GE Capital Commercial Finance
Private Equity: A Look at a
Maturing Asset Class
Chicago GSB Finance Roundtable
February 13, 2002
Timothy G. Kelly, Senior Vice President
GE Capital Commercial Finance
Equity Investment Team
(312) 441-7650
Timothy.Kelly2@GECapital.com
GE Capital Commercial Finance Agenda
Goals:
1. GE Capital Commercial
• Provide a broad- based Finance’s equity investment
overview of the private team and portfolio
equity asset class
2. A look at the past decade
• Highlight trends in the
industry 3. Private equity today: Why not
• Uncover valuation so private any more
games that can
4. Valuation and Benchmarking:
mislead investors
and other impossible feats
Audience:
5. Heard on the LP street
• Students
• Practitioners 6. Market predictions
• Investors 2
GE Capital Commercial Finance Structure/Players
LPs
Manage Co Public/Private
Pensions
Endow/Fdntns
Banks
GP/Sponsor Families
Insurance
Strategic
Other
1%
NewFund LP
2% Management Fees
1% share of Returns
20% Carried Interest 99%
PortCo PortCo PortCo PortCo
3
GE Capital Commercial Finance Fund Types
• Industry Niche
• Opportunistic
• Control v. Minority
• Operators or Financiers
4
Most often heard
GE Capital Commercial Finance marketing lines
– Everyone is in the top quartile of returns
– Everyone pays less than others for their deals
– Everyone’s deal flow is proprietary
– No one participates in auctions
– Everyone is more of an “operator”
– Those aren’t Venture deals in our track record,
their A, B and C rounds that we led in early
stage “growth equity” deals
5
GE Capital Commercial Finance
GE Capital’s Private Equity Investment
Programs
6
GE Capital Commercial Finance The Earnings Machine
28 Discrete Businesses
Specialized Financing
Equipment Management
GE
Equity
Rail Technology GE GE Aviation
Modular Americom Services Commercial
Services Services SeaCo
Space Finance Real Estate
Penske Truck
Leasing Structured
Finance
Trailer Group
Leasing
GE Capital
Mid-Market Financing
Fleet Vendor
Services
Commercial
Equipment
Financing
Employers
Reinsurance GE Auto
Financial AFS
Corporation Insurance Europe Mortgage
Services Services
Holdings European
Equipment
Finance
Financial Global
Guaranty GE Financial
Mortgage Consumer GE Capital GE Card GE Capital
Insurance Assurance
Insurance Finance Australia Services Japan
Specialty Insurance Consumer Services
7
GE Capital Commercial Finance Main Private Equity Areas
GE Equity
~$4.5 Billion
2/3 Early stage
1/3 Later stage buyouts
GE Asset Management
~$5 Billion Commercial Finance
Diversified
investments
8
GE Capital Commercial Finance CF Portfolios
Commercial Finance Equity Programs
LP Fund Portfolio Co-investment Portfolio
# Funds: 213 Goal: Leverage CF’s # Investments: 60
Committed: ~$1.2 Billion unique market insights Invested: ~$137mm
to generate above-
average economic
returns and augment
deal flow by investing
in top quartile potential
fund and passive direct
private equity Tag-along Portfolio
Public Stock Portfolio investments. (Directs with Debt)
# Stocks: >20 # Investments: 133
Exposure: ~$75mm Invested: ~$125mm
“Other” Portfolio
# Investments: 18
Invested: ~$25mm
9
GE Capital Commercial Finance Equity Investment Team
Team Skills Include:
Accounting
Capital markets
Complex financing
and equity capital
structuring
Comprehensive
portfolio
management
Finance
Legal
Operations
management
Options and other
derivatives
Public securities
issuance and trading
Syndications
Lean team of 10 professionals
10
GE Capital Commercial Finance Fund Selection Process
Rigorous selection process
Established Teams Past Performance
• Length of time that partners have • Proven skill sets (deal minimums)
worked together (Continuity) • 20% net historic returns
• Verifiable track record – Scrutinize IRRs and Valuations
• Strong deal flow • Strong cash on cash returns
• CF insights of team preferred • Low concentrations, volatility, loss
rates
Strategy Organizational Risk
• Middle market focus • Low turnover
• US, UK, Canada, Western Europe • Adequate capacity and depth
• Consistency • Considerable GP investment
• Control orientation
• Adequate succession planning
• Due diligence rigor
• Exit strategies
11
GE Capital Commercial Finance Why We Like the Middle Market
Middle market appears most attractive place to play
•Plentiful number of potential targets • Best practices and seasoned
~7,358 (54% private) w/revenues >$250mm management teams opportunities
~9,160 (72% private) w/rev’s $100-$249 mm • Purchase price advantages
~40,966 (86% private) w/rev’s $25-$99 mm • Excess Investment Opportunities Versus
~74,948 (93% private) w/rev’s $10-$24 mm Capital
Plus: unknown number of “divisional” – A recent analysis done by Heller: assuming 65%
opportunities and take privates leverage, suggests that there is nearly 4.5x more
equity value in market than has been raised in
•Less efficient auction market
the last 5 years.
