Private Equity

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 xviiModule I The Private Equity Model and Historical InformationChapter 1 Introduction to Private Equity 3Introduction 3What Is Private Equity? 4General Terms and Brief Overview 5The Limited Partner Agreement and General Partner Incentives 12Private Equity Firm Structure and Selected Regulations 15Types of Private Equity Investment 20The Private Equity Fundraising Process 22Recent Fundraising Trends 25General Partner Investment Restrictions 26Conclusion 28Notes 28Chapter 2 Overview of Historical Trends 29Introduction 29A Brief History of Private Equity 29Private Equity at the Turn of the Century 33Venture Capital Investment and Returns by Fund Stage 39Venture Capital and Buyout Returns by Fund Size 43Secondary Funds 45Conclusion 48Notes 48Chapter 3 Trends in Private Equity 51Introduction 51A Changing Tide 51Overall Industry and Fundraising Trends 54Selected Regulatory Changes and Proposals 60Rise of Strategic Buyers 64Conclusion 66Notes 66Chapter 4 Harvesting Private Equity Investments Through Initial Public Offering 69Initial Public Offerings 69Basics 69Initial Steps in the ‘‘Going Public’’ Process 72Role of the Securities and Exchange Commission and State Policing Bodies 75Post-IPO Underwriter Responsibilities 77Registration Documents 78Historical Trends 79Summary 83Notes 83Chapter 5 Legal Considerations in Initial Public Offerings 85Introduction 85Initial Public Offering 86Introduction 86Potential Advantages 87Potential Disadvantages 89Advance Planning Opportunities 91Selection of Advisors 91Securities Counsel 92Accountants 92Underwriters 93Corporate Housekeeping Matters 93Antitakeover Provisions 93Management 94The Initial Public Offering Process 94Principal Parties 94Principal Documents 96Selling Security Holder Documents 98The Registration Process 100Possible Liabilities Faced by a Company and Its Directors and Officers 102Liabilities under Federal Securities Laws 102The Sarbanes-Oxley Act and Dodd-Frank Act 105Public Company Filing Obligations 107Initial Public Offering Alternative: Reverse Mergers 107Advantages 107Disadvantages 108Conclusion 109Chapter 6 Harvesting Investments Through Mergers and Acquisitions 111Introduction 111M&A Basics 111Types of Takeovers 112Reverse Takeovers 113The Takeover Process and Financial Advisor Selection 114Analyzing Potential Buyers 115The Sale Process 116The Bidding Process 118Reaching an Agreement 119Historical M&A Trends 120Conclusion 122Chapter 7 Legal Considerations in Sale Transactions 123Introduction 123Sale Transactions 124Prior to the Sale Transaction 124Use of an Investment Banker 124Marketing Process 125Due Diligence 125Negotiations Phase 125Key Deal Issues 126Valuation and Pricing Issues 126Special Issues in Sales of Private Equity Fund–Owned Businesses 132Sale and Acquisition Structure 134Merger 134Asset Purchase 135Stock Purchase 135Employee Incentive Issues 135Cash Retention Bonus 135Stock Bonuses 136Recapitalizations 137The Sale Transaction Process 137Letter of Intent 137Disclosure of Acquisitions 138Time and Responsibility Schedule 138Definitive Agreements 139Necessary Consents 140Conclusion 142Chapter 8 Intellectual Property and Private Equity 143Introduction 143Intellectual Property Rights and Remedies 143Patents 144Trademarks 146Copyrights 147Trade Secrets 148Pre-Acquisition Due Diligence 149Established Barriers to Entry—Evaluating Investment Value 149Freedom to Practice—Assessing Risk of Proposed Acquisition 151Creating Intellectual Property Value During Management 152Leveraging and Monetizing Patent Rights 153Bolstering Technological Advantages 153Boosting Brand Development Efforts 154Preserving Knowledge-Based Resources of the Workforce 155Positioning the Exit—Reverse Due Diligence 156Minimizing Exposure of Representations and Warranties 158Notes 159Module II Governance Structures in Private EquityChapter 9 The Private Equity Governance Model 163Introduction 