Private Equity - Types of Financing

What is Private Equity (PE)?

PE is one of the source of financing for an enterprise. It is an investment in equity of a company that is not listed in a stock exchange. The difference between PE and Venture Capital (VC) is that VC investment is made in the very early stage of a company’s life cycle. VC is a part of private equity.

Concept of PE investment

PE investment is highly illiquid, it needs monitoring, and its price is not driven by the market.

Private Equity Investor (PEI) provides funds to the company and in return gets equity shares. Unlike an equity shareholder of a public limited company who can trade in stock exchange, PEI cannot do so as they are not listed in a stock exchange. Hence, PE investment is highly illiquid.

PEI gets return on investment in the form of capital gains which is directly linked to performance of the company. PEI has to monitor the functioning of the company because these entities are not regulated by regulators. PEI is treated as an insider while banks that provide loans are treated as an outsider.

PE pricing is not market driven and therefore it has to be favourably negotiated with other investor.

What are the benefits of PE investments?

PE investment provides certification, networking, skill transfer, and financial benefits to the company.

Generally, PE investment is based on thorough scrutiny. Access to PE funds certifies that the company is of high quality. PEI has to constantly monitor the working of the company for sustainability and growth. PEI apart from financing provides networking access, and transfers of knowledge and capabilities.

What is seed financing, start-up financing, and early financing?

The first three stages of the company’s life stages are seed financing, start-up financing, and early financing.

Seed financing focuses on Research and development (R&D) of a product/service. Successful R&D generate patents and upon necessary approval they become products. Seed financing follow 100/10/1 rule which denotes that if 100 ideas are screened 10 are selected for funding and ultimately 1 alone would be successful.

In start-up financing stage, PEI provides funds to the enterprise to buy fixed assets.

In early growth financing, financial needs are normally met by banks but if the need is huge it is met by PEI/VC. VCs provide seed, start-up, and early growth financing. PEI provides hands on approach by providing all necessary support for the sustainability and growth of the company.

What is expansion financing, replacement financing, and vulture financing?

Expansion financing is financing the growth process of the enterprise. It can be internal growth in the form of investment in new assets, increase in working capital or external growth through mergers and acquisitions. PEI provides money and if required acts as advisor and consultant.

PEI screen and scout the market, negotiate with potential target and provide funds to venture backed company and receive shares. PEIs also provide legal and taxation related support.

Replacement financing is financing a company that is in matured stage. The deals can be in the form of leveraged buyouts (LBOs), Private Investment in Public Equity (PIPE), and Corporate Governance deal.

In LBOs, the role of PEI is to identify the potential target. The acquiring company creates a separate entity called ‘Special Purpose Vehicle’ (SPV) to raise funds from banks and PEI. Banks provide debt while PEIs provide equity.  SPV’s asset (cash) is utilized to buy Target Company’s equity. These deals can be through negotiation, hostile takeover, or public offer.

PIPE is buying shares of public company and selling it to another buyer not related to the company. These deals are not through stock exchange.

Vulture financing is financing a company when it is in decline stage. It can be for restructuring the business or during distress. PEI provide finance for buying assets such as brand, patent, expensive machinery either to sell or to use them.

 Next, we shall discuss on PE formats.

Option Valuation

Option Valuation

This blog deals with why assets with option characteristics should be viewed distinctly in corporate valuation process.

Assets are generally valued using conventional valuation models such as book value, stock and debt, DCF etc. However, for some assets conventional valuation models may not be appropriate because these assets possess option characteristics and derive their value from it. Assets of pharma, oil producing, and gold mining companies possess such characteristics.

For example, a pharma company may be awaiting patent approval from Food and Drug Administration (FDA) for vaccine that can cure cancer disease. The valuation of the company changes depending upon the approval/rejection of the patent. If it successfully obtains approval its valuation would increases drastically, if not, it remains stable or decreases.

For such companies it is preferable to use option valuation method. In option valuation method the asset is treated as an option contract.

Why an asset is treated as an option contract?

An option contract is a contingent claim wherein the payoff is made only under certain contingency. In the above example, the contingency is obtaining necessary approval from FDA.

