Private Equity – A Comprehensive Guide

An infographic that explains what private equity is, the goal of private equity. the types of PE funding and who the investors are in private equity.

Private equity is all around us and has increased significantly since the financial crisis in 2008. Some even say private equity managers won the financial crisis, and now we live in a private equity world! The private equity industry, which runs funds that invest in private companies, has trillions of dollars in assets under management (AUM) and has made many billionaires. In addition, PE funds have acquired companies in many industries, such as retail stores, restaurants, newspapers, and real estate.

Recently, politicians, regulators, and activists have scrutinized the private equity industry for its predatory practices. For example, some private equity firms extract the maximum amount of value from a company they have taken over. They push them to the limit and then dump them on the public market, where many eventually file for bankruptcy. Some examples of companies that went through this are Toys R Us and Payless.

As it is hard for outsiders to understand the PE industry and how PE firms work and make money, this article will shed some light on their practices. We will explain what private equity is, how it is structured, how it works, the types of PE investment strategies, how they structure deals, how they create value, and finally, how to invest in them.

What Is Private Equity?

Private Equity or PE is an alternative investment category. It is composed of funds contributed by accredited investors directly invested in private companies or in buyouts of public companies to delist them and take them private. These investment funds are organized as limited partnerships and are not listed on public stock exchanges.

Firms and investors make private equity investments with specific goals and strategies. They provide working capital to private companies to fund their operations, acquisitions, technology, expansion, or new product development.

The private equity industry is comprised of institutional investors and large private equity firms funded by accredited investors. The largest PE firm is The Blackstone Group Inc., with $571 billion in total assets under management as of February 10, 2020. Two other huge ones are KKR and Carlyle. Besides the huge ones, some small PE firms invest between $1 and $2 million in private companies.

PE firms usually focus on a specific industry or sector, or region to invest in. Hence, they will only consider investing in private companies that fit within their focus area.

Structure of A Private Equity Fund

An infographic that explains the structure of a PE fund. It shows how the General Partner is responsible for the fund management and investment of some capital. The limited partners invest the bulk of the capital into the Private Equity Fund. The fund then starts investing in the different portfolio companies it has selected.

PE firms are started as limited partnerships by the General Partners (GPs). GPs are investment professionals, and under the structure of the PE fund, GPs are fund managers who are responsible for managing the funds, deciding which investments to include in the portfolio, sourcing deals, and maintaining communication with companies the fund invests in.

GPs typically contribute between 1 and 10% of the total investment. They have full liability, while the remaining capital comes from the Limited Partners (LPs), who have limited liability directly proportional to their capital contribution. Limited partners are institutional investors and accredited investors such as high net-worth individuals, banks, and trusts. Institutional investors include pension funds, insurance companies, university endowments, and commercial banks. Limited partners are not involved in the fund’s day-to-day operations. Instead, the PE fund is simply an investment vehicle for their capital.

How Does Private Equity Work?

Private equity funds have a closed-end investment structure. They raise funds from large institutional investors and wealthy individuals. PE firms often prefer large companies that invest huge amounts. The PE raises funds in two ways. The First Close is when the firm has raised the capital, but new private equity investors can still join the equity. The Final Close is when the fundraising is completed, and no new investors can join.

Raising the capital is the first step in creating a fund, which usually takes a couple of years. Then, the GPs spend a significant amount of time searching for companies that they can invest in. They often find them through their network of investment banks, merger and acquisition intermediaries, other equity firms, and through referrals from business associates. 

The next step is to carry out in-depth research and due diligence to make sure that the target companies fit the profile and have the ability to achieve their forecasted projections. Once the GPs decide that a company will be a good candidate for capital investment, the PE firm acquires a majority interest in the company. Then, the company becomes one of the PE firm’s portfolio companies. Typically, 15 to 25 different capital investments are made, and none can be more than 10% of the total fund. 

After the majority stake is acquired in the portfolio companies, the PE firm’s job is to advise on the companies’ operations. Its advice includes how to create value, manage risk, and position the companies for an exit.

Private equity firms generally only control 60-80% of a business. The other part is often in possession of the businesses’ founder or its management team. Thus, the firm does not typically involve itself in day-to-day operations but advises the acquired company’s management team on what strategy to follow to reach its goals.  Once each of the companies achieves the return on equity that meets the fund’s goals, the GPs will sell the companies or issue an IPO (Initial Public Offerings) within the preset time, typically ten years.

