CONFIDENTIAL

Understanding Private Equity

April 17, 2013

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Agenda Ø  Introduction / Background Ø  Asset Class Overview

Ø  Market Overview

Ø  Private Equity Funds

Ø  Evaluating Private Equity Funds Ø  Questions & Feedback

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Introduction / Background Ø  Justin Shuman -  Drexel University (2002 – 2007) -  DuPont Capital Management Private Markets Group Analyst (2007 – 2009) -  Cornell MBA (2009 – 2011) -  Sterling Partners Associate (Summer 2010) -  Harris Williams & Co. Associate (2011 – 2013)

Feel Free to Contact Me: Justin Shuman

215-837-1199 (mobile) justin.shuman@gmail.com

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Objectives Ø  Develop a high-level understanding of the private equity landscape -  Investors -  General Partners -  Portfolio Companies

Ø  Establish an elementary understanding of fund economics and how investors make money

Ø  Walk away with a “tool box” of questions that will help you evaluate private equity funds in the future

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What We are NOT Going to Focus on.. Ø  Mechanics of an LBO and academic financial explanations:

ROE = (Profit Margin )* (Asset Turnover)*(Equity Multiplier)

Ø  Finding a job in private equity Ø  Political views and potential legislation surrounding the asset class

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Asset Class Overview Ø  Private Equity

–  Capital that is invested in private and illiquid securities •  Leverage Buyouts (“LBOs”) – most common •  Venture Capital

–  Seed –  Early-Stage –  Late-Stage –  Growth

•  Mezzanine •  Real Estate •  Distressed Debt •  Secondary – the purchase of interests in all described herein •  Other – Mortgages, Real Assets (timber, toll roads, infrastructure)

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Private Equity Value Chain Ø  Value Chain -  Investors commit capital to funds, fund-of-funds, or directly invest in assets -  Funds deploy capital into assets on behalf of their investors (LPs or Fund-of-

Funds) -  Investments receive capital from LPs, Funds, and Fund-of-Funds

- Pension Funds - Endowments - Foundations - Bank Holding Companies - High-Net-Worth Individuals - Insurance Companies - Investment Banks - Corporations - Other…

INVESTORS (“LPs”) FUNDS

PE Fund

PE Fund

PE Fund

Fund of Funds

INVESTMENTS

Venture

Growth Equity

Buyouts

Mezzanine

Special Situations

Real Assets Direct Investments

Invests in PE Funds

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A Short Vocabulary Lesson… Limited Partnership Agreement (“LPA”): the agreement that binds LPs to GPs and defines investment

strategy as well as all other rules for fund governance Commitment: LP investment in a private equity fund Capital Call: issued by the GP before the closing of a transaction. A capital call requests capital from

LPs to fund investment Investment Period: normally 5 years from the fund being “turned on” (i.e. fees commencing and the

first capital call). After 5 years the GP may not draw down capital for new investments (“use it or lose it”)

Fund Life: usually 10 years Fund Extension: highly negotiated but often 2 year increments to provide more time for the GP to

manage and exit existing investments in the fund. Deal-by-Deal: economic calculation that determines carried interest on a deal-by-deal basis (easier to get

to the carry early) Back-Ended: economic calculation that determines carried interest on a total fund basis (more difficult

to get to the carry early) Hurdle Rate: the IRR hurdle which a GP must earn for LPs before it can begin to take 20% of the profits IRR: internal rate of return is the discount rate that will bring a series of cash flows to an NPV of 0 Return on Invested Capital (“ROIC”): realized capital / invested capital EBITDA Multiple: purchase price / EBITDA

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Fundraising Climate Ø  Significant amounts of private equity raised before the downturn created buying power

–  Moving further into an investment period heightens pressure to invest –  Assuming a five-year investment horizon, $141 billion of private equity’s $348 billion of dry powder will need to be

invested over the next two to three years

Ø  Given the capital overhang, fundraising has proven challenging since 2008 –  With 805 funds currently in the market, time from initiation to final close is proving longer than 2005 – 2008. –  Fundraising in 2012 fell to the lowest level seen in more than a decade, but the amount of capital raised increased 13%

from 2011 as larger funds found the most success

$428

$501 $481

$433

$373$348

$0

$100

$200

$300

$400

$500

$600

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

2007 2008 2009 2010 2011 2012

Cum

ulative OverhangO

verh

ang

by Y

ear

Cumulative Overhang Under $100M $100M - $250M $250M - $500M$500M - $1B $1B - $5B $5B +

For the Years Ended December 31, 2007 – 2012 ($ in billions)

Capital Overhang of U.S. PE Investors by Vintage Year

Source: Pitchbook.

229 228

275

221

118 113 128

110

0

50

100

150

200

250

300

2005 2006 2007 2008 2009 2010 2011 2012

No.

of F

unds

Rai

sed

U.S. Private Equity Fundraising

Source: Pitchbook.

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33%

21% 13%

12%

9%

8% 4% 34%

20% 13%

14%

6%

7% 5%

Business Products & Services Consumer Products & Services

Healthcare Information Technology

Financial Services Energy

Materials and Resources

0

100

200

300

400

500

600

700

800

900

$0

$50

$100

$150

$200

$250

$300

1Q07

2Q07

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

3Q12

4Q12

Total Capital Invested Deal Count

Private Equity Deal Activity Ø  172 exits took place in 4Q 2012, and the record 6,538 portfolio companies still held will drive future

activity Ø  Private equity deal flow has been partially supplemented by the record $64.1 billion in dividend

recapitalizations in 2012, 58% higher than the previous record of $40.5 billion for the full year 2010

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Total Private Equity Deal Flow PE Deals by Industry For the Years Ended December 31, 2011 – 2012

Source: Pitchbook.

