Private Capital Markets Midterm Review

What is PE

Alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange 

Lifecycle of PE

• Fundraise (-1 to 1 years), Investment (0-5 years), Divestment (5-10 years) 

• Typical holding period of underlying portfolio company is 4-6 years 

• Term: 10 plus two 1-year extensions 

Characteristics of Private Investments 

• Illiquidity over long period of time 

• Limited regulation 

• Significant transaction costs and multiple layers of fees 

• Unpredictable cash flows 

• High investment costs 

• Limited transparency 

• Benchmarking is difficult 

Why invest (PE)

PE allows providers of capital to compete for the right to govern the corporation 

Why invest in PE

• Right to establish structures and processes 

• Ability to hire and fire 

• Ability to set compensation of top managers 

• Ability to veto and ratify strategic initiatives 

• Ability to serve as internal consultants 

Public company governance 

Investors bear residual risk but don’t manage the firm, managers run the firm but don’t bear all of the residual risk (PE is supererior)

Ways to make money in PE

• Growth 

• Organic, TAM is growing or you are increasing market share 

• Operational, optimize the business. Improve margins 

• Inorganic, M&A, arbitrage 

• Financial engineering 

• Less reliable 

Manager Selection PE

• Widespread difference in performance between top quartile and bottom quartile firms 

• Target smaller funds 

• Businesses tend to be less efficiently prices = greater chance of multiple expansion 

• Businesses tend to be less efficiently operated = greater chance of margin improvement 

• Multiple paths to liquidity via strategic buyers and financial sponsors 

• Industry places too much emphasis on MOIC without consideration for duration which lowers return % 

Buyouts 

• Acquire controlling interests in under-valued or distressed companies 

• Characteristics 

• Equity control 

• Leverage 

• Economic alignment 

• Enact change 

• Leverage 

• Alter management team’ 

• Change reporting structure 

• Drive operational improvement 

• Exit planning 

LBO

• Typically, 50-75% cap structure post transaction is debt 

• Evaluate target to determine optimal level of debt 

• Stability of cash flows in industry 

• Ability to generate cash flows from operations 

• Range of operating scenarios 

• Benefit of Leverage 

• Buyer – achieve higher returns on equity stake 

• Seller – higher purchase price due to debt financing 

• Downside 

• More susceptible to external shocks 

Manager selection 

• Sector expertise 

• Sourcing 

• Several levers to create value 

• Fund size 

• Conservative leverage 

Growth Equity 

• Minority investments in high-growth companies 

• Sits between VC and buyout 

• Expansion capital (idk what that is) 

Late-stage venture backed (series D to Pre-IPO) 

• Defensible market position (product works) 

• Profitability or near it 

Mature small/medium sized businesses 

• Bootstrapped with strong market position 

• First institutional capital 

• Often founder or family owned 

Spin offs 

Orphaned or unloved from large corporations 

Challenges GE

• Lack of operating control 

• Company culture 

• Exit timing 

Benefits GE

• Attractive return profile on a risk adjusted basis considering shorter duration 

• Duration of 3-5 years 

Manager selection GE

• Not a price taker 

• Strong proprietary network 

• Financial and operating expertise 

• Exit optionality 

• Alignment is key 

Finance

deals with movement of capital across the economy

Facilitators of Capital 

Banks 

Investors of Capital 

Institutional, Retail

Users of Capital 

• Public companies via loans / bonds 

• Private companies through debt or equity funding 

“Private for longer” 

• 3x less public companies today than in 1996 

• Over 6 million private companies 

• Average age of new public company was 4.5 years in 1999, to 12+ in 2020 

Why Private for Longer

• Regulatory hurdles 

• Access to private capital 

• Long-term strategy focus 

Challenging characteristics (being an LP)

• Illiquid over long period of time 

• Limited regulation and transparency 

• Higher costs and fees 

• Unpredictable cash flows 

• Difficult to benchmark 

• J curve 

• Access constraints 

Endowment

• Long-term capital managed 

• Should increase to keep university competitive 

• Monthly distributions 

• Goal is to double every 5ish years 

Venture Capital 

• Minority investments in future high-growth companies 

• Negative cash flows 

• High burn rates 

• Often pre-profit, pre-revenue- or even pre-product 

VC firms add value through stage specific expertise 

• Financial or operational 

• Product market fit 

• Management team 

• Go to market 

• Scaling 

• Access to follow-capital 

Manager selection VC

• Access to deal flow and ability to win deals 

• Network and reputation 

• Value add & expertise leading to differentiated capital 

VC funds should offer high return expectations 

• 3-5x/20%+ net with upside 

• Expect higher loss ratio 

• More diversified for baylor 

• Consider duration along with multiple 

• Exit optionality 

• Post IPO policy 

VC Valuation 

• Subjective 

• Number of rounds & dilution 

• Pre-money + investment = Post-money 

VC term sheet 

• Non-binding 

• Economic terms 

• Valuation/Investment amount/Ownership stake 

• Liquidation preference 

• Employee stock ownership plan 

• Anti-dilutive provisions 

• Pro-rata rights 

• Control terms 

• Board representation/voting rights 

• Protective provisions 

• Drag along/tag along 

• No shop / exclusivity 

Funds and target levels

Venture: $0-10MM Rev, <50% ownership

Growth: $10-30MM Rev, <50% ownership

Buyout: $30MM+ Rev, >50% ownership

Baylor Endowment Target Levels

Public Equities: 15-45% (30%)

Fixed Income: 0-10% (5%)

Marketable Alternatives: 5-35% (20%)

Private Investments: 35-55% (45%)

Baylor Private Investment

Double endowment every ~5 years

Strategies that can outperform public market equivalents

• internal hurdle rate of +350 bps

• Shift those that cannot meet hurdle to marketable portfolio

Sectors with best go-forward opportunities: long-term trends

• IT (enterprise software in particular), healthcare, consumer

Allocate to have concentrated company level exposure

• $1M+ exposure per company on average

Managers in LMM with smaller fund sizes

Baylor Portfolio

Public Equity: Mutual funds, ETFs, different geographies

Fixed Income: Short & Long-term, cash

Alternatives: Long/Short hedge funds, relative value hedge funds, event driven debt/equity

Baylor Targets

Funds that <$1 billion
- businesses tend to be less efficiently prices = greater likelihood for multiple expansion
- businesses tend to be less efficiently operated = greater likelihood for margin improvement

Baylor Private Performance by Class

VC: Deal Level Target - 10X, Fund Level Target - 3x, Loss - 30%, Duration - 8-10 years, 5 year return - 16%

GE: Deal Level Target - 3-5X, Fund Level Target - 2-3x, Loss - 10-15%, Duration - 3-5 years, 5 year return - 24%

Buyout: Deal Level Target - 2-3X, Fund Level Target - 1.5-2.5x, Loss - 0-10%, Duration - 4-7 years, 5 year return - 21%