Although the life of a PE fund is often ten years, recently, there are more funds available with life cycles of 15 to 20 years.

Most private equity firms have multiple funds, and these funds usually run on different timelines. As a result, a private equity firm can be raising money for one fund while exiting a different fund.

PE Investment Strategies

Here are the most popular types of PE funding or private equity strategies used:

Distressed Funding

This type of PE funding involves investing in troubled firms with underperforming assets or inefficient units. Such investments aim to turn the company around and then sell it when its value reaches a certain target. PE firms accomplish this by making changes to the company’s operations or management or by selling some of the company’s assets for a profit. Those assets can be anything from physical machinery and intellectual property to real estate. Investors can make a fortune if they are successful in turning the company around. 

Leveraged Buyouts (LBOs)

The most common type of private equity funding, leveraged buyouts, involves a large amount of debt to acquire other companies. The PE firm acquires the target company and then helps improve the company’s efficiency to sell the company in the future for a profit. Firms generally use 90% debt and 10% equity to finance the purchase. The huge amount of debt makes this type of private equity investment very risky. 

The target companies involved are typically mature companies that generate operating cash flows. Often, part of the deal is that the acquired company’s operating cash flow has to cover the interest payments on the debt and the repayment of the loan. As a result, if the company’s revenue declines, which could easily happen during an economic downturn, the company can get into serious financial trouble, and the investors might lose their investment.

Real Estate PE

This type of PE funding has become very popular and is expected to show significant growth. Real estate private equity funds invest in REITs (Real Estate Investment Trusts) and commercial real estate assets. Real estate funds require a higher minimum investment amount than other types of PE funding. Moreover, funds are locked up for years in this type of funding. This is the reason why it is referred to as “illiquid” investments. 

Venture Capital

This type of PE funding usually involves startup companies with growth potential. Investors will fund entrepreneurs to start a company, help with early-stage developments, or fund expansion. Venture Capital is often found in new technology development and applications, new products, and new marketing concepts. It is often associated with fast-growing tech, healthcare, and biotech companies. Venture capital can take numerous forms depending on what stage of the company it is funding.

Fund of Funds

These are investments made in a fund whose primary activity is investing in other private equity funds.

Direct PE investment is not available to retail investors as the minimum investment amount is very steep. However, some mutual funds and Exchange Traded Fund specialize in private equity, so retail investors can still partake, although indirectly, in PE investments.  These mutual funds and ETFs buy shares in private equity firms, also called business development firms. These firms offer publicly traded stock, allowing retail investors to invest in private equity. The drawback is that it is relatively expensive due to various fees like performance fees and management fees.

Private Equity versus Venture Capital (VC)

Venture capital is a broad sub-category of Private Equity. Both raise funds from limited partners and raise capital to invest in private companies. In addition, their goals are the same as they both aim to increase the company’s value and then sell their stake or the whole company to earn a profit. However, there are some major differences.

While venture capital investment firms invest in early-stage start-up companies in mostly fast-growing industries such as tech, healthcare, and biotech, private equity firms invest in mature, established companies that are operating inefficiently. 

VC firms generally provide capital for a minority stake of ownership, so less than 50%. In contrast, PE firms often buy a 100% stake in the company or at least a majority stake. 

Venture capital investments are often riskier than regular PE investments as VCs invest in new companies that are not profitable yet. Sometimes do not even have any revenue yet, and are counting on new products and technology.

Venture capitalists typically spend $10 million or less per company they invest in, and they only use equity. Private equity firms usually invest $100 million or more in one company. Because of the size of the investment, they often use a combination of equity and debt.

Investors in VCs make their money when their portfolio company is sold or when it goes public. They can also make money by selling a portion of their shares to other investors. When PE firms sell their portfolio company or take it public, limited partners get 80%, and PE investors receive 20% of the profits.

The Ins and Outs of PE

The structure of a PE fund includes classes of partners and assets, investment horizons, management fees, and several other factors. 

Whenever a PE firm raises money, investors agree to terms mentioned in a limited partnership agreement. According to the agreement, the LPs are liable just for their investment, while the GPs have total liability. This means that they are responsible for the debts if the PE loses all its equity. The distribution of profits is usually 80-20, where limited partners get 80%, and PE investors receive 20% of the profits.