* Source: Venture Economics (Securities Data Company)/NVCA; Middle Market Data reflects mean average of pooled returns of small, medium and large funds (smaller 12
than $1 Billion) versus published pooled returns of “mega” buyouts ($1 Billion and greater.
GE Capital Commercial Finance Sample Fund Investments
We “are” the middle market with 200+ funds
*Sample Core Fund investments at 12/01.
13
GE Capital Commercial Finance GP Standards
What does our “average” GP look like?
*Sample set comprised of all former Heller fund investments through March, 2001 .
14
GE Capital Commercial Finance
Private Equity Management:
Past
15
GE Capital Commercial Finance LBO Market Growth
Operational focus
(a/ka back to the
basics)
Era of consolidations
and multiple arbitrage
driven by Bull market
Financial momentum
Leverage
Era
1980s 1990s 2000+
Initial concept source: McKinsley & Co.
16
GE Capital Commercial Finance The Private Equity Market
U.S. Private Equity Fund Commitment Trends 1995 - 2000
Commitments trended significantly upward until 2000
Totals $29,503 $38,263 $55,592 $92,160 $97,305 $153,905
+31% +45% +66% +6% +58%
(+422%)
_______________________________________
Source: Private Equity Analyst., January 2001.
17
GE Capital Commercial Finance The Private Equity Market
U.S. Private Equity Fund Commitment Trends 1995 - 2000
When the market sounded the wake up call…
1H01
Corp. Fin: $18b v. $35b (-49%)
Venture: $23b v. $25b (-7%)
Mezz: $2.5b v. $3b (-19%)
Other: $1.0b v. $0.3b (-68%)
Totals $29,503 $38,263 $55,592 $92,160 $97,305 $153,905
+31% +45% +66% +6% +58%
(+422%)
_______________________________________
Source: Private Equity Analyst., January 2001.
18
GE Capital Commercial Finance The Private Equity Market
OCF Purchase Price Multiples 1993-3Q01
And purchase price multiples have responded in kind…
Source: Heller Financial, Inc.
OCF=EBITDA less Normalized Cap Ex
19
GE Capital Commercial Finance Fund Draw-down Rates
But tight capital markets have slowed investment rates
Vintage Year
(# of Funds) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9
1993 (3) 8.0% 32.4% 49.2% 65.9% 81.5% 88.4% 95.9% 104.4% 106.6%
1994 (6) 18.8% 40.3% 60.0% 79.1% 91.3% 95.1% 102.0% 102.8%
1995 (7) 5.5% 28.0% 52.3% 70.5% 91.6% 95.1% 95.6%
1996 (8) 18.9% 44.2% 67.1% 84.0% 86.6% 88.8%
1997 (10) 10.5% 36.8% 61.8% 78.8% 85.8%
1998 (11) 13.7% 44.3% 64.8% 75.5%
1999 (15) 16.1% 42.0% 57.5%
2000 (19) 15.2% 28.0%
2001 (11) 9.5%
Aver. Incremental Change 12.9% 23.6% 21.9% 16.7% 11.7% 4.5% 6.0% 5.7% 2.2%
Aver. Cumulative Change 13.5% 37.0% 58.9% 75.6% 87.4% 91.9% 97.8% 103.6% 106.6%
2001 Incremental Change 9.5% 12.8% 15.5% 10.7% 7.0% 2.2% 0.5% 0.8% 2.2%
2001 versus Average -3.4% -10.8% -6.4% -5.9% -4.7% -2.3% -5.5% -4.9% 0.0%
Source: Heller Financial, Inc.
20
GE Capital Commercial Finance Fund Portfolio Performance
More cash available, higher prices, bull market… what bubble?
Heller Cumulative Fund Portfolio IRR
Net IRR Fund Portfolio Returns 12/31/94 Through 9/30/01 Cash Multiple
1.8
0.25 22.4%
0.2 1.6
16.0%
15.1%
13.0% 13.7%
0.15
1.4
1.42x 9.2%
0.1 7.3%
1.30x
1.24x 1.2
0.05
1.19x
1.16x
1.12x
0 1.06x 1
-0.05 0.90x Aver. Portfolio Age: ~3 yrs 0.8
-0.1 Net IRR w/directs: 15.2%
0.6
-0.15
-19.9%
-0.2 0.4
Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Sep-02
*Sample set comprised of all former Heller fund investments through September, 2001 .