The payoffs on call and put options depends upon the value of the underlying asset. The payoff happens when the value of the underlying asset:

·         exceeds a pre-specified value for a call option

·         fall below pre-specified value for a put option

An option variables include strike price, current market price, payoff, and time to expiration.

·         In an asset, investment outlay or cost is considered as strike price, patent life as time to expiration, market price as current value and payoff as future cash flows. If the value exceeds a pre-specified level, the asset is worth the difference, if not, it is worth nothing.

Option premium and DCF valuation model

Discounted cash flow, one of the popular methods in corporate valuation, understate the value of assets with option characteristics. DCF method is modelled on a set of expected cash flows and it does not fully consider changes when faced with real time situations.

For example, oil producing companies may decide to reduce the output of oil supply if the oil price is not at sustainable level (this happened when the oil price went below $30 per barrel in 2015).

By adjusting the output these firms can preserve or protect their valuation. This adjustment is valued in terms of option premium. If DCF model is used option premium so derived is added to DCF value.

Corporate Valuation - Series 1

Corporate Valuation – Series 1

Few assets are alone are purchased for aesthetic or emotional reasons. Rest all ought to create value or wealth for the investor. Financial assets, in particular, are expected to generate cash flows for the investor or the firm.

Is Valuation process a science or an art?

If the valuation process is done as per the model with right inputs it is science. It is an art if the analysts manipulate figures in whatever fashion, to derive at a desired outcome.  Whether it is an art or science the truth lies between these two because of certain factors inherent in the valuation process.  There could be:

Ø  biases that analysts may bring into the process

Ø  uncertainties that may shock the system, process, and the people associated with it

Ø  information overload and technological advancement

What is Fair Market Value of an Enterprise?

Fair market value is the price at which the property would change hands between a willing buyer and a willing seller. Both the buyer and seller are not any compulsion and it is assumed that both the parties are having reasonable knowledge or relevant facts of the enterprise. Corporate valuation is the estimation of fair market value of an enterprise at a given point in time.

Valuation of an enterprise is done for several purposes, for example, when it raises capital from the public or from venture capital and private equity, or during merger and acquisitions, divestures, or to determine the exercise price of ESOPs or during PSU disinvestment.

It is important to note fair market price must be neither too high nor too low. Too high a price relative to the value would result in lower returns to the buyer and cheaper valuation and price makes the seller less wealthy.

How to derive the true value of an enterprise?

To derive the true value of an enterprise we need two things (1) Forecasting of future free cash flows (FCF) of the business or a project accurately and (2) Discounting of FCFs at appropriate discount rate.

Ø  FCFs are post-tax cash flows generated from the operations of the firm after providing for investments in fixed assets and net current assets.

Ø  Discount rate is used for converting the expected future cash flows into its present value. It represents weighted average cost of all sources of capital viz., equity, preference capital, and debt. 

Let’s now learn about various valuation methods. To derive at true or intrinsic value of the firm there are five methods:

        I.            Book value method

      II.            Stock and debt method

    III.            Discounted cash flow (DCF) method

    IV.            Relative valuation method

      V.            Option valuation method

I.                    Book value method considers book value of all assets of the firm as stated in their balance sheet. Book value of the assets, in principal, equals book value of investor’s claim (the sum of equity, preference, and debt capital).

BV of assets = BV of Investor’s claim

This method has some drawbacks.

Ø  Book value items, even if adjusted to reflect fair value or liquidation price, would result in much lesser valuation as compared to market value of the enterprise.

Ø  Also conventional balance sheet does not consider valuation of intangible assets (e.g., human capital, brand equity). This divergence between book value and market value is visible more in service sectors.

 

II.                  Stock and debt method, also known as market approach, uses market value of equity and debt securities of a publicly traded firm to determine the value of the firm. This method relies more on market efficiency, which assumes that the market price of the securities is an unbiased estimate of its intrinsic or true value.

Market efficiency theory states that deviation in market price from intrinsic value are random and uncorrelated. According to this method the total value of the firm is equal to market value of equity and market value of debt.

                                    MV of equity = MV of debt

III.                Discounted cash flow (DCF) method

DCF method considers future cash flows of an asset or project to derive the value of an asset. The future cash flows are discounted to present value at discount rate that reflects the riskiness of the cash flows.

