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Feature Article

32 Imaging Spectrum August 2007 International Imaging Technology Council www.i-itc.org

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How Private Equity Really Works (Part 1 of 2)by Martin Stein, Managing Director, Blackford Capital,Tony Kiehn, Managing Director, Blackford Capitaland Jennifer Danzi, Marketing Analyst, Blackford Capital

Leveraged buy-outs (LBOs), in which an existing company

is acquired using a combination of debt and equity,totaled

just under $60 billion of transactions in 2002. In 2006,

LBOs accounted for more than $400 billion of transactions. In the

first half of 2007, there have been over $335 billion of LBO trans-

actions. Looking forward to 2008 and beyond, one might assume

that the volume of LBO activity will only increase. However,LBOs

are cyclical and the current cycle, the biggest ever, is bound to

come to an end given the potential for increased interest rates,

proposed tax increases, and increased competition.

Regardless of whether LBOs are at their peak today, tomorrow or

yesterday, savvy business executives are well-served knowing more

about the mechanics of private equity firms and how a leveraged

buyout works. Several private equity groups (PEGs) have made

forays into the compatible imaging supplies industry in recent years

(Hyde Park Holdings, Key Capital Partners, Stonehenge Capital,Kayne Anderson and Blackford Capital, among others), several

more have investigated the industry and, no doubt, a few more will

still contemplate making future investments.

In a two-part series, this article will provide entrepreneurs and busi-

ness owners with a basic understanding of the mechanics of a lever-

aged buyout, offer information to both buyers and sellers on the

process of a transaction and articulate the philosophy or point of

view of a private equity firm as they evaluate any given transaction.

What Is Private Equity?

Private equity,as its name suggests, is private,which means it is notsubject to ownership or results reporting, SEC filings (except when

acquiring public entities) or other public disclosure regulations.

Interestingly, two of the largest private equity firms (Blackstone

and KKR) have recently completed or announced initial public

offerings. As its name also implies, private equity typically involves

equity (not debt) investments. However many, if not most, private

equity firms also provide debt financing for businesses.

There are a variety of different types of private equity transactions

the term is used loosely to describe any capital providers that are not

public as well as a host of players involved in some form of transac-

tional events, financial solutions or participation in the capital struc-

ture of businesses. Generally, private equity refers to leveraged

buyouts, seed investments, venture capital, angel investing, growth

capital and other various forms of financing or investing.

Private equity can be categorized by the size of investment, type of

investment, target rate of return, investment horizon,source of cap-

ital, number of investments per year and location within the capital

structure, among other factors. There are approximately 1,000 to

2,000 private equity firms within the United States with approxi-

mately $200 billion of uninvested equity capital available for acqui-

sitions and investments. Most private equity firms manage capital

from both wealthy individuals and from institutions.

Two of the largest categories of private equity firms are venture cap-

ital firms and LBO firms. Venture capital firms provide financing tostart-up businesses that need seed financing to grow. LBO firms

acquire existing businesses with a combination of debt and equity

and work aggressively to improve the value of the companies they

acquire over a three- to seven-year period.

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Jennifer Dazi is a marketing analyst at Blackford Capital. She currently attends Williams College and the London

School of Economics.

Tony Kiehn is a managing director at Blackford Capital. Kiehn led Blackford Capitals sale of Rhinotek to Reliant

Equity Investors.Kiehn has 10 years of experience working in Asia.He is a graduate of Harvard Business School and theUniversity of Nebraska.

Martin Stein is the managing director ofBlackford Capital,a private equity firm focused on middle-mar-

ket acquisitions,and ser ves as treasurer on the executive board of the International Imaging Technology

Council.Previously,he served as president of Quality Imaging Products.Stein has received numerousindustry leadership awards and has substantial private equity,investment banking,operations and con-

sulting experience.He has published several Harvard Business School cases and received his MBA fromHarvard Business School and his BA from the University of Chicago.


