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Private Equity: History, Governance, and Operations, 2nd Edition


Praise For Private Equity Second Edition

"With Private Equity, Second Edition, Messrs. Cendrowski, Petro, Martin, and Wadecki go 'beyond the transaction' to provide a surprisingly holistic view of private equity, describing this often misunderstood industry in the context of its history and purpose. They also address the difficult area of investment due diligence and dig extensively into the process of business improvement that is at the heart of the value proposition of many PE firms. For readers, the organization of this treatise allows for a front-to-back read but also boasts sufficiently modular chapters to make it a fine ongoing reference on individual topics. A well researched and well explained book on an important set of topics."
—Chris Rizik, Chief Executive Officer and Fund Manager, Renaissance Venture Capital Fund

"The Second Edition of Private Equity: History, Governance, and Operations is a well researched, clearly written text that provides readers with in-depth analyses of the industry's best practices. The first edition's strengths are further reinforced through new chapters and an updated history that greatly details private equity's modern-day zenith as well as its rise following the Great Recession."
—W. Y. Campbell, Founding General Partner, Huron Capital Partners
Chairman and Partner, Superior Capital Partners
Chairman and Managing Partner, Peninsula Capital Partners

"You know it's an excellent book when a second edition is being published. The new chapter addressing intellectual property in Private Equity is a great addition, as it is a critical topic. While this book is obviously an excellent guide for any investor new to the private equity asset class, it also serves as an excellent reference guide for the savviest of investors. I have referred to it many times since the book was first published."
—Maribeth S. Rahe, President and Chief Executive Officer, Fort Washington Investment Advisors

"Private Equity, Second Edition is a thorough and thoughtful analysis. It addresses financial and business issues as well as important legal and regulatory issues that may arise for and should be considered by investors. It will serve as an important reference for businessmen and counsel who work in this important financial sector."
—Jonathan Feld, Partner, Katten Muchin Rosenman LLP

"A sharp update to a modern text, the authors do a phenomenal job dissecting the role of economic turmoil and its impact on the private equity and venture capital landscape of yesterday, today, and tomorrow."
—Jeff Mirmelstein, Sales Finance Lead, Americas Media Products, Google

Harry Cendrowski is a 30-year veteran consultant to and investor in private equity and venture capital funds. He is cofounder and Managing Director of Cendrowski Corporate Advisors, a midwest financial and operations consulting firm based in Chicago, Illinois, and Bloomfield Hills, Michigan.

Louis W. Petro has contributed to Wiley business publications and has written both books and journal articles. He is a professor at the University of Windsor and a CPA.

James P. Martin is Managing Director of Cendrowski Corporate Advisors. He is a seasoned enterprise risk management professional who has performed engagements for private equity funds and their portfolio companies as well as publicly traded organizations.

Adam A. Wadecki is Manager of Operations for Cendrowski Corporate Advisors and a lecturer at the University of Michigan, Ann Arbor.

Preface xvii

MODULE I The Private Equity Model and Historical Information

CHAPTER 1 Introduction to Private Equity 3

Introduction 3

What Is Private Equity? 4

General Terms and Brief Overview 5

The Limited Partner Agreement and General Partner Incentives 12

Private Equity Firm Structure and Selected Regulations 15

Types of Private Equity Investment 20

The Private Equity Fundraising Process 22

Recent Fundraising Trends 25

General Partner Investment Restrictions 26

Conclusion 28

Notes 28

CHAPTER 2 Overview of Historical Trends 29

Introduction 29

A Brief History of Private Equity 29

Private Equity at the Turn of the Century 33

Venture Capital Investment and Returns by Fund Stage 39

Venture Capital and Buyout Returns by Fund Size 43

Secondary Funds 45

Conclusion 48

Notes 48

CHAPTER 3 Trends in Private Equity 51

Introduction 51

A Changing Tide 51

Overall Industry and Fundraising Trends 54

Selected Regulatory Changes and Proposals 60

Rise of Strategic Buyers 64

Conclusion 66

Notes 66

CHAPTER 4 Harvesting Private Equity Investments Through Initial Public Offering 69

