this phase takes 1 year. This is a very hard phase for the PE. The
managers have to convince the investors of their idea: as a matter of fact, the investors will
remain in that project for a very long time (think of a Closed-end fund whose length is ten
years). Fundraising is a selling game for proposal.
a. Business Idea Creation: informal consensus / “testing the waters”, producing an
information memorandum (rationale of the business idea)
b. Job Selling: managers have to convince the investors not only to give an opinion
about the idea, but also to invest in that idea. This is actualized by the letter of
commitment with which the investors declare how they want to participate in the
fund.
c. Raising Debt: sell a project to a community of financers.
d. Closing: 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 both to the
reputation and to the purpose of the initiative. A “pure” closing occurs when the PE
firm is not able to collect the whole money in the fundraising phase. Such is the case
when the managers do not have a very robust network.
2. Investment activity: scouting, the screening, the choice, the managing and the exiting of
ventures. From when they decide to invest, managers have two problems: on 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.
a. Decision-Making: the activity of valuation and selection in which the PE has to assess
whether the investing activity makes sense.
i. Origination: spontaneous/proactive
 ii. Screening: 90% of the dossiers collected in the origination step will be
eliminated
iii. Valuation and due diligence: analysis of the business plan
iv. Rating assignment: 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.
v. Negotiation: negotiation with the entrepreneur to calculate the numbers 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.
vi. Decision to invest: 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.
b. 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 governance
rules…/ financial and legal issues related to the investment. find the right balance
between the need of money of the company and the expectation of IRR and capital
gain for the PE investors.
i. Targeting – Vehicle (direct investment, SPV), % of Shares (majority/minority,
voting rights)
ii. Liability profile - Syndication Strategy (to find other equity investors with
whom build a syndicate to invest together), Debt Issuance (combine equity
investment (with or without SPV, syndicated or not) with the usage of
leverage). PE firm will have to negotiate with the banking system
iii. Engagement - Categories of Shares, Paying Policy
3. Managing and Monitoring: Actions to create and to measure value, Rules to protect the
created value, Mitigate divergences of opinions and avoid conflicts between the PE and the
entrepreneur
a. Board Services: to support decisions, introduce professional expertise, and impose a
severe discipline.
b. Performance Evaluations and Review: Development of all the required processes to
monitor and measure value inside the company and between the company and the
investor (in terms of accountability, auditing, IT systems…).
c. Recruitment Management:
d. Relationship Management: network of the investor (customers, suppliers,
governmental lobbying, …).
e. Covenants: check slide
4. Exiting: in order to have a gain. PE has to identify another shareholder to which they sell
their stake of the company. Because the liquidity is very low, finding a counterpart is not
easy. (i.e., an IRR for the PE investor).
a. Trade sale – sale to another corporation or entrepreneur, acquisition to develop a
strategic business plan
b. Buyback - sells its stake to an existing shareholder or to a buyer chosen by the
existing shareholders themselves, buyer is not a new corporation coming from the
market.
c. IPO - a PEI can maximize the capital gain; and this occurs only in 1% of the cases.
d. Sale to Another Private Equity Investor
e. Write Off - cancels the value of the stake in its portfolio. company defaults and this
may occur in start up and seed financing because the business plan may be too
aggressive. A write off does not necessarily mean an IRR -100% because the PEI may
try to sell some valuable assets in order to recover from the loss.
VALUATION

“How many times do you have to multiply the EBITDA to buy the company?”

Cash Flow / Free CF for the firm (i.e. the cash flow available for financers and shareholders without
considering a new debt issuance and the old debt repayment).

“unlevered cash flow” / does not provide any information about the capital structure

EBIT - Income taxes + Depreciation - Increase in net working capital - capital expenditure à CAPEX =
CASH FLOW

Rf = rate of return yielded by a risk-free investment

Rm = rf + risk premium (i.e., the exceeding return investors expect from the market, measured with
historical series, with respect to a risk-free investment)

β stands for the degree of correlation between the investment and the market. regression of returns
of the stock against the returns on a market index

Procedure to unlever: βu = β/ [1+(1 – t)(D/E)]

Procedure to relever: β* = βu x [1+(1 – t)(D/E)*]

We need to deduct (if they exist): • Surplus Assets • Minorities’ equity • Net Financial Position from
the enterprise value in order to obtain the equity value.

Why do we use an after tax figures for cost of debt?

Since interest paid on debts is often treated favorably by tax codes, the tax deductions due to
outstanding debts can lower the effective cost of debt paid by a borrower. The after-tax cost of debt
is the interest paid on debt less any income tax savings due to deductible interest expenses.

Yearly IRR = (New Value/Old Value)^(1/Term)-1