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Private Equity is Bigand Growing Even Bigger

As Chart 1: Private Equity Invested reveals, the private equity indu

try grew from $1 billion of equity invested in 1993 to approximat

$15 billion in 2000 and was fueled, in large part, by the ventu

capital community. From 2001 to 2007,equity investments grew fro

$8.5 billion to $85 billion,fueled almost entirely by leveraged buyou

Chart 2: The Biggest LBOs of All Time provides a dramatic demo

stration of the recent rise of LBO transactions. The numbers a

quite impressive.As of July 3, five of the biggest LBOs have been

2007, four were in 2006, and one is the historic KKR deal immort

ized in the legendary business book, Barbarians at the Gate. Ar

cles in leading publications also point to the hot industry mark(see sidebar,Private Equity Makes Headlines).

Even more compelling is the data on Chart 3:Available Private Equ

ty Capital. The total amount of uninvested capital has increas

from $35 billion in 1990 to $180 billion today. Uninvested capital

used to denote the amount of available funds targeted to be inve

edthis number effectively represents the available capacity f

transactions. Uninvested capital is a trailing figure (note the low

level is in 2004, several years after the industry peak), but it is hig

ly meaningful because it sets the stage for coming years. From 19

to 1995, the amount of uninvested capital grew from $35 billion

$40 billion,approximately 3 percent per year. From 1995 to 2007, tamount of uninvested capital grew from $40 billion to $180 billio

approximately 70 percent per year.

How Private Equity Works

Private equity firms (both LBO and venture capital) are responsible fo

Sourcing transactions

Due diligence/completing investments

Ensuring the success of the portfolio companies

Exiting the investment

Private Equity Makes Headlines

Readers of the business press need not look far to find coverage on pri-

vate equity. Fortune, Forbes, the Wall Street Journal, BusinessWeek,

the New York Times, the Financial Times, and a host of other periodicals

and newspapers have provided extensive coverage of private equity deals

and firms over the past several years.The Blackstone Groups initial public

offering was the largest IPO in the past five years and,arguab ly,one of

the biggest business stories of the year, further highlighting the role pri-

vate equity has come to play in the capital markets.

Blackstone IP is hot,hotGlobe and Mail,6/22/07

US M&A Hits $1 Trillion in Record PaceFinancial News Online US,UK,6/28/07

Private Equity M&A In US Accounts For 35% Of Overall Activity,Up From 16%

A Year AgoThompson Financial,5/22/07

The 2000s M&A Boom Has ArrivedWall Street Journal,6/27/06

Worldwide Strategic M&A Total $1.7 Trillion, A 69% Increase From Last Year

Thompson Financial,5/22/07

Private Equity Buyouts Soar,While IPOs and Exit s SlowWall Street Journal,

7/14/06

Private Equity Buyers Are Creeping Into Non-Private Equity Sectors Such As

Financials,Energy and Power, High Tech,and TelecomThompson Financial,

5/22/07

Blackstone Buyout Fund Hits Industry High $15.6 BillionWall Street Journal,

7/12/06

Attracting Private Equity Becomes A National Spor t In EuropeNew York

Times,6/29/07

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Stein: How Private Equity Really Works (Part 1)

Each of these activities involves a very distinct set of skills and capa-

bilities and will often have different team members involved.

Sourcing Transactions

There are between 4,000 and 8,000 middle market merger and

acquistion (M&A) transactions completed per year in the United

States. There are many more acquisitions by individual buyers. The

middle market typically refers to transactions ranging from $10

million to $500 million. Most middle market transactions are notcompleted, so there are roughly 10,000 to 20,000 deals brought to

market each year. As Chart 4: Total Number of US M&A Transac-

tions Completed Each Year indicates, several hundred of these deals

exceed $500 million in value.Approximately 1,000 of these deals are

between $100 to $500 million in value and are called middle mar-

ket deals. The vast majority of completed transactions are for lessthan $100 million.Deals less than $100 million in value are referred

to as lower middle market. Additionally, an even larger number of

acquisitions are never recorded because they occur between indi-

viduals or are unannounced. Private equity firms are responsible

for roughly 20 percent of the transactions, while corporate buyers

account or the remaining 80 percent.