Initial Public Offerings 69

Basics 69

Initial Steps in the ‘‘Going Public’’ Process 72

Role of the Securities and Exchange Commission and State Policing Bodies 75

Post-IPO Underwriter Responsibilities 77

Registration Documents 78

Historical Trends 79

Summary 83

Notes 83

CHAPTER 5 Legal Considerations in Initial Public Offerings 85

Introduction 85

Initial Public Offering 86

Introduction 86

Potential Advantages 87

Potential Disadvantages 89

Advance Planning Opportunities 91

Selection of Advisors 91

Securities Counsel 92

Accountants 92

Underwriters 93

Corporate Housekeeping Matters 93

Antitakeover Provisions 93

Management 94

The Initial Public Offering Process 94

Principal Parties 94

Principal Documents 96

Selling Security Holder Documents 98

The Registration Process 100

Possible Liabilities Faced by a Company and Its Directors and Officers 102

Liabilities under Federal Securities Laws 102

The Sarbanes-Oxley Act and Dodd-Frank Act 105

Public Company Filing Obligations 107

Initial Public Offering Alternative: Reverse Mergers 107

Advantages 107

Disadvantages 108

Conclusion 109

CHAPTER 6 Harvesting Investments Through Mergers and Acquisitions 111

Introduction 111

M&A Basics 111

Types of Takeovers 112

Reverse Takeovers 113

The Takeover Process and Financial Advisor Selection 114

Analyzing Potential Buyers 115

The Sale Process 116

The Bidding Process 118

Reaching an Agreement 119

Historical M&A Trends 120

Conclusion 122

CHAPTER 7 Legal Considerations in Sale Transactions 123

Introduction 123

Sale Transactions 124

Prior to the Sale Transaction 124

Use of an Investment Banker 124

Marketing Process 125

Due Diligence 125

Negotiations Phase 125

Key Deal Issues 126

Valuation and Pricing Issues 126

Special Issues in Sales of Private Equity Fund-Owned Businesses 132

Sale and Acquisition Structure 134

Merger 134

Asset Purchase 135

Stock Purchase 135

Employee Incentive Issues 135

Cash Retention Bonus 135

Stock Bonuses 136

Recapitalizations 137

The Sale Transaction Process 137

Letter of Intent 137

Disclosure of Acquisitions 138

Time and Responsibility Schedule 138

Definitive Agreements 139

Necessary Consents 140

Conclusion 142

CHAPTER 8 Intellectual Property and Private Equity 143

Introduction 143

Intellectual Property Rights and Remedies 143

Patents 144

Trademarks 146

Copyrights 147

Trade Secrets 148

Pre-Acquisition Due Diligence 149

Established Barriers to Entry--Evaluating Investment Value 149

Freedom to Practice--Assessing Risk of Proposed Acquisition 151

Creating Intellectual Property Value During Management 152

Leveraging and Monetizing Patent Rights 153

Bolstering Technological Advantages 153

Boosting Brand Development Efforts 154

Preserving Knowledge-Based Resources of the Workforce 155

Positioning the Exit--Reverse Due Diligence 156

Minimizing Exposure of Representations and Warranties 158

Notes 159

MODULE II Governance Structures in Private Equity

CHAPTER 9 The Private Equity Governance Model 163

Introduction 163

A New Model for Corporate Governance 163

An Analogy to Physics 167

Corporate Governance and the Management of Crisis 168

Public Corporations and the Private Equity Model 171

The Magic of the Private Equity Governance Model 173

Conclusion 175

Notes 176

CHAPTER 10 Value of Internal Control 177

Introduction 177

Introduction to COSO and Internal Control 178

COSO Background 178

Internal Control Defined 178

Components of Internal Control 179

Control Environment 179

Risk Assessment 182

Enterprise Risk Management 183

Control Activities 184

Information and Communication 186

Monitoring 186

Limitations of Internal Control 188

Control Objectives and Control Components 189

Effectiveness of Internal Control 190

Internal Control and the Private Equity Firm 191

Value of Internal Control for Private Equity Fund Operations 191

Value and the Control Environment 193

Value and Risk 194

Value and Control Activities 194

Value and Information and Communication 195

Value and Monitoring 195

Value of Internal Control for Target Companies 195

Operational Value 196

Financial Reporting Value 197

Compliance Value 197

Conclusion 198

Notes 198

CHAPTER 11 Internal Control Evaluation 201

Introduction 201

PCAOB Auditing Standard No. 5 203

Phase 1: Planning the Audit 204

Risk Assessment 206

Scaling the Audit 206

Fraud Risk 206

Using the Work of Others 207

Materiality 207

Phase 2: Using a Top-Down Approach 208

Identifying Entry-Level Controls 208

Control Environment 209

Period-End Financial Reporting Process 209

Identifying Significant Accounts and Disclosures and Their Related Assertions 210

Understanding Likely Sources of Misstatement 211

Selecting Controls to Test 211

Phase 3: Testing Controls 211

Testing Design Effectiveness 212

Testing Operating Effectiveness 212

Relationship of Risk to the Evidence to Be Obtained 212

Special Considerations for Subsequent Yearly Audits 213

Phase 4: Evaluating Identified Deficiencies 213

Phase 5: Wrapping Up 215

Forming an Opinion 215

Obtaining Written Representations 215

Communicating Certain Matters 216

Phase 6: Reporting on Internal Controls 217

Conclusion 218

Notes 218

CHAPTER 12 Financial Statement Fraud and the Investment Decision 219

Introduction 219

Money Laundering 219

Categories of Fraud 221

What Is Fraud? 222

The Required Elements of Fraud 223

Financial Statement Attestation 225

Tax Return Preparation 225

Compilation 226

Review 226

Audit 226

Recommendations 227

Do Not Rely Solely on Financial Statements 227

Pay Attention to Details 228

Follow Up on Unexpected or Interesting Items 229

Maintain Professional Skepticism 229

Explanations Should Be Rational, Reasonable, and Verifiable 230

What Do the Financial Statements Say about the Entity’s Ability to Meet Its Objectives? 230

