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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%