Chart 5: Sourcing TransactionsThe Deal Pipeline provides detail

on the number of transactions a private equity firm will investigate

to close on a new platform company. A typical private equity firm

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(LBO) in the lower middle market might evaluate 1,000 to 3,000

deals per year (roughly one-quarter to one-half of the total deals

brought to market, if the PEG is in touch with the right intermedi-

aries such as bankers, accountants, and lawyers). Of those, between

5 percent and 10 percent (some 50 to 300) actually meet the firms

criteria. The largest venture capital firms will see even higher num-

bers of deals from all of the start-up business plans and miscella-

neous deals that are submitted to them.Larger LBO firms evaluating

$500+-million-sized transactions will look at a smaller number ofdeals given the fact that their universe is smallerthere are only so

many $500+ million deals per year.

Once a private equity firm has determined that the deal fits its crit

ria (size, industry, growth, earnings, management team, etc.) an

more importantly, they believe the company has the potential

increase in value,the PEG will schedule a meeting with the manag

ment team to get additional information. PEGs may schedule mee

ings with between 5 percent and 50 percent of the firms that me

their initial criteria, depending upon how strict their criteria a

These meetings can be short or long, but in order to be productithey almost always involve the exchange of financial information

After a preliminary meeting, the PEG will evaluate the business, t

industry, the management team, and the opportunity to increa

the value of the business. If the PEG believes there is an opportun

ty to increase the value of the company and the shareholders hav

reasonable expectation of value, the PEG will submit a Letter

Intent (LOI) based upon the feedback or direction from t

shareholders (see sidebar,Interpreting an LOI). Typically, an L

is a serious indication of a desire to move forward on the part of t

private equity firm. Once an LOI is signedmost are non-bin

ingthe shareholders of the firm and the PEG will work throu

additional due diligence needs over a 60- to 120-day period to co

summate the transaction.

Due Diligence/Completing Transactions

Chart 6: A Typical Due Diligence Process for a Private Equity Fir

delineates the seven mission-critical steps a PEG will need to compl

during due diligence to consummate a transaction.From start to clo

a well-managed transaction should take approximately 16 weeks. P

vate equity firms may take four weeks to present an LOI (although th

process can certainly take longer) and then 12 weeks (approximate

75 to 90 days) following the signing of a LOI to complete a transactioThe schedule in Chart 6 assumes that the entire process (including in

tial introduction to the company) begins on Jan.1.

Interpreting an LOIA Letter of Intent (LOI) is a non-binding indication of

interest based on a private equity groups (PEGs) desire to

acquire or make an investment in a particular company.

LOIs are based on the information made available to t he

PEG.The more information that the PEG has received,the

stronger the LOI;the less information,the weaker the LOI.

LOIs typically range in length from one to 15 pages.Short

LOIs are not necessarily better or worse than long LOIs,

although,as one might assume,the more details that are

addressed in the LOI,the fewer the details that will need

to be addressed later.

LOIs often contain the following elements pertaining to

the transaction:

Price of a DealWhat is the value of the entity?

How is it being valued?

Structure of the TransactionHow will the deal be

structured? Cash at close? Payments over time?

Terms of the DealWhat assets are being acquire

(if the deal is not a stock deal)? What liabilities are

being assumed? Is there a working capital amount

that is specified in the transaction?

TimelineWhen is the transaction expected to

close?

Conditions to CloseWhat activities need to be

completed in order to close the transaction? Are the

any particular activities that would prevent a transa

tion from being closed? Must the business meet a

certain performance requirement?

Due Diligence ProcessWhat will occur during t

due diligence process? Will employees, customers a

suppliers be contacted? Will there be an environme




www.i-itc.org International Imaging Technology Council August 2007 Imaging Spectrum 37

Immediately following the signing of the LOI, the PEG will begin

to complete the financial model/operational plan for the business.