163A New Model for Corporate Governance 163An Analogy to Physics 167Corporate Governance and the Management of Crisis 168Public Corporations and the Private Equity Model 171The Magic of the Private Equity Governance Model 173Conclusion 175Notes 176Chapter 10 Value of Internal Control 177Introduction 177Introduction to COSO and Internal Control 178COSO Background 178Internal Control Defined 178Components of Internal Control 179Control Environment 179Risk Assessment 182Enterprise Risk Management 183Control Activities 184Information and Communication 186Monitoring 186Limitations of Internal Control 188Control Objectives and Control Components 189Effectiveness of Internal Control 190Internal Control and the Private Equity Firm 191Value of Internal Control for Private Equity Fund Operations 191Value and the Control Environment 193Value and Risk 194Value and Control Activities 194Value and Information and Communication 195Value and Monitoring 195Value of Internal Control for Target Companies 195Operational Value 196Financial Reporting Value 197Compliance Value 197Conclusion 198Notes 198Chapter 11 Internal Control Evaluation 201Introduction 201PCAOB Auditing Standard No. 5 203Phase 1: Planning the Audit 204Risk Assessment 206Scaling the Audit 206Fraud Risk 206Using the Work of Others 207Materiality 207Phase 2: Using a Top-Down Approach 208Identifying Entry-Level Controls 208Control Environment 209Period-End Financial Reporting Process 209Identifying Significant Accounts and Disclosures and Their Related Assertions 210Understanding Likely Sources of Misstatement 211Selecting Controls to Test 211Phase 3: Testing Controls 211Testing Design Effectiveness 212Testing Operating Effectiveness 212Relationship of Risk to the Evidence to Be Obtained 212Special Considerations for Subsequent Yearly Audits 213Phase 4: Evaluating Identified Deficiencies 213Phase 5: Wrapping Up 215Forming an Opinion 215Obtaining Written Representations 215Communicating Certain Matters 216Phase 6: Reporting on Internal Controls 217Conclusion 218Notes 218Chapter 12 Financial Statement Fraud and the Investment Decision 219Introduction 219Money Laundering 219Categories of Fraud 221What Is Fraud? 222The Required Elements of Fraud 223Financial Statement Attestation 225Tax Return Preparation 225Compilation 226Review 226Audit 226Recommendations 227Do Not Rely Solely on Financial Statements 227Pay Attention to Details 228Follow Up on Unexpected or Interesting Items 229Maintain Professional Skepticism 229Explanations Should Be Rational, Reasonable, and Verifiable 230What Do the Financial Statements Say about the Entity’s Ability to Meet Its Objectives? 230Fraud and Due Diligence Procedures 231Background Investigation of Key Employees 231Testing of Journal Transactions 232Check File Metadata 232Conclusion 233Notes 234Chapter 13 Professional Standards 235Introduction 235Federal Trade Commission 235Federal Antitrust Legislation 235Sherman Antitrust Act (1890) 236Clayton Antitrust Act (1914) 236Federal Trade Commission Act (1914) 236Robinson-Patman Act (1936) 237Celler-Kefauver Antimerger Act (1950) 237Hart-Scott-Rodino Antitrust Improvement Act (1976) 237Federal Consumer Protection Legislation 238Securities and Exchange Commission 239Securities Act (1933) 239Securities Exchange Act (1934) 240Public Utility Holding Company Act (1935) 241Trust Indenture Act (1939) 241Investment Company Act (1940) 242Investment Advisers Act (1940) 242Foreign Corrupt Practices Act (1977) 243Sarbanes-Oxley Act (2002) 244Public Company Accounting Oversight Board 244Auditor Independence 245Corporate Governance 246CEO/CFO Certifications 247Enhanced Financial Disclosure 247Civil and Criminal Penalties 247‘‘Private’’ Equity Going Public 248Introduction to Public Standards 248Public Company Accounting Oversight Board Standards 249PCAOB Auditing Standard No. 1 249PCAOB Auditing Standard No. 2 249PCAOB Auditing Standard No. 3 250PCAOB Auditing Standard No. 4 