Editor’s Letter

We remain, as I write these notes, in a period of greater than usual discomfort with the immediate future of our capital markets. But why are the capital markets so important to all of us in the private equity markets? By definition, we are “private” equity—we raise our own funds quietly, in conference rooms around the world, outside of the noisy public markets.

The reason is, of course, that even though we raise private funds for our investments, it is the public capital markets that often provide our exits—and which always have a hand in pricing what our portfolio companies are worth. When public stock markets are uncertain, so are the values of our companies. Therefore, we have selected the question of valuation as the central theme of this issue.

What better place to start than with a careful review of the valuation placed by one of the all-time great value buyers, Warren Buffett. Joseph Calandro, Jr. takes us through the price paid when Burlington Northern Railroad was taken private. That was an interesting deal, because commentators at the time indicated that perhaps the price paid was too generous. The key valuation questions for a stable, existing firm always are: How can we improve the operations? And, how high are the risks that we will be able to make the indicated changes? What’s your answer? Was it a fair price?

Foreign acquisitions are becoming far more common in our continually shrinking world. One of the central questions for any acquisition outside of your home country is how the particular aspects of the foreign country will affect your projected return. To what extent do various factors, such as the level of business freedom, degree of trade protection, size of the government, price stability, the extent of corruption, and the burden of taxation have on returns? Anthony George and Sharon Watson review 72 cross-border deals made by U.S. and U.K. firms and parse the results. It may surprise you to see what does and doesn’t matter.

Are the investments your fund makes driven by the affiliation of your owners? Do bank-affiliated funds tend to buy different companies than independent funds or corporate-sponsored funds? How about funds sponsored by the government of public organizations? We all have a general idea of what these data look like, but Nancy Huyghebaert looks closely at 326 firms in Europe and Japan and traces for us what types of funds invest in what types of deals.

Since we rely so much on capital market pricing in our various deals, it is fair to test how “efficient” these markets are. Harlan Platt, Sebahattin Demirkan, and Marjorie Platt challenge the common assumption that the present value of a public firm is equal to the discounted sum of its future cash flows. They present an intriguing set of data that suggest markets, at times, severely underprice stock values. The authors use actual cash flows to prove their point. Of course, tomorrow’s cash flows are only estimated today, and it is often appropriate for investors to use caution when pricing the value of these projected cash flows. As this is not a peer-reviewed academic finance journal, we present this piece for the discourse it can generate. Their data and methods may be the subject of much academic debate in the months to come.

If you are looking to buy an undervalued asset today, many point to the wide assortment of financial institutions that may be available. Of course, the great unknown is the value of their loans on the balance sheets, as the worth of these loans is based on the underlying value of the collateral. Residential housing values have fallen, but plenty of bad lending is on commercial real state. With values hard to judge, prices of financial institutions have come under intense pressure. This may be the classic “bottom of the market” that makes for a fabulous buying opportunity. If you have that idea in mind, as I have heard so many folks do, the article by Richard Coll, Rusty Conner, Jeffrey Hare, David Krohn, and Michael Reed will help you begin to understand the regulatory climate you’ll need to unravel.

We shift focus now for two articles about a growing problem some venture capital and private equity funds are stumbling onto: the issues of domestic and global anti-corruption enforcement. The first of these articles centers on the United States, with the Foreign Corrupt Practices Act and the essentially broad scope given to regulators to bring actions. It is this loose set of rules that allows enforcement to vary widely during different administrations. RogerWitten, Kimberly Parker, Jay Holtmeier, and Serena Wille introduce us to the issues and highlight the areas where private equity firms may be at most risk.

Our second piece on this topic takes a look around the world—again especially for PE players—and points out statutes that will be of interest. The countries where troubles have happened to U.S. companies include, but are by no means limited to, the U.K., Brazil, Azerbaiijan, Thailand, China, and Germany. The industries include nutritional supplements, the oil business, filmmaking, specialty chemicals, and many others. Sentences run from large fines to prison time. Joan McPhee, Kirsten Mayer, and Amanda Raad lay out the rules to keep us out of trouble.

Our final article asks the question: What if you could invest in two different technologies to solve the same problem at once, rather than having to bet on the winner before the race is over? This intriguing idea leads to a potential solution from David Goldenberg, who proposes using exotic options as a way to invest in more than one technology at once and yet retaining your ability to proposer when the winner is announced. This would require a liquid secondary market in VC investments and will seem quite radical to many of you. But it is an idea that may be worth pursuing.

TOPIC: Private equity

James E. Schrager

Chicago, Illinois

August 2010

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