This process requires involvement by the companys management

team and, potentially, its shareholders (frequently the same peo-ple in small enterprises). In this process, PEGs are looking to test

their initial hypotheses about the potential future financial per-

formance of the business.PEGs will invest a significant amount of

time in the financial analysis of the business, testing questions

such as:

RevenuesHow many current customers are there? What

have the average sales of each customer been? What will they

tal audit? A legal audit? A financial audit? Operational

and IT audits?

Additionally, LOIs include the following components,

which benefit both the PEG and the selling shareholders:

Non-CompeteIf the owner is leaving the business

(or may leave the business),PEGs will require a strong

non-compete to ensure that the owner or shareholders

do not receive money for the purchase of their business

and then go out and directly compete with it.Clearly,

most well-intentioned owners would never do this.

ConfidentialityOften,a non-disclosure or confi-

dentiality agreement has already been signed,yet the

LOI will reaffirm the intention of both parties to keep

the information exchanged confidential. LOIs that do

not come to fruition are best left undisclosed for all

parties involved.

ExclusivityPEGs will insist upon exclusivity for

selling shareholders.From the point of view of a PEG,

an LOI without a period of exclusivity is meaningless

(for private transactions,public transactions have a

different process).PEGs will spend anywhere from

$50,000 to $1 million and 1,000 to 4,000 hours dur-

ing the due diligence process.PEGs are much less

inclined to make this investment in a transaction if

the selling shareholders will not agree to a period of

exclusivity while the PEG is making this investment.

The first draft of an LOI should be perceived by selling

shareholders as a starting point for dialog about a trans-

action.Most PEGs are open and willing to make modifica-

tions to an offer,based on the interests of the selling

shareholder.By definition,LOIs are legal documents,wh

means they can be a little dry and unintentionally dis-

tancing for those not familiar with their language,struc

ture and scope.

If an LOI takes six or more drafts or two or more months t

get negotiated,it often signals an unwillingness on the p

of both parties to come to a mutually satisfactory agree-

ment.Conversely,LOIs that are signed on the first draft

within a day or two of being presented may not be partic

larly meaningful if both parties have not fully explored an

discussed all of the components of the LOI.


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be in the future? What are the sources of revenue? How is the

product/service mix changing?

Cost of Good SoldWhat is the cost structure for the busi-

ness? How volatile are the costs? Will costs increase or

decrease? What are the general trends for the business costs?

What will affect material costs? What is happening with labor?

Is labor increasing or decreasing productivity? Are there fixedcosts? Are there economies of scale?

Operating ExpensesWhat functions do the various man-

agement team members serve? How much are they paid for

these functions? What is the structure of the sales team? How

much advertising is required? Will additional investments

yield increased results?

Many PEGs will test the hypotheses for the business with rigorous

analysis involving customers, vendors, employees and outside

industry analysts. Typically,PEGs will require a substantial amount

of data to complete their analysis. The company will need to be

intimately involved in providing this information, and most PEGs

(or buyers, for that matter), will not engage outside service

providers until they have received, processed, and digested the

information presented to them. This completes roughly the first

third of the transaction.

The second third of the transaction involves the outside service

providers, such as accountants, lawyers, and other miscellaneous

consultants. PEGs will select the number of outside consultants

based upon the size of the transaction,the risk factors identified, the

financial model, and the information accumulated during the initialdue diligence. Acquirers of businesses can spend anywhere from

$10,000 to $500,000 on this portion of the transaction. General

the outside consultants, lawyers and accountants are confirming t

information that has been presented.All parties (buyers and seller

want to ensure that there are no surprises.

The final third of the transaction is financing and documentatio

In most LBOs, PEGs will use debt both to satisfy the purchase pri

requirements of the seller and to increase their returns. Typicalsellers prefer a higher price than what equity returns alone wou

justify. As a result, buyers are forced to finance a transaction w

debt. Similarly, buyers have certain thresholds for returns th

require them to use debt to finance a transaction. If a buyer pu

chased a business entirely with equity, the performance of the bu

ness would need to be incredibly high in order for the buyer

achieve the necessary returns.