Fraud and Due Diligence Procedures 231

Background Investigation of Key Employees 231

Testing of Journal Transactions 232

Check File Metadata 232

Conclusion 233

Notes 234

CHAPTER 13 Professional Standards 235

Introduction 235

Federal Trade Commission 235

Federal Antitrust Legislation 235

Sherman Antitrust Act (1890) 236

Clayton Antitrust Act (1914) 236

Federal Trade Commission Act (1914) 236

Robinson-Patman Act (1936) 237

Celler-Kefauver Antimerger Act (1950) 237

Hart-Scott-Rodino Antitrust Improvement

Act (1976) 237

Federal Consumer Protection Legislation 238

Securities and Exchange Commission 239

Securities Act (1933) 239

Securities Exchange Act (1934) 240

Public Utility Holding Company Act (1935) 241

Trust Indenture Act (1939) 241

Investment Company Act (1940) 242

Investment Advisers Act (1940) 242

Foreign Corrupt Practices Act (1977) 243

Sarbanes-Oxley Act (2002) 244

Public Company Accounting Oversight Board 244

Auditor Independence 245

Corporate Governance 246

CEO/CFO Certifications 247

Enhanced Financial Disclosure 247

Civil and Criminal Penalties 247

‘‘Private’’ Equity Going Public 248

Introduction to Public Standards 248

Public Company Accounting Oversight Board Standards 249

PCAOB Auditing Standard No. 1 249

PCAOB Auditing Standard No. 2 249

PCAOB Auditing Standard No. 3 250

PCAOB Auditing Standard No. 4 250

PCAOB Auditing Standard No. 5 250

The Standard Is Less Prescriptive 251

Scalable Audits 251

Audit Focus 251

Using the Work of Others 252

PCAOB Auditing Standard No. 6 252

PCAOB Auditing Standard No. 7 252

PCAOB Auditing Standard No. 8 252

PCAOB Auditing Standard No. 9 253

PCAOB Auditing Standard No. 10 253

PCAOB Auditing Standard No. 11 253

PCAOB Auditing Standard No. 12 253

PCAOB Auditing Standard No. 13 254

PCAOB Auditing Standard No. 14 254

PCAOB Auditing Standard No. 15 255

American Institute of Certified Public Accountants Auditing Standards 255

SAS 99, ‘‘Consideration of Fraud in a Financial Statement Audit’’ 256

SAS 1 Amendments 257

SAS 85 Amendments 257

SAS 82 Replacements 257

Descriptions and Characteristics of Fraud 258

Professional Skepticism 258

Engagement Team Discussions 258

Fraud Risks 259

Identifying Risks 259

Assessing Risks 259

Responding to the Risk Assessment 260

Evaluating Audit Evidence 261

Auditor Communication 263

Audit Documentation 263

SAS 104, ‘‘Amendment to Statement on Auditing Standards No.1, ‘Codification of Auditing Standards And Procedures (‘‘Due Professional Care in the Performance of Work’’)’ ’’ 264

SAS 105, ‘‘Amendment to Statement on Auditing Standards No. 95, Generally Accepted Auditing Standards’’ 265

SAS 106, ‘‘Audit Evidence’’ 265

SAS 107, ‘‘Audit Risk and Materiality in Conducting the Audit’’ 265