 

Value of an asset   =   E(CF₁)  + E(CF₂) +  ….. E(CF_n)

                                        (1+r)       (1+r)²            (1+r)ⁿ

 

Where E(CF_n) = Expected cash flow in period n

                      r = Discount rate reflecting riskiness of estimated cash flow

                     n = Life of the asset

 

Assets with high and predictable cash flows generally have high valuation compared to firms with low and volatile cash flows. DCF model is popular in M&A transactions.

 

Difference between Asset and Going concern based valuations

In asset based valuation cash flows from all the assets of the firm are discounted to present value. Going concern based valuation is based on the premises that a business, being an ongoing entity, has existing assets (or assets in place) and assets it expect to invest in future (growth assets).

Growth assets create value to the enterprise when the firm makes future investments. Hence, both these assets are considered. Firms with good growth opportunities will have a better valuation if going concern valuation method is used as against asset based valuation.

 

DCF Valuation Models

A.      The enterprise valuation model values the business in entirety with both assets in place and growth assets. It has two components, Free Cash Flows to the Firm (FCFF) and cost of capital

Ø  FCFF is the cash flow available for distribution to all investors after meeting the capital expenditure and net working capital needs of the firm.

Ø  FCFF is discounted at cost of capital, which reflects the composite cost of financing from all sources of capital.

 

B.      The equity valuation model considers Free Cash Flows to Equity (FCFE) and discounts the same at cost of equity.

Ø  FCFE is the cash flow available for distribution to equity shareholders after the firm has met its obligations towards other investors (debt  holders and preference shareholders) and provided for its capital expenditure and net working capital needs.

Enterprise valuation considers FCFF and cost of capital while equity valuation considers FCFE and cost of equity.

 

C.      The excess return valuation model segregates cash flows into two segments, the normal return cash flow and excess return cash flow. Any cash flows above normal return is categorized as excess return cash flows. Excess return can be either positive or negative.

Value of the business = Capital invested in firm today + Present value of excess return cash flows from both existing and future projects.

 

D.      The Adjusted Present Value Model separates the effect on value of debt financing from the value of assets. The reason is debt creates tax benefits (interest expenses are tax deductible) on the positive side while on the negative side it increases bankruptcy costs.

Value of the business =   Value of business with equity financing alone + Present value of expected tax benefits of debt – Expected bankruptcy costs

Dividend discount model uses dividend as cash flows and these cash flows are discounted at cost of equity.

 

IV.                Relative Valuation Method

It is based on the premises that similar assets should be traded at similar prices. This model is popularly used in realty sector. This model is also used for pricing of initial public offerings (IPOs).

A company approaching for an IPO can be compared with any other peer company that are public traded. Difference that may arise are adjusted but these controls are generally subjective.

                                   V_T = X_T (V_C/X_C)

Where V_T is the appraised value of the target firm

X_T is the observed variable

V_C is the observed value of comparable firm

X_C is the observed variable for comparable firm

 

 

V.                  Option Valuation Method

This method uses valuation of a financial option. A financial option is an agreement in which the option owner enjoys the right to buy or sell a security without an obligation to do so. To enjoy this right the option owner has to pay a premium. Similar to DCF valuation this method uses estimation of expected future cash flows and these cash flows are discounted at appropriate discount rate. Estimating cost of capital is very difficult because the value of underlying asset (stock) changes constantly.

 

‘Kinked’ Capital Allocation Line

What is meant by ‘Kinked’ Capital Allocation Line (CAL)?

CAL is ‘kinked’ when investment in a complete portfolio is leverage and when the borrowing rate is greater than risk free rate.

What is CAL?

CAL is a straight line in investment opportunity set with risky assets and a risk free asset in the expected return-standard deviation graph.

What is expected return, risk premium and the standard deviation of a complete portfolio?

                                                                                                  

The expected return of a complete portfolio is denoted as

                            E(r_c) = r_f + y[E(r_p) - r_f]

Example: 
Let's say the proportion of investment budget in risky asset is y= .5 and that of risk free asset is (1-y).                        

The standard deviation of risk free asset (r_f ) = 0 and that of risky assets = 12%.