21
GE Capital Commercial Finance Fund Portfolio Performance
More cash available, higher prices, bull market… what bubble?
Heller Cumulative Fund Portfolio IRR
Net IRR Fund Portfolio Returns 12/31/94 Through 9/30/01 Cash Multiple
Atypical Public Market Effect 1.8
0.25 22.4%
(Venture exposure 10 securities
– HFI > 50 securities – IPO and Secondary
– EMA treatment creates Lockups
sensitivity to volatility – FAS 133 issues
– GP has obvious conflict – More robust choice of
in timing distribution hedging opportunities
– Maybe moral but no
legal barriers to hedging
– Does GP sell after LPs?
30
GE Capital Commercial Finance Managing Implied Volatility
Implied Exposures
Case Study
• Implied exposure grows*
– 1999: ~5 stocks
– 2000: +40
– 2000: 18x cost
• Market volatility doubles
• Quarterly P&L stressed
References are to Heller Financial, Inc. fund portfolio
31
GE Capital Commercial Finance Managing Implied Volatility
• Between 3/00 and 6/00, Heller’s portfolio fell 36% before recovering to a
loss of 19%. In September 2000 alone, we experienced a further drop in
value of 24%.
• Remember, this is a private equity portfolio!
32
GE Capital Commercial Finance Managing Implied Volatility
Implied Exposures
Case Study
• Implied exposure grows Strategy choices
– 1999: ~5 stocks • Do nothing
– 2000: +40 • Buy Puts:
– 2000: 18x cost
• Market volatility doubles
– $5m min/position
• Quarterly P&L stressed – Costly & Continuous
• Desire to smooth income • Sell Calls: same and
• Desire to protect gains downside limited, cash
• Must have flexibility re: only exercise
settlement method • Collar:
– Min. position
– Cash exercise only
– Inflexible/asymmetric
• Swap?
33
GE Capital Commercial Finance Proposed Swap
Owner of Broker pays HFI if portfolio depreciates in value (quarterly “true-up”) $1:$1
Securities Being
Shorted
HFI pays Broker if portfolio appreciates in value (quarterly “true-up”) $1:$1
Loans
Paid
Shares
Rebate
Notional Value Held as Generates 90 day
collateral for short LIBOR on Balance
position Escrow
Account
Offshore Broker Heller
Pays Rebate to Pays Broker
Owner of
Plus 25 bps p.a.
Pays Borrowed to administer
Security Shorts Shares (~1.75% Holding rebate and
Notional Securities p.a.) LIBOR constant, HF
Value $ receives 4.73% p.a.
as incremental
Flexible income (which
fluctuates daily) and
Market
Buyer Symmetric locks-in gains at
current levels once
Low Cost executed.
34
GE Capital Commercial Finance Managing Direct Volatility
Direct Exposures
Case Study Strategy
• Co-investment goes public • Lockup bars only sales
at $10 ($6 cost) • Analyzed alternatives
• 180 day lockup – Goal: protect gains,
• Start selling at $20 timing
• Secondary: 180 lockup • Costless collar (250 days)
• Stock runs to $50 in 3 – Stock: $42
months – Puts: $39 (7%)
• 3 months left to expiration – Calls: $52 (14%)
of lockup
• +1 month: Stk @ $12
• Gain: ~$10mm
35
GE Capital Commercial Finance
Valuation Methodologies and
Benchmarking
(a/k/a Other Ways to Make 2+2=5)
36
GE Capital Commercial Finance Benchmarking
This is a nearly impossible asset class to benchmark!
Year closed or funded?
Just Buyouts or Combination?
Methodology Used?
Not really an IRR!
Best method but reliable?
Be careful!
37
GE Capital Commercial Finance Improving IRRs
And even hard to compare on an absolute return basis
Time Weighted Basis: Time Zero Basis:
A: 20%
B: 44%
C: 52%
D: -12%
(A:D)
Impact on Cash Flows:
Time Zero
Impact
Time Weighted
38
GE Capital Commercial Finance Improving IRRs
Sample: 8 realized deals (6+, 2-), varying hold periods, 2%, 20%
Note: Early, big winners in a portfolio can reverse Time Zero
effect shown above.
39
GE Capital Commercial Finance Other Valuation Considerations
And almost everyone uses a different metric
• Net versus Gross
– Using 2% capitalized management fees and 20%
carried interest (no organizational expenses):
~ Net equals 27% discount to gross
– Heller uses 29% discount as rule of thumb
Valuation Methodologies: Some real life examples...
