Session 1

PRIVATE EQUITY
AND VENTURE
CAPITAL
Course 20260
Classes 31-32 (ATTENDING STUDENTS)
Professor Stefano Caselli
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The Fundamentals
of Private Equity
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Preliminary Definitions
The definition of Private Equity (PE) is based on two aspects, each related to the two
man characteristics of the PE relation:
 PE is a source of financing: It is an alternative to other sources of liquidity,
(such as a loan or an initial public offering (IPO)) for the company receiving
the financing.
 PE is an investment made by a financial institution: Private Equity Investor
(PEI) in the equity of a non-listed company (i.e. not a public company).

Throughout the course, the definition of PE will be used in its broad meaning, which also
includes Venture Capital.
Venture Capital is a very specific case of PE. It is the investment in the very early stages
of a company’s life.

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The Need of Financing
How does the relationship between the PEI and the venture-backed company (i.e. the
company financed by the PEI) work?

The investor gets shares of the equity of the

company in return for the inflow of cash.

Venture-Backed
Company

Debt
Private
Assets Equity
Investor
Equity

cash
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The Consequences the Financing
As a consequence, the relationship between the venture-backed company and the
PEI is based on some relevant issues:

• A company needing money for a certain and clearly identified reason;

• The company collects money with the issuance of equity on the private market,
the company does not pay any interest expenses to the PEI;
• The newly issued shares will be bought by the PEI;
• The professional investor will not only become a shareholder but will contribute
to the management of the company. The smaller the company is, the larger the
contribution of the PEI in the business management will be;
• The professional investor will create profit only through the generation of capital
gain, i.e. exiting from the investment by selling shares to someone else on the
market.

The most critical aspect in PE is the strict

relationship between the investor and the
entrepreneur.
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The Difference Between:
PE and Corporate Finance
What is different between corporate finance and private equity finance
(or entrepreneurial finance)?

• Interdependence between investment and financing decisions

• Managerial involvement of the external investors
• Information problem and contract design
• Value to the entrepreneur
• Legal and fiscal ad hoc rules

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The Difference between: PE and Investing in
a Public Company

PRICING LIQUIDITY MONITORING

The price is driven Liquidity is very high. When trading on the stock
by the market, Whenever an investor wants exchange, there is always a very
Public either upwards or to sell the shares of the high level of protection for the
downwards. public company there is shareholders, regardless their
always a buyer. stake in the company.
The price is the Selling the shares is not so The shareholders (the PEI) have to
result of the easy. Since there is no stock protect themselves and the values
Private negotiation process exchange, finding a new generated by the company. All of
which be both easy shareholder can very hard the rules will be stated in a formal
or hard. and time consuming. agreement.

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Why Would a Company Need PE?
PE is based on two aspects:
 PE is a source of financing;
 And PE is an investment.

… but why would a company need PE? Why should a company let an external investor sit
on its board of directors and make managerial decisions? (Note: The bank would have
been an outsider.)

1. Certification Benefit
The venture-backed company wants to
enjoy some direct and indirect benefits 2. Network Benefit
that a company can exploit when financed
3. Knowledge Benefit
by a PEI.
4. Financial Benefit

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1. The Certification Benefit
Due to the long screening phase before deciding to invest in a company, if the PEI
finally does choose to invest in the venture-backed company, in a way, that confirms
the very high quality of the company’s accounts.

This can give a sign of great health of the company and this high quality can be used
as a kind of promotion for the venture-backed company’s brand.

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2. The Network Benefit
The PEI can give the company a very strong network, in terms of suppliers,
customers and banks therefore multiplying its possible contacts.

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3. The Knowledge Benefit
The PEI can transfer knowledge to the company:

 Soft Knowledge: the capability to manage the business

 Hard Knowledge: the specific-field knowledge of a business, this applies
particularly to high-tech or pharmaceutical industries

With this knowledge, an investor can even carry the company through very hard and
difficult steps, such as a merger and acquisition (M&A) process.

The PEI plays the role of an advisor and mentor.

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4. The Financial Benefit
The financial benefit is generated through the injection of cash in return for shares of
the venture-backed company.

The increase generates the following effect on the cost of capital:

Positive effect on the cost

EQUITY RATING
of capital

If a company needs at least one of the four benefits,

then PE is the only choice; if not, there are other
sources of financing, each suitable for the life stage
where the company has that specific need.

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Financing and Life Cycle of a Company

Sales
Investment Profitability Cash flow
Growth
Concentrated to
Development Negative Negative n.a.
develop the idea
Startup Concentrated to buy
Strongly negative Strongly negative Starting
productive factors
Early Growth Negative but Negative but Positive and
Limited to inventory
reducing reducing increasing
Positive and Positive and Positive and
Expansion Limited to inventory
increasing increasing increasing
Mature Age Inventory and
End of decreasing End of decreasing Close to zero
replacement
Crisis or decline Not possible to be
Falling down Falling down Negative
identified
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Financing and Life Cycle of a Company

Founder Other Private Banking Trade Financial

Angels
& Family Partners Equity System Credit Markets
These sources are not right for the company
Development does not yet exist at this stage
The risk is too
high for banks
Startup (capital
requirements)

Early Growth
Maybe for an
Expansion To do IPO
something
Mature Age complex

Crisis or It goes back They

decline to them disappear

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