The expected return of risky asset  E(r_p) = 8%

§   The expected return of risk free asset E(r_f) = 4%

The expected return of the complete portfolio is:

                             E(r_c) =  4% + .5 (8%-4%)

                                      =  6%

The risk premium of a complete portfolio is 2%  (i.e., 2% greater return  for additional risk)

The standard deviation of a complete portfolio is 6% (= .5 x 12%) (i.e., risk has reduced by 50%).

What is the slope of CAL?

The slope of CAL (S) is the incremental return per incremental risk.  It is called reward to volatility (Sharpe) ratio.

                           

                           S = [E(r_p) –r_f ] / σ_p

                                                 

                                   = 4% /12%   = .33

Let's see what would be the slope of CAL when the portfolio has borrowed at risk free rate

Now, the proportion of investment in risky assets ‘y’ would be greater than one.

Let’s say an investor has investment budget of $2,000,000 and has borrowed $1,000,000 and plans to invest all the funds in risky asset.

                                    

                              Y = 3,000,000/2,000,000

                              Y = 1.5 and

                         (1-y) = -.5  (i.e., the proportion of risk free asset)

                                                                                  

 Other things remaining same, 

 Levered  E(r_c) = 4% + 1.5 (8%-4%) = 10%

Standard deviation of the portfolio (levered) = 1.5 x 12% = 18%

Slope of CAL (levered)    S = [E(r_c)-r_f] / σ_c

                                           = [10%-4%]/18% 

                                           = .33                                    

                                                

As long as risk free rate is equal to borrowing rate the slope of CAL will remain unaffected and CAL is straight.

Kinked CAL

Not everyone can borrow at risk free rate, particularly non-government investors. Default risk of borrowers induce lenders to charge higher rate of interest. Suppose the borrowing rate is 5% the slope of CAL now is:  

                          S = [E(r_p) – r_f] / σ_p

                             = [8% -5%]   / 12%                   

                             = .25

The reward-to-volatility ratio or the slope of CAL gets reduced from .33 to .25 and hence CAL is slightly flattened or kinked.

Financial Asset Classes

Hi,

In this blog, I am trying to explain various types of financial assets with more focus on derivatives and its variants.

Financial assets are broadly classified into equity, debt securities, and derivatives.                               

Equities or common stocks represent ownership share in the corporation.

§  Common stock holders have residual claim on the assets and income of the corporation (when the corporation is liquidated they have a last claim), and their liability is limited (creditors cannot lay claim to personal assets of the stock holder). 

§  Equity shareholders are entitled to vote and receive dividends (if declared). Returns to shareholders are tied to corporation performance.  

§  An investor can purchase share of foreign company, not directly, but through Depository Receipts. American Depository Receipts (ADRs) are certificates traded in U.S. markets representing ownership in shares of a foreign company.

Debt or fixed income securities promise to pay fixed stream of income (e.g., In a 8% 5 year bond, par value $1,000; the investor gets $80 as interest each year) or a stream of income determined by a specified formula (e.g., In a 5 year LIBOR +2% bond, par value $1,000; the investor gets interest at the prevailing LIBOR rate + 2%).

§  London Interbank Offered Rate (LIBOR) is short term interest rate at which large banks in London are willing to lend money among themselves, and it also acts as reference rate in European money market.

§  Money market securities consists of very short term, highly marketable, low risk securities (e.g., Treasury bills, Certificate of Deposits, Commercial papers, Repos and Reverses etc.)

§  Long term securities include Treasury bonds, bonds issued by federal agencies, state and local municipalities (these will be discussed separately).

A derivative security derives its value from another security’s characteristics or value. The other security is termed as underlying asset.

Derivatives have variants such as forwards, futures, options, and swaps etc.

A spot contact is an agreement to buy/sell an asset today. In contrast, a forward contract is an agreement to buy/sell an asset at an agreed (exercise) price and quantity to be delivered on or before the future agreed date (expiration date).

§  Forwards are private contracts traded in over-the-counter markets and are usually between two financial institutions or between financial institution and one of its clients. They are highly customized and usually not regulated.

Future contract, unlike forward contract, is a more formalized, legally binding agreement and are traded on registered exchanges.

§  They are highly standardized regarding quality, quantity, delivery time and location for each specified commodity.

