You must have heard about private equity and private equity firms. Currently, they are on a roll with about $3.9 trillion in assets as of 2019. That is a year-to-year increase of 12.2%, and this percentage will only get bigger in the coming years.
Private Equity – What Is the Meaning of the Term?
PE or private equity is an interest or ownership in an entity that is not traded or listed publicly on a stock exchange. The source of the funds is high-net-worth individuals or firms. Their goal is to buy stakes in private companies and claim ownership or acquire control of listed public companies to make them private after delisting from the stock exchanges.
The bulk of the private equity industry funds are from large private equity firms and institutional investors like pension funds. These funds or individuals must have deep pockets because the ultimate motive of a private equity firm is to get control over a private company and get a high and positive Return on Investment (ROI). The capital required by investors in private equity funds varies, ranging from a minimum of $250,000 to millions of dollars. The typical investment horizon for shareholders to get favorable yields on investment is between five years and seven years.
What Is a Private Equity Firm?
A private equity firm is a company that manages investments and provides financial support in the form of private equity in startups or established companies. There are several investment strategies like venture capital, leveraged buyout, and growth capital, all of which will be seen in some details later in this post. A private equity firm will raise capital (PE funds) and, in turn, will receive a management fee and a part of the profits earned from every managed equity fund.
It starts with private equity firms and their investors acquiring control or a substantial part of the stakes in a company and then maximizing the value of their investment over time. The return on investment generally takes one of the following ways.
- Merger or Acquisition – The company’s stakes are sold to another company, either for cash or shares.
- Initial Public Offering (IPO) – The shares in the privately held entity is sold to the public. Apart from the instant realization of funds, the door is also opened for selling more shares in the future.
- Recapitalization – Shareholders or the financial sponsor get cash either from the cash flow generated by the company or by raising debt to monetize the distribution.
In industries where the private equity firms have a great deal of expertise, the investments are made for longer periods.
Types of PE firms
PE firms have a wide spectrum of investment options. Some PE firms are passive financiers, i.e., they invest in a company and depend solely on the management to scale up the growth and give them increasing returns. Others are considered as active investors. They play a dynamic role in management and provide operational support for higher growth and development. This is when the active investors have proven professional industry experience.
Active PE firms work in close contact with the CFOs and CEOs of the specific industry where their investment is made. Hence, by increasing synergies and operational efficiencies, they can add value to a company and increase revenue. Sellers generally prefer investors who will increase the value of a company over time. A case in point of an active investor in Bain Capital, one of the world’s leading multi-asset alternative investment firms based in Boston with offices in New York and other major cities in the world.
Major investment banks compete with PE funds to finance promising startups and good companies. These deals are facilitated by the biggest investment-banking entities based out of New York and other financial hubs of the world. These include Goldman Sachs, Citigroup, and JPMorgan Chase, among others.
The funds of private equity firms are offered to only a limited number of accredited investors, with the founders of the firm taking the major stake in the company they finance.
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Even though the focus of PE firms is on private companies, the larger firms have their shares listed on the stock exchanges. Bain Capital and Blackstone Group, two of the largest and most prestigious private equity firms, trade their shares on the New York Stock Exchange. They have been involved in buying out reputed companies like Hilton Hotels and MagicLab.
Investment Strategies of Private Equity Firms
There are several investment strategies followed by private equity firms. Here, two of the most common will be taken up for a closer look.
- Leveraged Buyouts (LBOs) – This is how it works. A company in New York, for example, is purchased by a private equity firm. The sale is financed by debt, and the operations and assets of the company are taken as collateral for the debt. Hence, the PE firm is buying the company from capital that has been raised against the same company’s assets. The PE firm thereby assumes control of a company without putting up any substantial amount of its funds, mostly a fraction of the purchase price. PE firms can then maximize their returns in as little as three to five years as the venture’s investment is negligible. This is known as leverage buyout.
- Venture Capital – VC or Venture Capital is used when an equity infusion is made in a startup or a nascent company in a less active industry. If a private investment firm feels potential in the target company in a rising industry, but only a lack of good management, revenues, cash flow, and debt financing is retraining growth, it will invest in the company.
Based on the potential for exponential growth in the future, a private equity firm will acquire significant stakes hoping that the company will grow into a robust entity. Additionally, venture capital firms will use the expertise and skill sets of its executives to guide the company and its inexperienced managers. Indirectly, the private equity firm will be adding value to the company, which will maximize its returns on investment.
