Private Equity: Venture Capital, Leveraged Buyouts and Exit Strategies

Private equity is a special asset class form of equity ownership, as these investments are not exchange traded.

The exam should focus on two forms of private equity: venture capital (VC) and leveraged buyouts (LBO).

Private equity typically requires investors to have a long investment time horizon; therefore institution investors, such as pension funds and endowments, are key players in this asset class.

Sources of Value

The following list represents sources of value from private equity:

• Ability to turn companies around (primarily an LBO driver).

• Ability to obtain better borrowing terms (primarily an LBO driver).  Private equity firms with established track records may be able to borrow on better terms than the target company.

• Alignment of interests between the private equity firm and the target company’s management.

• The term sheet states the duties and rights of the private equity firm and the company’s management.

• Term sheet clauses include:

• Tag along, drag along rights.

• Results driven pay packages.

• Earn outs.

• Reserved matters.

• Non-compete agreements.

• Board seats.

Venture Capital (VC) vs. Leveraged Buyouts (LBO)

While both falling under the broad category of “private equity” there are some notable differences between VC and LBO.

Venture Capital (VC)

This private equity approach is associated with providing funding to new companies with high growth potential, often in new and/or high tech industries.

Some VC investment characteristics:

• Unpredictable cash flows.
• Low company asset base.
• Low leverage, primarily equity financed.
• Products and market are often new and not yet established.
• High working capital needs.
• Unseasoned management team.
• Focus on revenue growth.
• The risk/reward tradeoff can be difficult to assess, but a private equity fund typically generates most of its returns from a small number of big successes.