Bank financing is not a complex process for a good business and

good private equity firm. Banks will provide debt based on asse

and cash flows. Businesses with poor cash flows (low profitabilit

or limited assets will have difficulty getting financed. Additional

businesses with less than $2 million of earnings before intere

taxes, depreciation and amortization (EBITDA) have difficulty ge

ting financed because they are perceived as quite risky businesse

Larger deals are much easier to get done. Banks can take three

eight weeks to complete their own due diligence and agree

financing commitments.

The documentation process involves the drafting, editing and sig

ing of the asset or stock purchase agreement. The terms of the AP

should roughly mirror the terms of the Letter of Intent. Howev

oftentimes during the due diligence process, buyers will identfinancial costs, litigation, or other risk factors not previously d

closed that require an adjustment in the price and/or structure

the transaction.

For example, the owner may have suggested that the financial sy

tem would need to be upgraded prior to the signing of the LOI,b

he did not inform the buyer that the system was a $100 off-th

shelf product that froze multiple times a day, did not perm

monthly closings, and/or have a general ledger that was off

approximately $1 million, a material amount. Alternatively, t

seller may have informed the buyer that the inventory was valu

accurately, yet the buyer identified $2 million worth of non-virginkjet cores that were completely unusable and would need to

written off. Neither of these factors should be deal killers. Howe

er, they do represent material findings that could negatively imp

the value of the entity being acquired.

In addition to an asset purchase agreement, documentation m

also,but does not necessarily, involve the following legal documen

Employment Agreementsa potential agreement with the

chief principals remaining after the transaction that governs


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the relationship post transaction

between the acquirer and the principal.

Non-compete Agreementa poten-

tial agreement that determines the

length of time, after exiting the firm,

that principals will not work in direct

or indirect competition with the busi-ness they sold.

Disclosure Schedulespotential

documentation that supports the asset

purchase agreement and provides

details about the business. Schedules

provide representation on inventory,

accounts receivable, litigation and

many other facets of the business.

Loan DocumentsIf debt is used in

the transaction, there will be loan doc-

uments that detail the loan provisions,

covenants, terms, price and other vari-

ables associated with the loan.

Miscellaneous AgreementsThere

are other specific documents that may

be required for both buyers and sellers

to complete, including shareholder

consents, board approval of the trans-

action, and assignment and assump-

tion documents.

Ensuring the Success

of Portfolio Companies

A typical private equity firm will manage

between three and 40 portfolio companies

at one time. Some larger, well-established

funds could potentially have more portfolio

companies, and select smaller funds with a

more limited focus or a firm that was exit-

ing its investments could manage fewer

portfolio companies.

Typically, private equity firms hold posi-

tions on the boards of their portfolio

companies with quarterly in-person

meetings. At the early stages of an invest-

ment, PEGs may look for weekly results

reports and performance reviews.Assum-

ing a portfolio company is doing well,

PEGs will become less involved as the

management team achieves the targeted

results. PEGs are responsible for ensuring

that management is successful, but they

are not necessarily responsible for manag-

ing the business itself. If management is

not doing well, PEGs may be required to

find new management for a business.

Given that PEGs look at an investment for a

three- to seven-year horizon, with a usualtarget of five years, one year of missed

results translates into a 20 percent setback

(one year divided by five years) on the life

of the investment. Every quarter represents

5 percent of the investment horizon. There-

fore,a PEG is not likely to let more than sev-

eral quarters of missed results transpire

before needing to seriously evaluate the

management team.

Exiting the Investment

After a company has achieved its desired

results, PEGs will look to harvest their

investment and ensure that they achieve the

appropriate returns on the investment.To do

so, the PEG will take the business to mar-

ket and go through another sales process,

similar to the process that brought the PEG

to the acquisition in the first place. Again,

this will typically occur three to seven years

after the initial investment. Rarely do PEGs

look to exit earlier than three years, and they

will typically only remain longer than sevenyears if the company is performing quite well

or if the company still needs to achieve cer-

tain results to meet the required equity

returns of the PEG.

Next months article will explore the top 10

misperceptions of buyers and sellers in pri-

vate equity transactions.