Fees and Carried Interest – How PE Firms make money
PE firms also make money through fees and carried interest.
- Fees – The most trusted and common method of private equity investors for revenue generation are fees used to maintain a PE firm and pay for its establishment expenses like salaries and other overheads. These entities have mastered the fine art of charging fees in several ways. First, all LPs are required to pay a management fee – usually 2% – to the private equity fund for the privilege of being allowed to invest in the fund. Sometimes, they exercise the option of waiving the fee but instead invest directly into the fund. This offers an advantage to the general partners to realize revenue at the tax rate for capital gains.
Apart from charging the investors, equity funds also earn revenue from their portfolio companies. The fund charges the companies a transaction fee of around 1% of the total investment amount. Portfolio companies are also levied monitoring fees for various advisory and consultancy services carried out during the lifecycle of the investment, usually five years to seven.
- Carried Interest – Fees are used to ensure that a private equities firm can keep the operation running smoothly. But it is with carried interest from portfolio companies that equity funds make the real money. Carried interest is the share of the capital gains generated by the finances of equity firms. It is earned from profits made on portfolio investments. While equity firms get returns on their capital by taking the portfolio companies to the public or selling them, there is another avenue, dividend recapitalization.
According to their limited partnership benchmark, private equity funds can receive 20% of the carried interest. But this comes with strings attached. PE firms are eligible to receive 20% only after they have hit a pre-fixed rate of return, which is typically 8% and is known as the hurdle rate. This is to ensure that equity investors receive an adequate return too. High performing equity funds like Bain Capital and others from New York, the USA’s financial capital, are often able to demand more than 20% carried interest and a low or negligible hurdle rate.
The fees and carried interest are the main income-generating routes for private equity funds.
How Private Equity Firms Create Value
Private equity firms create value in several ways. Creating, maintaining, and developing relationships through mergers and acquisitions with banks and other professionals in this field are some of them. A few top private equity firms in New York and Europe hire specialized staff with a wide contact base to identify and reach out to owners of companies for generating long-term transaction leads. In the highly competitive environment of private equity sourcing, proprietary deals ensure that the equity finances raised are optimally deployed and invested in companies.
Further, efforts made to source funding from internal resources instead of relying on intermediaries to do so cut out the fees payable. Hence PE firms also strive to establish a robust link with transaction professionals who can give them an early and first access to a deal.
Conclusion
In the initial years of the present buyout boom, the focus of private equity entities was acquiring the non-core business units of large blue-chip companies. Those businesses had suffered setbacks and needed to be better managed along with an infusion of credit. Recently, equity firms are gunning for greater growth by shifting their attention to the acquisition of entire public traded companies. This has created new challenges but reports that PE firms hold $3.9 trillion in assets as of 2019 more than prove that they have risen to the task.
FAQs
What Does a Private Equity Fund Do?
A private equity fund manages investments and offers financial support to both established companies and startups by investing in equity. These entities have several strategies, including leveraged buyouts, venture capital, and growth capital. Instead of the investments, private equity companies receive management fees and a part of the profits earned from managing the fund.
Generally, the investors get either full control of the management or a part of the ownership of the companies. This helps to maximize the rate of return on the investments.
What Is Private Equity Investment?
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Private equity investment is the finances invested in a company to offer financial support regardless of whether it is an established company or a startup. There are several ways that it can be done. One is the leveraged buyout, where a private equity firm purchases a company by putting the assets of the company as collateral; it is financing. Hence the share in the finance of the private equity firm as well as the risks is negligible. This results in a very high rate of return on capital. Another is Venture Capital, where the control of the business is taken by not the only infusion of capital but also at the management level.
How Do You Start a Private Equity Firm?
The first step is to raise a pool of capital from institutional investors unless you want to raise capital as per requirement deal by deal. To raise money from investors, you have to use various strategies to assure them that they will get high returns on their capital. It is critical to have a compelling reason lined up as LPs are inundated with hundreds of proposals every year.
How Do Private Equity Firms Value a Company?
The primary method followed by private equity funds to value an organization is to compare one business with another. A business can be set off against the nearest competitor in terms of certain parameters like sales, revenue, profits, product launches, and market share. Another is the discounted cash flow method, where the estimated future cash flow value is compared with the value prevailing today.
