Roberto Albisetti, IFC
Private Equity and Venture Capital in Europe: Markets, Techniques, and Dealsby Stefano Caselli
The distinctive nature of the European pe/vc environment is on display in Stefano Caselli’s presentation of its complete conceptual framework, from the volatile (its financial side) to the stable (its legal organization). A Bocconi University professor, Caselli offers a European perspective on market fundamentals, the v.c. cycle, and valuation issues,
The distinctive nature of the European pe/vc environment is on display in Stefano Caselli’s presentation of its complete conceptual framework, from the volatile (its financial side) to the stable (its legal organization). A Bocconi University professor, Caselli offers a European perspective on market fundamentals, the v.c. cycle, and valuation issues, supporting his observations with recent examples and case studies. Written for investors, his book achieves many "firsts," such as clarifying many aspects of EU and UK financial institutions. Complete with finding aids, keywords, exercises, and an extensive glossary, Private Equity and Venture Capital in Europe is written not just for Europeans, but for everybody who needs to know about this growing market.
* Only book that provides a comprehensive treatment of PE/VC in UK/Europe, ideal for European business schools teaching professionals or pre-professionals who will work in Europe
* Provides a complete analysis of the EU versus US in all areas of PE/VC
* Contains cases and theory, providing both in one package
* Filled with pedagogical support features and online student and instructor resources
- Elsevier Science
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Private Equity and Venture Capital in EuropeMarkets, Techniques, and Deals
By Stefano Caselli
Academic PressCopyright © 2010 ELSEVIER Ltd.
All right reserved.
Chapter OneThe fundamentals of private equity and venture capital
This chapter presents the fundamentals of private equity and venture capital. The first section covers private equity and venture capital, underlining important differences between American and European approaches to funding startups and the typical characteristics of the business. The second section explains how private equity finance is different from corporate finance, emphasizing the distinguishing elements. The third section analyzes private equity and venture capital from the entrepreneur's perspective, while the last section discusses the views of all types of potential investors.
1.1 DEFINITION OF PRIVATE EQUITY AND VENTURE CAPITAL
There is evidence that investing in the equity of companies started during the Roman Empire. However, the first suggestion of a whole structured organization that funded firms to improve and make their development easier was found during the fifteenth century, when British institutions launched projects dedicated to the increase and expansion of trade to and from their colonies.
Modern private equity and venture capital have been around since the 1940s when it started to be useful and essential for financial markets and a firm's development. Financing firms by private equity and venture capital has become increasingly more important, both strategically and financially.
Because this type of business has been around so long, together with differences between firms and financial markets, one worldwide definition and classification for private equity and/or venture capital does not exist. However, it is clear that a broad definition does exist: private equity is not public equity because it includes the investments realized from the stock market.
In the third part of this book, various definitions are formulated based on the operation, the stage of the firm's life cycle, the operator's approach, and the type of support.
Institutionally, private equity is the provision of capital and management expertise given to companies to create value and, consequently, generate big capital gains after the deal. Usually, the holding period of these investments is defined as medium or long.
This definition, even if very broad, cannot be applied to the real world, because operators' national associations (i.e., NVCA, EVCA, BVCA, AIFI), or central banks interpret the definition according to the countries in which they operate. For this reason, many definitions still exist. According to the American version, venture capital is a cluster of private equity dedicated to finance new ventures. Therefore, venture capitalists fund firms during their initial phases or look for sources to expand and develop the activity of the firm, whereas private equity operators fund firms at the end of their first/fast growth process.
The European definition proposes that private equity and venture capital are two separate clusters based on the life cycle of the firm. Venture capitalists provide the funding for start-up businesses and early stage companies, whereas private equity operators are involved in deals with older firms. Different from the American definition, the European definition does not consider the expansion phase (the phase after the beginning and the start-up) as a part of venture capital, but more of an autonomous subcategory.
Although there are differences in definition, private equity and venture capital create a strict relationship between the investor and the entrepreneur. This is a unique characteristic not found in any other financial institution. This is attributed to the typical characteristics of private equity and venture capital financing schemes:
Modification of shareholder composition Knowledge and non-financial support Predefined time horizon of the investment
Private equity and venture capital investment are used to invest in equity; for this reason, operators specializing in these kinds of deals may decide on the firm's strategy and day-by-day management. This participation, or the admission of a new subject among the original shareholders, generates a metamorphosis in the decision process. Additionally, a modification in the stability and symmetry of the organization and its consequences among original shareholders may be noted.