§  Clearing house acts as counterparty to all future contracts (i.e., if one of the party to the contract fails to fulfill his/her obligation clearing house fulfills the contract either by buying/selling).

§  Futures contracts are marked to market on a daily basis (i.e., profit/loss are booked on a daily basis). The investor is required to maintain sufficient funds in margin account.

§  A long position in a futures contract is held by the trader who commits to purchase the asset on the delivery date. A trader holds short position if he/she commits to deliver the asset on delivery date.

A call option contract gives the option holder the right, but not the obligation, to buy an asset at the exercise price from the option seller within the specified time period.  

A put option contract gives the option holder the right, but not the obligation to sell an asset at the exercise price from the option buyer within the specified time period.

§  The value of an option depends upon strike (exercise) price, current stock price, time to expiration (maturity), dividends etc. To exercise or not to exercise the option depends on all these factors.

§  The buyer of option contract (both call and put) has to pay option premium. The owner of the option contract is called buyer or holder of long position, and the seller is called writer or holder of short position.

§  An American option contract can be exercised at any time between the issue date and expiration date, but a European option contract can be exercised only on the expiration date.

§  There are various trading strategies involving options (e.g., covered calls, protective puts, butterfly spreads, bull and bear spreads etc.)

A swap is an over-the-counter agreement between two entities to exchange cash flows in the future. For example, a corporation agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a predetermined period. In return, it receives interest at a floating rate on the same notional principal for the same period of time. This type of swap is known as interest rate swap.

§  Currency swap involves exchange of principal and interest payments in one currency for principal and interest payments in another currency. Currency swaps are used to transform liabilities into assets.

 

 

Financial Assets Vs Real Assets

Hi,

This blog tries to explain the readers meaning of real and financial assets, how financial assets facilitate to create real assets, and the reasons why real assets alone matters in determining the net wealth of the nation.

Let me begin with the term ‘Investments’. Investments are current commitments of money and other resources in expectation of future earnings or benefits. Material wealth (also known as productive capacity) of an economy is determined by goods and services produced in that economy.

Corporations use real assets such as land, building, equipment etc. to produce goods and services. Other than these tangible assets, intangible assets such as knowledge, trademark, patents etc. are also used.

Corporations need finance to obtain real assets. Hence, to raise sufficient funds (also known as capital) they sell securities such as stocks, bonds etc. These securities have claim to the income generated by real assets or on real asset itself. These securities are known as financial assets.

Financial assets, unlike real assets, do not contribute directly to the productive capacity of the economy.

Why real assets alone matter in determining the net wealth of the nation and why not financial assets?

National wealth comprises of net wealth of all the households and corporations. Financial assets of a household usually comprises of fixed deposits with banks, stocks, bonds etc. For the issuer of such securities claims are established. Hence, financial assets and financial liabilities are aggregated (netted).

For example, when a household makes a fixed deposit with a bank an asset is created. However, for the bank it is a liability as it has created an obligation to repay the deposit at a future date. When these financial assets and liabilities are aggregated real assets alone will remains as national wealth.

In my next blog, types of financial assets will be discussed.

 

 

On-Balance Sheet Hedging and Off-Balance sheet Hedging Using Forwards

On-Balance Sheet Hedging and Off-Balance sheet Hedging Using Forwards

When is financial institution long and short in forex exposure?

FI is long when its assets are greater than liabilities and is short in exposure if its liabilities are greater than assets.

The mismatch between FI’s foreign financial asset and foreign financial liability portfolio leads to FX exposure.

How to create opportunities for higher returns in Forex market?

Banks try to exploit forex market that creates opportunities using Off-balance sheet and On-balance sheet hedging tools. This can be done either by increasing the Return on asset (ROA) or by lowering cost of funds (COF) or both.

(1)     Let’s see how Unhedged Balance Sheet is exposed to forex risk.

Let’s say a U.S based FI has USD 200m 8% CDs for one year and loaned USD 100 million in U.S at 9%, and USD100 million equivalent in U.K.loans at 15%. The exchange rate is 1GBP = $1.60.