Most private PE funds use debt as part of their financing because it increases the fund’s rate of return. Each year after the acquisition, the debt gets paid down and decreases, and the equity grows. A structure of 75 % debt and 25% equity is pretty common.

The agreement also states the duration of the fund. The PE firm manages the fund and ensures that they return the investor’s money within the investment horizon. This is usually about 10 years and involves 5 different phases: 

  • Deal formation
  • Fund-raising period of two years
  • Deal sourcing period of three years
  • Portfolio management – After firms invest in a company, they will advise on how to operate it to create value, manage risk and position for an exit
  • Deal exiting period of up to seven years through IPOs or trade sales

PE funds generally exit the deal within 10 years, as that was part of the agreement. However, this time frame can change due to market conditions such as IPOs failing to attract enough capital. 

The terms also include the fees that the investors need to pay to the firm. Private equity funds charge 2 types of fees: a management fee and a performance fee. 

The management fee is paid by limited partners and covers the administrative and operational fees like transaction charges and salaries. It is calculated as a certain percentage of total Assets Under Management. It is a yearly fee and is usually about 2%. 

The performance fee is a percentage of the profits passed on to the GP. This fee can be up to 20% of the return on investment and only gets paid for funds that deliver a positive return. In addition, a hurdle rate is usually set. For example, if the hurdle rate is 10%, the performance fees only get paid for the amount of return that is over 10%.

How Does Private Equity Create Value?

Although all private equity firms have their own investment strategies, they all share a common goal: value creation. 

The most obvious way they create value is by acquiring private firms in financial distress or operating inefficiently and then turning these companies around by restructuring their debt, increasing the efficiency of their operations, and changing the management team. The end goal is to sell the company for a profit or take it public.

Another way PE companies create value is by offering investments to companies with strong growth potential but cannot find funding or the expertise necessary to increase their growth. Because these companies are not profitable yet and sometimes do not even have revenue yet, traditional investors usually have no interest in investing in them because the chance of failure is too high. These companies like to partner with PE companies because PE companies can provide them with capital and access to a lot of expertise. Experience in operations, management, financing, industry, logistics, and markets can save the companies a lot of time and increase their potential for success.

PE firms also create value by trying to align the company’s interests with those of their investors. In addition, they create value by recognizing patterns that allow them to find and invest in the most suitable portfolio targets.

How To Invest in PE?

Wealthy individuals and institutional investors often prefer investing in PEs because it offers the potential of extremely high returns. But, of course, high returns come with high risks. Because of the high risk involved, the Securities and Exchange Commission (SEC) sets rules on who can invest in PE. They have decided only to allow “accredited” investors to invest in private equity. Accredited investors include anyone who has been making more than $200,000 per year for the last 2 years, or has a net worth of more than $1 million, not including your home’s equity, or is an officer, director, or general partner of the company in which they are investing. In addition, most PE funds have a very high minimum investment requirement.

So, investing in private equity is not possible for the average retail investor. However, there are some ways for retail investors to invest in PE indirectly.

Fund of Funds is an effective way for PE firms to lower their minimum investment requirement. This type of investment holds the shares of multiple private partnerships investing in private equity. A fund of funds is also more diverse as it invests in different companies across industries. Due to its size and diversification, it offers a reduced risk when compared to individual PE investments.

Another way to invest in PE is by purchasing ETFs (exchange-traded funds) that focus on private equity. These funds do not have minimum investment requirements either. However, this type of investment involves a management fee and a brokerage fee. 

Investing in SPAC (Special Purpose Acquisition Companies) is another option. SPACs invest in undervalued private companies. However, they don’t provide much diversification and can be risky.

Conclusion

Private Equity can provide an effective way for acquired companies to grow and expand. PE firms can help improve the acquired company’s operations and efficiency and increase its value and revenue. The end goal is to help sell the company or take it public.

PE firms offer amazing investment opportunities to institutions and high net-worth investors. However, investors must understand the risks involved. The overall risk of private equity investment is higher than that of other asset classes.  The required minimum investment is usually very high, and the investment is for the long term. This means that the investment cannot be pulled out until the fund has sold all its assets. This often takes 10 years or longer, and there is a high risk for default.

As mentioned before, the returns on PE investment can be extremely high. So, for investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of their portfolio.

Additional reading:

The September 2007 Issue from the Harvard Business Review has a fascinating article on the Strategic Secret of Private Equity worth reading.

https://hbr.org/2007/09/the-strategic-secret-of-private-equity

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.