The operation of private equity and venture capital is not limited to simple money provision; the financial support comes from managerial activity consisting of a series of advisory services and full-time assistance for firm development. For young firms or a new business idea, cooperation with financiers is very important, because reputation, know-how, networking, relationships, competencies, and skills are the non-financial resources provided by private equity and venture capital operators. Although difficult to measure, these resources are the real reason for the deal and important for firm growth.
Private equity and venture capital agreements always define length and exit conditions for financial institutions. Even though funding institutions are active shareholders and engaged in company management, they are not interested in taking total control or transforming their temporary participation into long-term involvement. Venture capitalists and private equity operators, sooner or later, sell their position; this is the most important reason for defining this type of investment as "financial" and not "industrial." The presence of a predefined time horizon for the investment makes private equity and venture capital useful for firms wanting quick development, managerial change, financial stability, etc.
1.2 MAIN DIFFERENCES BETWEEN CORPORATE FINANCE AND ENTREPRENEURIAL FINANCE
What is the difference between corporate finance and private equity finance (or entrepreneurial finance)? This is a very interesting question and the answer is not as easy as it may seem. The question can be answered in two different ways: institutionally and environmentally (see Figure 1.1).
Corporate finance, which is the most traditional way to fund firms, is more standardized, less flexible, and focused on debt. Expected returns are lower and linked to the costs that financial institutions incur while collecting money from savers. The reference point for the valuation (i.e., costs, feasibility, etc.) is the whole company, independent of funded sources. Another interesting point is the financial institution's unwillingness to participate in the firm's decision framework.
Private equity finance is very flexible and the expected returns are higher (non-financial resources must be paid) than corporate finance. It is characterized by a medium to long time horizon, higher options available for the financial institution's exit strategy, and by its high profile in the decision process. The focus of private equity finance is the potential growth path of a company.
The institutional approach, even though it is able to distinguish between corporate and entrepreneurial finance, does not consider the environment companies face when they contemplate private equity as a financing option. The environmental approach does consider the environment and the situation faced by entrepreneurs during the financial selection process. Some aspects of the environmental approach are the same as the institutional approach, whereas some aspects better explain the consequences of entrepreneurial finance.
The elements in the following list distinguish private equity finance from corporate finance using the environmental approach.
Interdependence between investment and financing decision Managerial involvement of outside investors Information problem and contract design Value to entrepreneur Legal and fiscal ad hoc rules
With the institutional approach, private equity financing does not fund the whole company. In this scheme of financial and non-financial support, a specific project the entrepreneur needs to finance is targeted. Because of this, a strong and effective interdependence between the firm's investment and financing must exist and must continue during the entire length of the deal.
Private equity operators and venture capitalists provide financial and nonfinancial sources. This generates the involvement of third parties (external investors) in the decision process and/or company management. It must be emphasized that only in private equity finance is there a decisive participation in the firm's administration.
The third issue seen in the environmental approach is that private equity operators support firms on risky projects. This increases conventional information problems occurring in all firm financing schemes. These problems lead to a lack of standardized agreements, so a special settlement is signed for every funded project.
The strong interdependence among companies and financial institutions generates problems in wealth and value distribution too. As private equity financiers became shareholders, a strong co-participation between the entrepreneur's desires and the financial institution's purposes exists. Private equity financiers support firms with their skills, competencies, know-how, etc. Because this creates value for funded firms, the investor allows the entrepreneur to take value from the funded idea. In most cases, without private equity or venture capitalists, firms would not be able to develop projects.
The special legal and fiscal framework for the investor and/or vehicle used to realize the deal is the last factor that sets private equity finance apart from venture capital. It will be shown throughout the following chapters that the private equity industry, because it simultaneously acts as entrepreneur/shareholder and financier, needs special treatment regarding taxes and legal frameworks to develop and carry out investments.
In the private equity business, relationships between entrepreneur, shareholders, and external investors are intertwined. In large deals within large corporations there is a clear convergence between the entrepreneur (and many times, his family) and the shareholders. This modifies the traditional perspective of corporate finance in which shareholders and managers are two separate blocks with different goals and tasks.
This is particularly true for venture capital. The smaller the firm or the earlier the life cycle, the more likely the entrepreneur is the shareholder and the manager. This makes it easier for the deal to be realized, developed, and carried out.
1.3 THE MAP OF EQUITY INVESTMENT: AN ENTREPRENEUR'S PERSPECTIVE
Development of the private equity and venture capital industry starts when the entrepreneur realizes he needs to be funded by external investors to support the expansion or the transformation of his firm. Therefore, equity investment provides a firm's specific financial needs or the finances to create a firm.