Extract of Balance sheet

Assets	Liabilities
U.S. loans (9%)                         =  USD 100.0 m	USD  (8% CDs 1 year)                = USD 200.0 m
U.K loans (15% )                       =   GBP   62.5m (1GBP = USD1.60)

Rate of interest in U.K.is 15% and in U.S. 9%

Let’s now compute Return on Asset (ROA), Cost of Funds (COF) and Return on Investments (ROI) under two scenarios:

(1) When GBP depreciates to 1GBP = $1.45

(2) When GBP appreciates to 1GBP = $1.70

Computation of ROA, COF and ROI

	When GBP  depreciates	When GBP  appreciates
Exchange rate - end of the year	1 GBP =  1.45 USD	1 GBP = 1.70 USD
Returns from U.K Investment 62.5 x .15 = 71.875 GBP Converting back to USD we get	71.875 x  1.45 = USD 104.22 Returns in USD = 4.22%	71.875 x 1.70 = USD 122.18 Returns in USD = 22.18%
ROA	.5 x 9% + .5 x 4.22% = 6.61%	.5 x 9%+.5 x 22.18% = 15.59%
COF	= 8%	= 8%
ROA – COF = ROI	6.61% - 8% = -1.39%	15.59% - 8% = 7.59%

Inference: ROI is negative when GBP is depreciating.

 (2)     On-balance sheet hedging - When GBP is depreciating and appreciating

Continuing with our previous example, the FI has instead sold CDs equivalent to USD100 million each in U.S and U.K at 4% and 11% respectively. The extract of balance sheet is given below.

Extract of Balance sheet

Assets	Liabilities
USD 100 million U.S loans 9%	USD 100 million (U.S. 8% CDs 1 year)
USD 100 million equivalent U.K. loans 15% = 62.5 GBP	USD 100 million in U.K CD’s (11%)

Exchange rate at the beginning of  the year  1GBP = $1.60

Let’s now compute Return on Asset (ROA), Cost of Funds (COF) and Return on Investments (ROI) under two scenarios using on-balance sheet hedging:

                                        On-Balance Sheet Hedging

	When GBP  depreciates	When GBP  appreciates
Exchange rate - the end of the year Converting to GBP 100/1.60 = 62.5m Interest rate = 15%	1 GBP =  1.45 USD	1 GBP = 1.70 USD
Returns from U.K. investment GBP 62.5 x 1.15 = 71.875 Converting it to USD	71.875 x 1.45 = 104.22 Returns in USD = 4.22%	71.875 x 1.70 = 122.18 Returns in USD = 22.18%
Cost of funds (U.S Loans)	8%	8%
Cost of funds (U.K Loans) 62.5 x1.11 =69.375	69.375 x 1.45 = 110.59 Returns in USD = .59%	69.375 x 1.70 = 117.938 Returns in USD = 17.938%
Weighted average cost of funds	.5 x 8% + .5 x .59% =4.30%	.5 x 8% + .5 x 17.94% = 12.97%
Weighted return on asset portfolio	.5 x 9% + .5 x4.22% = 6.61%	.5 x 9% + .5 x 22.18 % = 15.59%
Net Return	6.61% - 4.3% = 2.31%	15.59% - 12.97% = 2.62%

Inference:

The firm can lock in positive ROI even when GBP is depreciating.

When GBP appreciates the firm can earn higher returns.

 

(3)     Balance sheet hedging using Forwards

Continuing with our previous example, suppose the bank enters into forward currency contract at 1GBP = $1.55 the ROI would be:

Exchange rate - end of the year	1 GBP = 1.55 USD
Returns from U.K Investment 62.5 x .15 = 71.875 GBP Converting back to USD we get	71.875 x 1.55 = USD 111.41 Returns in USD = 11.41%
ROA	.5 x 9%+.5 x 11.41% = 10.21%
COF	= 8%
ROA – COF = ROI	10.21% - 8%  = 2.21%

(4)   Comparison of Net Returns

Net return (ROI)	When GBP  depreciates	When GBP  appreciates
Un-hedged balance sheet	(1.39%)	7.59%
On-balance sheet hedging	2.31%	2.62%
Off-balance sheet hedging using forwards		2.21%

On-balance sheet hedging is providing higher returns when GBP appreciates compared to Off-balance sheet hedging using forwards.