MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 6 Section B: Coursework Brief and Requirements Context This assignment comprises two (2) sections: Section A and Section B. Both sections relate to analysis, valuation or return computations related to i) an LBO situation, and ii) a venture capital situation. Section A carries 120 marks (60%) and Section B carries 80 marks (40%). Your mark out of 200 marks will be converted to a percentage (%). The use of Excel in Section A is highly advised where applicable. Brief Section A [120 marks] This question is compulsory. It is sub-divided into sub-parts. You are a General Partner (GP) at The Excelsior Fund (referred to as the Fund), a $750 million US-based LBO fund. The Fund has identified Superb Semiconductors, a publicly traded US semiconductor manufacturing company, as a potential investment. The Fund intends to take it private and believes that it can achieve its goals after three years. The fund developed the following forecasts regarding this investment: Year 1 Year 2 Year 3 $m $m $m EBIT 104.00 108.16 112.49 Depreciation and Amortization 10.30 10.61 10.93 Increase / (Decrease) in NWC (0.20) 0.30 0.40 CapEx 10.61 10.93 11.26 The Fund is considering the following two capital structures: Capital Debt Equity Cost Bid Structure $m $m of Debt $m A 650 300 9% 950 B 650 230 12% 880 MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 7 The marginal tax rate is equal to 21%. The Fund will use all free cash flows generated by Superb Semiconductors to service the debt. The Fund estimates that it will be able to sell the company in 3 years at an EV/EBITDA multiple of 9 times. a) Required: ,QUHODWLRQWRWKH,55RIWKH)XQG VLQYHVWPHQWLQSuperb Semiconductors under each of capital structures A and B: i. Calculate the ending balance of debt every year for each structure. You are advised to take full account of tax-related aspects. Show your workings. [24 marks] Capital Structure A Interest rate = 9% Year 1 Year 2 Year 3 $m $m $m EBIT 104.00 108.16 112.49 Depreciation and Amortization 10.30 10.61 10.93 Increase / (Decrease) in NWC (0.20) 0.30 0.40 CapEx 10.61 10.93 11.26 Debt Beginning of Year 650.00 614.17 573.01 Interest 58.50 55.27 51.57 Taxable income 45.50 52.89 60.92 Taxes 9.56 11.11 12.79 Cash flow 35.84 41.16 47.40 Debt End of Year 614.17 573.01 525.61 MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 8 Capital Structure B Interest rate = 10% Year 1 Year 2 Year 3 $m $m $m EBIT 104.00 108.16 112.49 Depreciation and Amortization 10.30 10.61 10.93 Increase / (Decrease) in NWC (0.20) 0.30 0.40 CapEx 10.61 10.93 11.26 Debt Beginning of Year 650.00 629.57 604.43 Interest 78.00 75.55 72.53 Taxable income 26.00 32.61 39.96 Taxes 5.46 6.85 8.39 Cash flow 20.43 25.14 30.84 Debt End of Year 629.57 604.43 573.59 ii. Calculate the IRR for the investment under each of the two the different capital structures. Show your workings. [14 marks] EBITDA = EBIT + Depreciation and Amortization (all for Year 3) EBITDA = 112.49 + 10.93 = $123.42m Selling price = exit EV/EBITDA multiple times exit EBITDA Selling price = 9 x $123.43 = $1,110.78 m For Capital Structure A: Initial equity investment = $300.00m Ending equity = selling price ± debt balance Ending equity = $1,110.78 – $525.61 = $585.17m Ψ For Capital Structure B: Initial equity investment = $230.00m Ending equity = selling price ± debt balance Ending equity = $1,110.78 – $573.59 = $537.19m MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 9 Ψ b) The Fund decides on Capital Structure B. Superb Semiconductors entry EBITDA is $110m. Required: Identify the value drivers for the created equity and calculate the percentage contribution of each driver. Show your workings. [12 marks] Initial equity = $230.00m Ending equity = $537.19m Value created = $307.19m Ψ Ψ Ψ c) Still with Capital Structure B, suppose a two-tiered sweet equity deal is adopted. Of the $230 million equity investment, assume the capital partners of the Fund put up MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 10 $130 million in the form of 12% PIK preferred equity, and $90 million as common shares. The management of Superb Semiconductors, which will remain at the helm of the company, puts up $10 million as sweet equity common shares. Required: Calculate the MoM and the IRR for the capital partners of Fund and for the management of Superb Semiconductors, Show your workings. [16 marks] The proceeds available to shareholders are the ending equity under Capital Structure B, which is equal to $537.19m. The payoff to the preferred shares is equal to principal plus interest, or: Ψ Proceeds available to common shareholders is equal to $537.19m minus $182.64 or $354.55. The Fund owns 90%, while management owns the remaining 10%. The Fund common equity is worth: Ψ Management common equity is worth: Ψ 7KHFDSLWDOSDUWQHUVRIWKH)XQG V0R0LVHTXDOWR 7KHFDSLWDOSDUWQHUVRIWKH)XQG V,55LVHTXDOWR Ψ 0DQDJHPHQW V0R0LVHTXDOWR 0DQDJHPHQW V,55LVHTXDOWR Ψ MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 11 d) In the course of one of the internal meetings at the Fund to discuss this deal, these opinions are heard from various attendees: i. I believe we should consider a Capital Structure C that involves using significantly more debt. Using more debt will mean a lower capital outlay on our part and hence guaranteed higher returns. ii. ,GRQ WNQRZZKZHKDYHQRWFRQVLGHUHGYHQGRUILQDQFLQJ for this deal. If we could make use of it, it can reduce our outlay and/or further incentivize management. It is like free debt. iii. If we make a shareholder loan to the deal rather than issue preferred shares, our forecast returns (IRR) would be lower. iv. It is way too soon to think about it, but if our investment in Superb Semiconductors exceeds our current forecasts, our preferred exit route should be a sale to a strategic investor, since it allows us to do a partial exit, yet retain control. v. If our priority is to be paid top dollar upon exit, rather than retain flexibility, we should sell our investment to another PE fund. Required: State the validity of and comment on each of the five statements listed immediately above. Each discussion/critique carries 5 marks [25 marks] i) I believe we should consider a Capital Structure C that involves using significantly more debt. Using more debt will mean a lower capital outlay on our part and hence guaranteed higher returns. False. Using more debt involves less equity outlay, but the more debt is added, the higher the cost of debt (interest rate), and the riskier the equity in the deal becomes as debt has to be paid first. ii) ,GRQ WNQRZZKZHKDYHQRWFRQVLGHUHGYHQGRUILQDQFLQJIRUWKLVGHDO,IZH could make use of it, it can reduce our outlay and/or further incentivize management. It is like free debt. False. While vendor financing would reduce outlay (if it is done on top of other forms of loan, and not instead of some of them), and it can further incentivize MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 12 management (if it takes the form of earnouts), it is not like free debt as it comes with an interest rate. iii) If we make a shareholder loan to the deal rather than issue preferred shares, our forecast returns (IRR) would be lower. True. As a shareholder loan would have a lower interest rate than a preferred, the Fund would receive less payment on the preferred. The money saved would go into the pool of available equity funds, but since the Fund only has 90% common equity, their equity stake would be higher but not by enough to compensate for the reduce payment on shareholder loan. iv) It is way too soon to think about it, but if our investment in Superb Semiconductors exceeds our current forecasts, our preferred exit route should be a sale to strategics, since it allows us to do a partial exit, yet retain control. Not true. Strategics require majority stake, hence the Fund would lose control if it went that route. v) If our priority is to be paid top dollar upon exit, rather than retain flexibility, we should sell our investment to another PE fund. Not true. While another PE fund is a more sophisticated buyer than a strategic, they are not likely to overpay. Top dollar is usually obtained from an IPO. Part e) immediately below draws upon the original data detailed at the start of this section (Section A) and the additional information and data shown below. After 7 years, the Fund is in the winding-down stage. Over its lifetime, the Fund invested in Superb Semiconductors in its first year, another company Buzzing Utilities in its second year, another company Your Radio Vibe in its third year, and another company DoN in its fourth year. It fully exited Superb Semiconductors during the fourth year, and fully exited its investments in Your Radio Vibe and DoN during the seventh year. As for Buzzing Utilities, it partially exited the investment during the fifth year before completely exiting during the sixth year. The following table contains the capital it invested and realized over its lifetime (cash inflows and outflows are assumed to take place at the end of the year): MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 13 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 $m $m $m $m $m $m $m Invested 230 300 120 100 – – – Realized – – – 520 250 350 400 The Fund charged a 1.5% management fee on committed capital for the