Firms need funding during sales development, which occurs during different stages for each firm. The drivers that measure the firm's need for funding are investment, profitability, cash flow, and sales growth. These four variables are strictly linked together, and should be evaluated from a long-term perspective. These four variables/drivers represent the stage the firm is in, which helps financiers define their strategy.
Analyzing the four drivers, typical stages of the firm used to classify financial needs can be identified. There are six different stages:
2. Start up
3. Early growth
4. Rapid growth
5. Mature age
6. Crisis and/or decline
These stages impact the four drivers — investment, profitability, cash flow, and sales growth — used when analyzing financial needs and equity capital demand of a firm as seen in Figure 1.2.
During the first stage, the entrepreneur has to cope with development, the length of which depends on the business features and the entrepreneur's commitment. The objective is to define the most convenient structure for the project's progress. In this phase, sales do not exist and profitability and cash flow are negative due to the presence of compulsory investments such as the completion of information memorandum, costs for legal and fiscal advisory, engineering development, etc.
The start-up stage consists of company creation and launch of firm activity. During this period, sales start, but the trend is not solid enough to support costs incurred by sizeable and substantial investments related to the acquisition of productive factors. Consequently, cash flows and profitability are strongly negative.
The next stage, early growth, occurs just after start up. Investments have been made and the firm's current needs are related to inventory, rather than working capital; the revenues realized by the company are increasing. There is a rise in profitability and cash flow, even though they remain negative. However, the whole trend is positive and stable and the negative value is slowly becoming greater than zero.
The next stage is rapid growth. The investments needed are the same as the early growth stage. In this period, sales are increasing but the growth trend is negative and cash flow and profitability are positive and increasing.
After the rapid growth stage, there is a period of maturity and firms enter the mature age phase. The sales growth tends to zero while profitability and cash flows level off. During this phase, investments are not just related to inventory and/or working capital but the replacement of ineffective or unused assets also must be taken into account. The last of the six stages is the crisis or decline phase. During this period, sales, profitability, and cash flow fall and the firm is unable to decide what investments should be completed to overturn the decline.
These stages create a demand for financial resources measured by the net cash flow produced by the firm. Demand for financial resources is satisfied by different players with different tools ranging from debt capital to equity capital.
1.4 THE MAP OF EQUITY INVESTMENT: AN INVESTOR'S PERSPECTIVE
Private equity operators and venture capitalists are just a sample of the groups in the financial system. They represent one of the various options that entrepreneurs consider to finance their business. At the same time, entrepreneurs must think about profitability, investment needs, sales growth, and cash flow to find the right counterparty.
Many potential investors are considered from both a debt and an equity perspective:
Founder and family Other partners Business Angels Private equity operators and venture capitalists Banks Trade credit operators Financial markets
For equity investors it is critical to answer these questions:
1. What is the financial need?
2. What part can be satisfied through equity capital?
3. How long before the firm is able to repay the equity investor?
The first question determines the size of resources required by the firm and the amount of resources that the financial institutions have to satisfy this need. The greater the amount the firm requires, the greater the size, reputation, and skills of the counterparty. The second question ascertains what sort of financial resources the firm needs; for example, venture capitalists and private equity operators tend to participate with equity, whereas banks are focused on debt. At the same time, the founder and the family equity investment in the firm or trade credit institutions only propose debt. The third question defines the time horizon and the capability of investors to wait and remain confident in their deals.
The answers to these questions help to define profiles of investors with different levels of risk tolerance, chances to invest in equity, and the ability to support a shorter or longer payback period. The different profiles are related to different risk-return combinations and time horizons (Figure 1.3).
Excerpted from Private Equity and Venture Capital in Europe by Stefano Caselli Copyright © 2010 by ELSEVIER Ltd. . Excerpted by permission of Academic Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Meet the Author
Stefano Caselli is Vice Rector for International Affairs and Full Professor of Banking and Finance at Department of Finance of Bocconi University in Milan. He conducts research at domestic and international levels and has written about private equity, SME’s and family business financing, corporate finance, corporate banking and banking strategy. He is a member of the scientific committees of CER (Centro Europa Ricerche in Rome), ECMI (European Capital Market Institute in Bruxelles), EVCA (European Private Equity and Venture Capital Association for PEREP Group in Bruxelles), ENTER (the research centre for entrepreneurship of Bocconi University) and CAREFIN (the research centre for financial innovation of Bocconi University). He serves as an independent director on several boards of corporations and financial institutions and has supported many companies and institutions as strategic consultant (among them, Borsa Italiana for Elite Project, ABI Associazione Bancaria Italiana, OCSE, Consob for the working group devoted to incentives for stock exchange).
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