My finances, my projects, my life
December 14, 2018

What is Private Equity?

  Compiled by myLIFE team myINVEST September 24, 2018 162

With funds under management already in the trillions, private equity (PE) has become a prominent fixture in global capital markets. The fast-growing PE industry is becoming an ever more popular destination for the capital of wealthy individuals and institutions seeking lucrative investment opportunities within the “real” economy. However, as it stands, many still do not have a good grasp on what PE fully encompasses. This piece aims to outline the key facets of PE and the opportunities and considerations for would-be investors.

In a nutshell, private equity (PE) is exactly as its name suggests – it is ownership of, or an interest in, an entity (equity), it being however specified that the entity is private, meaning that it is not publicly listed or traded on a stock exchange.

Since PE entails direct investment into a firm, to gain a significant level of influence over the firm’s operations, often a large capital outlay is required. For this reason, the PE industry is dominated by institutional investors, such as pension funds, and large PE firms. PE firms pool capital from various accredited investors, amassing millions, or even billions, which are then used to acquire stakes in companies.

How does private equity produce returns?

The ultimate goal of PE is to buy quality firms with potential at attractive valuations and then re-sell them at a later date in the future at a higher price. Because private firms are not under constant public scrutiny with the obligation of publishing quarterly earnings and other such filings, the PE firm and the acquired firm’s management can therefore take a longer-term approach with regard to bettering the company’s outlook. Investors who take the PE route can typically expect an investment horizon that can last as long as 10 years.

Some PE managers take a passive approach and rely on the management of the company to grow the business and generate returns. Others are much more hands-on; they bring knowledge, support and strategic expertise to the table and take an instrumental role in unlocking as much value as possible for the firms in their portfolio. The role that they assume typically depends on the stage of development the target company is at. In the earlier stages, the PE firm will normally try to boost the business and help it realize its full potential. In the latter stages, energy is usually directed at creating efficiencies and optimising processes.

PE firms with an active approach hire some of the best and brightest talent in the market and in doing so, build a wealth of in-house knowledge. Usually PE firms also have a strong network within the business world, featuring “C-suite” contacts (think CEOs, COOs and CFOs). This can help when it comes to making deals and in realising operational efficiencies and synergies.

The final objective is to sell the ‘revamped’ companies at a multiple of invested equity. Shareholders in PE firms then receive their slice of the profits and can often see a significant return on their original investment (…).

The final objective is to sell the ‘revamped’ companies at a multiple of invested equity. Shareholders in PE firms then receive their slice of the profits and can often see a significant return on their original investment – of course, one must consider that there is no guarantee that the goals of enhancing value and improving performance will be achieved. If the company stumbles, the PE fund and its investors will lose money.

Functions covered by PE firms

PE firms can perform various functions, depending on what stage the acquired firm is at in the business cycle. Three of the most common types are:

Venture Capital

A PE firm will perform this function when the acquired firm is in the early stages of the business cycle. In short, Venture Capital is normally provided to high-potential, high-risk, growing start-ups. Usually these smaller firms have a niche product or service that isn’t currently offered by large conglomerates.

Take for example a new, Silicon Valley start-up that has developed a coveted technology but has a limited operating history. It is too small to raise capital via an IPO and has been unable to secure a bank loan. A PE firm, in sniffing out the potential of the firm and the industry in which it operates, may come forward with funding and know-how. However, in exchange for the high risk that comes with investing in smaller and less mature companies, the PE firm will usually obtain a significant stake in the company as well as a degree of power over decision-making. Strong start-ups that are highly-desirable can be in the position to select their venture capital investor and seek a partner that can provide key capabilities and/or resources.

Growth Capital

Growth capital typically refers to minority investments in relatively mature companies with major growth potential. Whilst profitable, these firms normally seek additional capital in order to expand or restructure operations, enter new markets or finance a strategic acquisition. They usually do not cede control of their business as part of the deal.