250PCAOB Auditing Standard No. 5 250The Standard Is Less Prescriptive 251Scalable Audits 251Audit Focus 251Using the Work of Others 252PCAOB Auditing Standard No. 6 252PCAOB Auditing Standard No. 7 252PCAOB Auditing Standard No. 8 252PCAOB Auditing Standard No. 9 253PCAOB Auditing Standard No. 10 253PCAOB Auditing Standard No. 11 253PCAOB Auditing Standard No. 12 253PCAOB Auditing Standard No. 13 254PCAOB Auditing Standard No. 14 254PCAOB Auditing Standard No. 15 255American Institute of Certified Public Accountants Auditing Standards 255SAS 99, ‘‘Consideration of Fraud in a Financial Statement Audit’’ 256SAS 1 Amendments 257SAS 85 Amendments 257SAS 82 Replacements 257Descriptions and Characteristics of Fraud 258Professional Skepticism 258Engagement Team Discussions 258Fraud Risks 259Identifying Risks 259Assessing Risks 259Responding to the Risk Assessment 260Evaluating Audit Evidence 261Auditor Communication 263Audit Documentation 263SAS 104, ‘‘Amendment to Statement on Auditing Standards No.1, ‘Codification of Auditing Standards And Procedures (‘‘Due Professional Care in the Performance of Work’’)’ ’’ 264SAS 105, ‘‘Amendment to Statement on Auditing Standards No. 95, Generally Accepted Auditing Standards’’ 265SAS 106, ‘‘Audit Evidence’’ 265SAS 107, ‘‘Audit Risk and Materiality in Conducting the Audit’’ 265SAS 108, ‘‘Planning and Supervision’’ 266SAS 109, ‘‘Understanding the Entity and Its Environment and the Risks of Material Misstatement’’ 266SAS 110, ‘‘Performing Audit Procedures in Response to Assessed Risks and Evaluation of the Audit Evidence Obtained’’ 267SAS 111, ‘‘Amendment to Statement on Auditing Standards No. 39, ‘Audit Sampling’ ’’ 267SAS 112, ‘‘Communicating Internal Control Related Matters Identified in an Audit’’ 267SAS 113, ‘‘Omnibus Statement on Auditing Standards’’ 268SAS 114, ‘‘The Auditor’s Communication With Those Charged With Governance’’ 269SAS 116, ‘‘Interim Financial Information’’ 270American Institute of Certified Public Accountants Accounting and Review Standards 270SSARS 10 271SSARS 12 271Institute of Internal Auditors Standards 272Information Systems Audit and Control Association 272Conclusion 273Notes 273Module III Understanding OperationsChapter 14 Contemporary Business and Competitive Intelligence 277Introduction 277Contemporary Business Intelligence 278Sources of Information 278Public Records Searches 278News Archives 279Legal Proceedings 279Patent Awards and Applications 280Social Networking 280Employees 280Competitive Intelligence and the External Environment 281Normalizing Performance 282Cost of Capital and the Option to Invest 285Developing Unique Intelligence 287An Economic View of Quality 289Developing Relationships and Navigating Crises 290Application to Private Equity 291Investment Decision 291Strategic Management of Portfolio Companies 291Exit Strategy 292Conclusion 292Notes 292Chapter 15 Organizations as Humans 293Introduction 293Purpose of the Organization 294Genesis 295Development and Specialization 296Parts of the Whole and Maturation 297Environmental Adaptation 299Environmental Influence and Interaction 302Maturity Creates ‘‘The Machine’’ 303Death of the Organization and Rebirth 304Strengths and Weaknesses of the Organizations as Humans Metaphor 305Conclusion 307Notes 307Chapter 16 Beginning the Lean Transformation 309Introduction 309The Origins of Lean Operations: Lean Manufacturing 310Potential Pitfalls of Lean 311Organizational Development 312Discipline Building 315What Private Equity Means for Lean 317Conclusion 318Note 318Chapter 17 Performing Manufacturing Due Diligence Assessments 319Introduction 319Performing the Assessment 319Employee Satisfaction 320Customer Satisfaction and Perceived Quality 322Corporate Vision and Mission 323Equipment and Facility Maintenance 324Visual Management 326Inventory Management and Product Flow 327Operational Data and Cost of Sales 328Conclusion 333Notes 333About the Authors 335Glossary 339Index 345