The ABCs of a Private Equity Deal

1
The ABCs of a Private Equity Deal

• October 11, 2008
• Justin Ward 09 (formerly at Thomas H. Lee
  Partners)Enzo DAngelo 09 (Norwest Equity
  Partners formerly at Wind Point Partners and
  American Securities Capital Partners)

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Overview of a Deal at LBO Company
Bringing Ii all together
Structuring Negotiating
Deal Screening
Deal Sourcing
Financing
Docu-mentation
Due Diligence
Post-closing
Harvest
Adding Value
Exiting the Deal
Doing the Deal
Getting the Deal
3
Why Deal Sourcing Matters
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Firms may only close 1 of 100 deals they look at
the more quality deals brought in, the more
quality deals closed
Deal Funnel
PE industry is increasingly competitive.
Proprietary deal flow can be a meaningful
competitive advantage
Competition
Looking at multiple deals helps firms stay in
touch with the industry and helps firms calibrate
business plans and management teams
Calibration
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How Sponsors Source Deals Overview
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Proprietary deal flow
• Proactive approach
• Referrals from the Company network
• Advantaged industry insight
• Effective marketing
• Industry conferences
• Press releases
• Elevator speech
• Auctions led by intermediaries
• Auctions where Company has an advantage
• Auctions where there is no advantage

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Why Deal Screening Matters
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Time

• Time is often the biggest constraint
• Avoid deals with fatal flaws that could never get
  to the finish line

Prioritization

• Test a deal against Company hurdles at every
  stage
• Allocate your time wisely

• Be responsive to all external parties
• Often better for relationships to kill a deal
  early than to let it linger

Responsiveness
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Diligence Process Where to Begin
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Investment Thesis
Principles
Process

• Investment thesis drives diligence and the
  investment decision
• See the forest through the trees dont let
  numbers consume you
• Prioritize your diligence and examine deal
  killers up front
• Dont just check boxes deliver end products
• Look for the 3-4 killer end products that will be
  the backbone of findings

• Clearly assign responsibility to Company team
  members
• Proactively manage your resources
• Be careful of due diligence expenses (scope work
  up front)
• Use resources to fit nature of deal

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Investment Thesis and Work Plan
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• What they are
• Investment thesis crystallizes and drives the
  investment decision
• Thesis should encompass investment decision
  rationale
• Work plan turns investment thesis into diligence
  road map and outlines deliverables

• Why they are important
• To frame evaluation and drive the diligence
  process
• Should provide the structure necessary to
  independently test the sub-theses
• Should keep the diligence process focused and
  tied to key decision criteria

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Common Thesis Elements and Issues
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Existing Markets
• Penetration
• Historical / projected growth rates
• Drivers of growth
• New Markets
• What is the size of a potential market?
• How much of the market does the company need to
  capture?
• What needs to happen for market to develop?
• Profitability versus return on incremental
  capital
• Relate economics to strategy
• Unit economics as building block

Market
Economics
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Common Thesis Elements and Issues
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Results

• Why has the company or management team succeeded?
• Why will success continue?
• What is the advantage of being market leader?
• Is industry fragmentation/concentration good or
  bad?
• Why are firms able to invest at this valuation?
• Proprietary deal flow
• Fundamentally different view
• Buyers or sellers?
• Big company versus entrepreneur?
• Operators versus visionaries versus deal-doers?

Position
Value
Management
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From Thesis to Due Diligence
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Begin by breaking down investment hypothesis into
  main points and sub-points
• Design the analytical outputs that support each
  point
• A picture, a table, a number, a summary of
  interviews
• Determine what analysis and what data are
  required to produce the output
• Engage external advisors as required, providing
  specific scope of work
• Prioritize the work
• Based on sensitivity, uncertainty, cost
• See the forest

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Reviewing the Tools Used in Due Diligence
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
12
Basic Financial Analyses
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• What they are
• Projections with capital structure alternatives
  and returns
• Current and historic trading multiples, operating
  performance metrics
• Comparable company analysis
• Analysis of management carry
• Capitalization table and sources uses

Why they are important
Provide the quantitative support for the
investment thesis Determine risk-reward profile
for transaction how much will you pay for given
profile
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Basic Financial Analyses Key Considerations
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Dont get lost in the numbers relate analysis
  to investment thesis
• What are the 2 or 3 key independent variables?
• Accuracy versus precision
• Build flexible models, use sensitivity tables,
  consider scenarios
• Summarize when possible, but include backup
  detail
• Know your audience

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Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Basic Financial Analyses Valuation

• Valuing a company is an art, not a science
• Beware of over-reliance on Excel
• GIGO
• Projections are always wrong
• No such thing as a 23.6 IRR deal
• Develop range of potential outcomes / operating
  cases
• Understand sensitivities operating, capital
  structure, price
• Use judgment about whats likely
• Deals should get priced based on expected
  outcomes and distribution of returns
• Focus on free cash flow net income is only
  relevant in public markets

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Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Basic Financial Analyses Valuation
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Confidential
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Basic Financial Analyses Valuation

• Primary drivers of returns
• Debt paydown
• Reducing leverage increases equity value, all
  else equal
• Working capital management can unlock value
• EBITDA growth
• Top line growth, margin improvements
• Multiple expansion
• EBITDA growth, improved free cash flow profile,
  buyer competition, underlying market trends
• There are almost always trade-offs between
  leverage and growth
• Optimal choice of initial leverage level and
  ongoing use of free cash flow strikes this
  balance
• Function of strategy, market opportunities,
  growth capital requirements and returns on
  incremental capital