first three years and 1% of invested capital thereafter. The fund also charged a 25% deal-by-deal carry fee. (Note: GP catch-up and hurdle rate calculation are not relevant in this case due to the profitability of the deals). e) Required: Calculate the IRR and Net IRR for the Fund. (Hint: Keep track of each investment and its corresponding cash flows.) Show your calculations. [29 marks] Year Invested Realized Net to GPs Invested Capital Management Fee Carry Net to LPs 1 230 0 -230 230 11.25 -241.25 2 300 0 -300 530 11.25 -311.25 3 120 0 -120 650 11.25 -131.25 4 100 520 420 520 5.2 72.5 342.3 5 250 250 270 2.7 247.3 6 350 350 220 2.2 75 272.8 7 400 400 0 0 45 355 IRR = 24.35% Net IRR = 17.29% END OF SECTION A MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 14 Section B [80 marks] This question is compulsory. It is divided into sub-parts. You are an associate working for The Platinum Star Fund (referred to as the Fund), a $300 million venture capital fund. The Fund is focused on investing in start-up medical companies in the US. It has identified a company it would like to invest in, Golden Years Devices. You are part of the team working on this deal. Jude Diamond (referred to as Jude or the founder) is a first-time entrepreneur and the founder of Golden Years Devices, a US-based start-up medical equipment and devices maker. Last year, Golden Years Devices successfully launched a cardiovascular device with patented technology. So far, Golden Years Devices has been funded exclusively with -XGH VRZQPRQHJLYLQJ-XGH00% of equity in the firm. To hit the next development milestone and build on the success of Golden Years Devices, the founder decided to approach a VC fund for seed money of $4.5 million. Jude estimates that Golden Years Devices has a cash burn rate of $125,000 per month, and believes that should everything go according to plan, only one additional round of external funding of $6.7 million would be needed before Golden Years Devices becomes profitable. The founder reached out to the Fund, and after both parties conducted their due diligence the Fund and Jude realized they are a good match. The Fund identified three comparable companies to Golden Years Devices with the following forward enterprise value to revenue (EV/REV) ratios: Abbott Labs Boston Scientific Medtronic 3-Year Fwd EV/REV 2.88 4.14 4.48 6-Year Fwd EV/REV 4.67 5.68 4.44 The Fund forecast a revenue of $15 million in two years, $17 million in three years, $18.5 million in four years, $19.5 million in five years and $20 million in six years. The Fund also gathered the following information regarding Golden Years Devices: Probability of Failure Cost of Equity on a Similarly Risky Investment Years 0-3 35% 6% Years 0-6 30% 7% MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 15 a) The Fund is contemplating investing either $4.5 million in one round or investing $2.25 million in the first round and another $2.25 million a year later, contingent on *ROGHQRequired: i. Identify the implications of each option for the founder. [5 marks] If Jude accepts the first option, they would be giving up more of an equity stake. However, they would be raising enough capital in one shot which allows them to achieve the next development milestone in a quicker manner. The second option would allow Golden Years Devices to raise additional capital in exchange for a lower stake of the company. ii. Identify five other considerations that the founder must keep in mind while raising capital from a VC fund for the first time. [5 marks] Other considerations they should keep in mind are: 1. Approach funds whose expertise fit in with the company (geography, sector, verticals, etc.). 2. Conduct due diligence on the VC funds they approach. 3. Decide on the timing and size of various rounds of funding. 4. Recognize that planning the amount of funding needed to achieve the next development milestone and optimizing the time between rounds are determined by the burn rate. 5. .QRZWKDWSUHYLRXVLQYHVWRUV HTXLWVWDNHVGHFOLQHIROORZLQJeach round of investment which leads to dilution when raising external funding. b) The Fund estimates that the time horizon for this investment is six years. Required: i. Calculate the percentage ownership of the fund after it invests $4.5 million. Show your workings. [12 marks] MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 16 Ψ Ψ Ψ Τ Ψ ii. Calculate the pre-money value of Golden Years Devices. Show your workings. [5 marks] Pre-money valuation iii. Jude and the Fund agreed that Golden Years Devices would issue 2,500,000 shares. Calculate the number of shares that the Fund owns and the value per share. Show your workings. [5 