(Leveraged) Buyouts

When a company is established and profitable, and the current ownership looking to exit, PE firms will embark on a buyout. This involves acquiring a company using both equity and debt. The assets of the company are put up as collateral to secure the debt so that, in essence, the PE firm is able to purchase companies by putting up only a fraction of the purchase price. By leveraging the investment, PE firms aim to maximize their potential return on the upside (but of course if this go wrong this can also magnify losses). Buyout PE firms use their expertise and engage in financial engineering to try to improve company financials and increase profitability before positioning the company for sale.

In days gone by, PE was like an exclusive club only accessible to the super rich or large institutions, but now there are ways to invest without putting up millions in capital.

Access

If this all sounds interesting to you, opportunities to participate in PE are now becoming available to a broader spectrum of investors. In days gone by, PE was like an exclusive club only accessible to the super rich or large institutions, but now there are ways to invest without putting up millions in capital.

In its purest form, PE is a direct investment or “co-investment” into a company. Very few investors have the scale, sophistication and resources to make direct investments, and so this option is mostly limited to large pension plans, endowments and sovereign wealth funds. An alternative way to invest in PE is by investing in a primary fund which is established by a General Partner to identify and invest in companies. But again, the entry ticket is high, with the typical minimum investment sitting around $10 million.

However, vehicles such as access funds open up PE opportunities to High Net Worth individuals, with a minimum investment somewhere around $100,000 – $150,000. Access funds are set up by General Partners that invest in one primary fund (referred to as the “underlying fund”). Normally, these are only available from large brokers/ dealers with a high degree of knowledge.

There are also fund-of-funds whereby investors commit capital to a fund, which then identifies and invests in several primary funds over a predefined time period. The benefit of this approach is that this provides more diversification, should one PE project turn sour. Normally the minimum investment is lower.

These are only some of the main PE vehicles from a broader universe. But on top of selecting the vehicle appropriate for them, an investor with the will and the means to invest in a PE product has many other things to consider…

Considerations for investors

Fees

For their work, PE firms of course have to be paid. Investors should closely analyse their fee structure (vis a vis peers and industry norms). Performance fees are applicable above a pre-defined hurdle or “preferred return”, and these are usually 8%, sometimes 6%. For primary funds, a common fee structure is the two-and-twenty model: a 2% annual management fee and a 20% performance fee charged at the time the investment is sold, but of course this can vary. Because fund-of-funds and access funds also incorporate fees in accordance with their own value-added services such as diversification, fund selection and ease of access for example, the fees are normally higher for these types of vehicle.

Investors should understand that this is a long-term commitment and should ensure the ability to meet capital calls within a short timeframe.

Risks

PE involves taking on a high level of risk and putting a lot of faith in the PE firm – especially given that at times there can be a lack of visibility on the investment. An investor should perform the necessary due diligence and make sure the PE firm (and/or promoter) is reputable, with a successful track record. Some questions that an investor may ask themselves are: What firms have they worked with in the past, what is their success rate and average rate of return?

Investors should understand that this is a long-term commitment and should ensure the ability to meet capital calls within a short timeframe. There is a greater degree of liquidity risk inherent in such PE vehicles than for example there is for exchange traded equities. Often, once the money is locked in (for periods that can be ten years long), some structures do not permit early redemption and it can often be that the NAV calculation is infrequent – perhaps even annual. This makes reliable, capable and dependable management essential.

Investors should consider the remuneration policy at the PE firm – are management salaries linked to performance? This adds more accountability.

Of course these are only a few of the many considerations a potential PE investor should take into account.

But despite the risks, investors are increasingly drawn to the opportunities offered by private markets. McKinsey, the consultancy firm highlights in a recent report entitled ‘The rise and rise of private markets’ in 2017, private markets raised a record sum of nearly $750 billion worldwide as investors showed increased interest and confidence. PE makes up by far the biggest chunk of the private market and at this point, it is a segment that seems to be awash with cash and swimming in opportunity for the investor who has the capability to navigate the nuances of the industry.