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Confidential
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Basic Financial Analyses Valuation

• Key Transaction Assumptions
• 25M EBITDA at close 175M purchase price
  (7.0x) 5.0x leverage at close 5 yr hold
• Scenario 1 No Growth
• Flat EBITDA 7.0x exit multiple
• Scenario 3 EBITDA Growth Multiple Expansion
• 5 EBITDA CAGR, 7.5x exit multiple

• Scenario 2 EBITDA Growth
• 5 EBITDA CAGR 7.0x exit multiple

Positive free cash flow alone can be sufficient
to drive positive returns EBITDA growth can
improve returns by increasing TEV and equity
value If growth generates more cash flow than it
consumes, it can further enhance returns by
accelerating debt reduction
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Deal Structuring Framework
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Context
• Understand opportunity
• Evaluate situation
• Prioritize objectives
• Structure proposal
• Create documentation

• Content
• Valuation
• Choice of Security
• Governance
• Management Incentives
• Transfer rights and restrictions

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Deal Structuring Choice of Security
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• What it is
• Choosing the securities firms own
• Company philosophy
• The security should match the intended
  risk-reward profile

• Key considerations
• Seniority should match the business plan /
  investment thesis
• Think about likely outcomes
• Look for ways to get extra upside
• Determine whether additional elements are
  required to properly align investment to
  risk-reward

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Documentation Tracing Structure Through to
Documentation
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Term sheet structure
• Purchase price
• Choice of security
• Subscription agreement
• Management incentive plan
• Employment agreement
• Terms of non-common securities
• Board governance
• Negative / affirmative controls
• Transfer restrictions

• Documentation
• Stock Purchase Agreement
• Employment Agreement / Option Plans
• Charter, Bylaws
• Shareholders Agreement (and Registration Rights
  Agreement)

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Key Areas of Focus in Stock Purchase Agreement
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Form of contract (stock vs. asset)
• Purchase price, form of consideration (cash vs.
  stock seller paper / earn-out, etc.), purchase
  price adjustments
• Equity purchase price vs. TEV (Closed Loop vs.
  Peg)
• Reps and warranties organization and title,
  litigation, environmental, financial statements,
  third party rights and claims, obligations to
  employees
• Indemnities Survival of reps, baskets,
  deductibles, caps, escrow
• Material Adverse Change (MAC) Scope, carve
  outs
• Working capital measurement, delivery
• Closing Conditions representations true,
  approvals, HSR, compliance, no MAC, documents
• Covenants access, exclusivity, efforts,
  preservation of business
• Termination - how, break-up fee, reverse
  break-up fee?

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Financing (if you can get it) Key Considerations
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
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Why Financing Matters
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Financing availability and terms are key driver
  of returns
• Risk-reward profile influenced by capital
  structure

Returns

• In highly leveraged deals, better financing can
  help Company win the bid in auctions and other
  competitive situations

Winning deals
Equity check size

• Certainty around the financing package is
  required to provide certainty around the size of
  the check that Company will need to write

• Financing structure must adhere to and reinforce
  strategy, e.g. reinvest cash flows or pay down
  debt
• Creative financing can often solve process or
  structural issues, e.g. bridge financing to
  acquire a 40 then 60 JV interest

Fit with strategy
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Financing Timeline
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together
Typical transaction process time line
Submit 2nd round bid and PSA mark-up
Sale Process
Receive offering memorandum
Make initial judgment to pursue
Selected for second round
Make 1st round bid
Selected as winner
Negotiate PSA
Seek approvals
Detailed diligence
Basic diligence
Weeks
1
5
2
3
4
7
8
6
11
10
9
12
0
Financing Process
Select Bank(s) and share offering material
Receive preliminary financing proposals
Request commitment papers
Negotiate commitment papers have banks execute
Finalize documentation
Counter-sign Commitment papers
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Bringing It All Together
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Investment thesis hold up?
• Right risk-reward profile at right price?
• Chance to get lucky?
• Deal terms make sense?
• Fit with Company portfolio?
• Is Company value added realistic?
• Any remaining deal breakers unresolved?

Conviction Around Deal
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Post-closing How Company Adds Value
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Take advantage of Companys experience and
  history
• Bringing best practices to bear
• Finance, strategy, organization, management
  processes
• Shared services
• Marketing / public relations capital markets,
  IT, tax accounting
• Company Network
• Create business opportunities for portfolio
  companies (West, Warner Music)
• Make introductions (directors / senior managers)
• Company industry conferences
• Advisor / confidant to CEO its lonely at the
  top
• Peer review/discussion
• Portfolio monitoring processes

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Harvest
Deal Sourcing
Post-closing
Harvest
Financing
Docu-mentation
Structuring/ Negotiating
Due Diligence
Deal Screening
Bringing it all together

• Exit strategy is an issue that should be
  discussed with management prior to consummating
  the deal
• IPO is almost always a financing event to set up
  a path to liquidity (not a liquidity event in and
  of itself)
• To best sell a company, planning should ideally
  be done well in advance
• Assist in internal corporate finance activities
• Assist in selection of intermediaries, monitor
  performance throughout
• Market awarenesspick the right time