40
GE Capital Commercial Finance Forward IRRs
Stated IRR: Aggregate 62.3% Gross IRR
Portfolio Mix: 4 Realized, 7 Unrealized (~18 months old)
Methodology Employed:
• Applied CAGR assumption to Sales and EBITDA
• Applied assumed Net Funded Debt Paydown
• Applied multiple arbitrage for all 7 unrealized deals on
exit
• Exits begin +3 years and end ~5 years
• Stated IRR based on DCF of future values on exit
IRR using TTM methodology: 16.2%
41
GE Capital Commercial Finance Budgeted Values
Stated IRR: Aggregate 32.5% Gross IRR
Portfolio Mix: 4 Realized, 6 Unrealized (~2.5 years old)
Methodology Employed:
• September: meeting GP discloses values based on
EBITDA levels “As of 6/30”
• November: updated financial performance requested as
part of due diligence
– Discover that prior values based on Budgeted YE
numbers as of 6/30
– 2 deals showing gains on prior valuation now worth
zero due to troubled/failed acquisitions
– 2 deals reflect Budgeted YE data 2 years in the future
IRR using TTM methodology: 10.6%
42
GE Capital Commercial Finance Multiple Arbitrage
Stated Deal IRR: 150% Gross IRR
6/23 Transaction:
– Control position closed on 6/23; Equity value of
$47.5mm
– Full Auction
– Purchase multiple at close: 7.1x EBITDA
9/30 Valuation:
– EBITDA TTM +.5 million
– Gain shown of $13.5mm
– Gain largely reflects assumed 2.5x multiple arbitrage
IRR using TTM methodology: 0% (Less than 1 year old)
43
GE Capital Commercial Finance Gross Optimism
June August
• Company loses major customer • GP buys bank debt at
• EBITDA drops 65% 62% of par with buyout
• EBITDA projected to be 25% of prior capital and delevers
year level company
• Banks act aggressively
September December
GP valuation: Cost • GP valuation:75% of cost
• GP notes loss of customer but
reflects strong optimism in future
potential
44
GE Capital Commercial Finance Public Stocks
Market Inefficient
“Public stock is valued at multiple of revenue based on comparable
market data. The General Partner has determined that the current
stock price does not properly reflect the true value of the company”
Market Highly Efficient
Minority position purchased 2/1 at aver. price of $7/sh
Position valued on 3/31 at current price of $12.50/sh
Gain of 78% reflected along with IRR near infinity
Data Games
No discounts applied to restricted/partially restricted positions
45
GE Capital Commercial Finance Closing Valuation Comments
• Do your homework
• Beware the “lemming” factor
• Watch out for the Front Page risk!
Like the Forbes’ motto says advises:
“With all they getting, get understanding.”
46
GE Capital Commercial Finance
Heard on the LP Street: General
Market Observations and Predictions
47
GE Capital Commercial Finance Heard on the LP Street...
•Strategy migration does not fare
well (“Style Drift”)
– Buyout to venture
– Buyouts into CDOs
– Domestic to foreign
•Succession planning more critical
•ENRON sending shivers through
LP market!
•Illiquidity: realizations needed!
•New financial structures being
tested
– Traded trust certificates (ex:
Std. Life)
– CEOs
48
GE Capital Commercial Finance Collateralized Equity Obligations
Assets ($500mm): Liabilities ($250mm):
Diversified Portfolio of Zero Coupon Notes
Private Equity Funds (Principal Insured; Small current
pay coupon for some structures)
Equity participation notes
Equity (~6-9x leverage)
+ Cash flow (not periodic) - Cash flow
49
GE Capital Commercial Finance Heard on the LP Street...
•Strategy migration does not fare • Secondary markets growing
well (“Style Drift”) rapidly
– Buyout to venture • Advisory board roles no longer
– Buyouts into CDOs “rubber stamp” for GP actions
– Domestic to foreign – Valuations
•Succession planning more critical – Conflicts
•ENRON sending shivers through • Absence of “venture pyramid”
LP market! placing more emphasis on
•Illiquidity: realizations needed! portfolio management
•New financial structures being • Hedging risks more topical
tested – Public market volatility
– Traded trust certificates – Equity method of accounting
– CEOs treatment
50
GE Capital Commercial Finance Predictions
Don’t quote me… but…
• Over next 3 Years - Market digests “mature” stage of growth cycle
– consolidation occurs
– branding more important
– differentiation grows critical
– Standardization of financial reporting and accounting
• Over next 5 Years - Market rating system implemented
• Over next 5 Years - Advisory boards begin utilizing outside directors
• Within next 10 Years - Retail products materialize
– Exchange traded fund securities
– Options on funds?
51
GE Capital Commercial Finance
52