marks] Ψ c) Required: %DVHGRQ-XGH VDVVXPSWLRQVDQGWKHLQIRUPDWLRQJDWKHUHGEWKH)XQG i. Calculate how long the funding from the initial round would last, before additional funding is required. Show your workings. [4 marks] Jude would need to raise funds in 3 years. MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 17 ii. Calculate the value of Golden Years Devices at the time when the additional funding is required. Show your workings. [4 marks] Τ iii. Calculate the price per share when the second round of funding is taking SODFHDQGWKHIXQG VHTXLWVWDNH6KRZRXUworkings. [5 marks] d) The Fund is willing to invest the additional $6.7 million required if the assumptions hold up. Required: Calculate the dollar value of -XGH VVWDNHLQGolden Years Devices following the second round of financing. Show your workings. [7 marks] Ψ
Ψ Ψ Ψ
Ψ e) Required: Briefly describe what the purpose of clawback is as related to venture capital. [3 marks] The LPs would try to include a clawback provision in the Limited Partnership Agreement. The triggering of a clawback provision allows LPs to reclaim any MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 18 overdistribution to GPs. The provision protects them in case GPs receive too much distributions or in case the LPs do not achieve their hurdle rate. f) As part of a planning meeting with higher-ups at the fund, you note the following SURQRXQFHPHQWVPDGHEYDULRXV*3 V i. I would prefer to avoid the Employee Stock Ownership Plan altogether. It may be beneficial to Jude, but it is not for us as it is dilutive. ii. We will be asking for convertible preferred shares in return for our investment as those are advantageous to us. iii. The one downside to convertible preferred shares is the forced conversion in the event of a downround. iv. We need to have a say in management decisions at Golden Years Devices. If we need to maximize our influence, we must convert our preferred shares into common equity, so we have more voting rights. v. The way I understand it, if we own more than 50% shares in Golden Years Devices, the drag-along clause is meant to protect Jude whereas the tag- along clause is meant to protect us. State the validity of and comment on each of the five statements listed immediately above. Each discussion/critique carries 5 marks [25 marks] i) I would prefer to avoid the Employee Stock Ownership Plan altogether. It may be beneficial to Jude, but it is not for us as it is dilutive. False. While ESOPs are dilutive, the higher % the Fund requires as available (unused) post-closing option pool, the lower the price they are paying for their shares, and the more dilution the founders (Jude) are absorbing. ii) We will be asking for convertible preferred shares in return for our investment as those are advantageous to us. True. Convertible preferred shares are attractive. Preferred shareholders are given preference over any distributions received in case of a defined liquidity event. They receive their invested capital back first before any distributions are made to common shareholders. Preferred shareholders may convert at any time to common stock at their sole discretion. MSIN0164 2019-20 Private Equity and Venture Capital P a g e | 19 iii) The one downside to convertible preferred shares is the forced conversion in the event of a down round. False. In the event of a down round, there is no forced conversion. Instead, the conversion price of the preferred share class is adjusted downwards to the level of the new valuation, allowing preferred shareholders who invested at a higher valuation in earlier rounds to receive additional shares to maintain their ownership stake and avoid dilution. iv) We need to have a say in management decisions at Golden Years Devices. If we need to maximize our influence, we must convert our preferred shares into common equity, so we have more voting rights. False. Convertible preferred shareholders do not need to convert to exercise voting rights since those are given to WKHPRQD3DVFRQYHUWHG′EDVLV v) The way I understand it, if we own more than 50% shares in Golden Years Devices, the drag-along clause is meant to protect us whereas the tag-along clause is meant to protect Jude.′ True. The drag-along clause allows majority shareholders to force minority shareholders to sell their shares when the majority shareholders wish to exit. If the fund is the majority shareholder, this clause protects the fund. The tag- along clause allows minority shareholders to join majority shareholders in the sale of their shares when the majority shareholders wish to exit. If Jude is the minority shareholder, this clause protects Jude. END OF SECTION B END OF COURSEWORK