For the Quarters 1Q07– 4Q12

Source: Pitchbook.

Transaction Volume

Valu

e of

Dea

ls

CONFIDENTIAL

Ø  Middle market M&A transactions (<$500MM) accounted for 91% of private equity deal volume in 2012 as investors exhibited a preference toward smaller deals

Ø  49% of private equity capital was allocated to deals below $500 million in 2012, the second highest total since 2005

Ø  Since credit market conditions are positive, the proportion of large deals should grow in 2013

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2006 2007 2008 2009 2010 2011 2012

0-24M 25M-99M 100M-499M 500M-999M 1B-2.5B 2.5B+

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2005 2006 2007 2008 2009 2010 2011 2012

0-24M 25M-99M 100M-499M 500M-999M 1B-2.5B 2.5B+

Private Equity Deal Size

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For Years Ended Dec. 31, 2005 – 2012 For Years Ended Dec. 31, 2005 – 2012 Percentage of PE Transactions (Count) by Size Percentage of PE Investment by Deal Size

Source: Pitchbook. Source: Pitchbook.

CONFIDENTIAL

Economics Ø  LP Management Fee -  LPs agree to pay funds 2% of commitments during the 5 year investment period -  Continue to pay 2% on cost-basis of remaining fund investments -  Management fee pay for deal team members’ salaries, travel, and other fund

expenses -  Any “excess” fees not used at the end of the year are normally paid out in

bonuses to deal team members and divided among the partnership Ø  Carried Interest -  Incentive payment for successful transactions that exceed hurdle requirements

•  Normally 8% hurdle rates (management fee, invested capital, and other fees are taken into this calculation)

-  The fund is entitled to 20% of profits in excess of the hurdle Ø  Company Management Fee -  Funds often charge their portfolio companies a percentage of EBITDA as a

management fee

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Finding Attractive Assets Ø  80 deals are reviewed on average for every 1 investment

Ø  Funds use a myriad of filters to sort through deal-flow to identify potential investments

ü  Strong and stable cash flow (EBITDA – CAPEX)

ü  Strong management

ü  Low maintenance and growth CAPEX requirements

ü  Growing end-markets

ü  High barriers to entry

ü  Potential for margin improvement and cost reduction

ü  Acquisition opportunities

ü  Logical path to exit in 4-7 years

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Financing the Deal Ø  Equity

-  Fund: capital call draws down equity from LPs in pro-rata fashion

-  Management: existing management usually “rolls” equity

-  Co-investors: LPs that directly invest in the equity outside of the fund

Ø  Debt

-  Senior Debt: secured by assets

-  Subordinated Debt: unsecured, second lien on assets

-  Mezzanine Debt: fills the gap between equity and debt

•  14%-16%, PIK, warrants, “bullet” amortization

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Creating Value Ø  Funds pull many levers to create values for their LPs

ü  Professionalize management, accounting & control systems

ü  Adjust firm strategy and rationalize product lines, workforce, etc

ü  Debt can increase firm value if you can afford it! (Exploits corporate aversion to debt)

ü  Regulatory Arbitrage – Sarbanes-Oxley

ü  “Bolt-on” acquisitions

Ø  Robust company performance can lead to dividend recaps as early as years 2 and 3

-  Used normally when sale prospects are less than optimal

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Exiting: 4-7 Years Later… Ø  After value has been created over the hold period, it is time to sell the company

-  Filter and select 5-7 investment banks to “pitch” a sale process

•  Firm credentials

•  Industry and positioning thoughts

•  Valuation range

•  Most likely purchasers

Ø  “Winning” bank conducts a sale process

-  Broad: show the deal to hundreds of potential buyers

-  Narrow: show the deal to the most likely potential buyers

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Evaluating Fund Managers Ø  Team

-  Does the team have complementary backgrounds? – not just all ex-bankers or ex-consultants

-  What qualifies the team to purchase and operate businesses? -  Are there any legal blemishes on any team member’s background?

Ø  Strategy -  Industry expertise? What’s the angle? -  Operationally focused – professionalize the business through accounting and control

upgrades, manufacturing best practices, customer/workforce rationalization -  Financial engineering (debt pay-down) – NO private equity fund will ever market

that they are using financial engineering to generate returns -  “Roll-up” – purchase a platform business from which a large company will be built

through acquisitions Ø  Track Record

-  How many deals have <1.0x ROIC? – What missteps occurred? Has the fund learned from mistakes?

-  Is the fund executing deals outside of its historical strategy? – New industries than in the past…larger deals than in the past….etc.

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Recommended Books & Websites Ø  Books -  “Applied Mergers & Acquisitions” – Robert F. Bruner -  “Investment Banking: Valuation, Leverage Buyouts, and Mergers &

Acquisitions” – Joshua Rosenbaum and Joshua Pearl Ø  Websites -  www.prequin.com -  www.pehub.com -  www.pitchbook.com -  www.thedeal.com -  www.dealbook.com -  www.altassets.com -  www.bloggingbuyouts.com

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