SAS 108, ‘‘Planning and Supervision’’ 266

SAS 109, ‘‘Understanding the Entity and Its Environment and the Risks of Material Misstatement’’ 266

SAS 110, ‘‘Performing Audit Procedures in Response to Assessed Risks and Evaluation of the Audit Evidence Obtained’’ 267

SAS 111, ‘‘Amendment to Statement on Auditing Standards No. 39, ‘Audit Sampling’ ’’ 267

SAS 112, ‘‘Communicating Internal Control Related Matters Identified in an Audit’’ 267

SAS 113, ‘‘Omnibus Statement on Auditing Standards’’ 268

SAS 114, ‘‘The Auditor’s Communication With Those Charged With Governance’’ 269

SAS 116, ‘‘Interim Financial Information’’ 270

American Institute of Certified Public Accountants Accounting and Review Standards 270

SSARS 10 271

SSARS 12 271

Institute of Internal Auditors Standards 272

Information Systems Audit and Control Association 272

Conclusion 273

Notes 273

MODULE III Understanding Operations

CHAPTER 14 Contemporary Business and Competitive Intelligence 277

Introduction 277

Contemporary Business Intelligence 278

Sources of Information 278

Public Records Searches 278

News Archives 279

Legal Proceedings 279

Patent Awards and Applications 280

Social Networking 280

Employees 280

Competitive Intelligence and the External Environment 281

Normalizing Performance 282

Cost of Capital and the Option to Invest 285

Developing Unique Intelligence 287

An Economic View of Quality 289

Developing Relationships and Navigating Crises 290

Application to Private Equity 291

Investment Decision 291

Strategic Management of Portfolio Companies 291

Exit Strategy 292

Conclusion 292

Notes 292

CHAPTER 15 Organizations as Humans 293

Introduction 293

Purpose of the Organization 294

Genesis 295

Development and Specialization 296

Parts of theWhole and Maturation 297

Environmental Adaptation 299

Environmental Influence and Interaction 302

Maturity Creates ‘‘TheMachine’’ 303

Death of the Organization and Rebirth 304

Strengths and Weaknesses of the Organizations as Humans Metaphor 305

Conclusion 307

Notes 307

CHAPTER 16 Beginning the Lean Transformation 309

Introduction 309

The Origins of Lean Operations: Lean Manufacturing 310

Potential Pitfalls of Lean 311

Organizational Development 312

Discipline Building 315

What Private Equity Means for Lean 317

Conclusion 318

Note 318

CHAPTER 17 Performing Manufacturing Due Diligence Assessments 319

Introduction 319

Performing the Assessment 319

Employee Satisfaction 320

Customer Satisfaction and Perceived Quality 322

Corporate Vision and Mission 323

Equipment and Facility Maintenance 324

Visual Management 326

Inventory Management and Product Flow 327

Operational Data and Cost of Sales 328

Conclusion 333

Notes 333

About the Authors 335

Glossary 339

Index 345