What do private equity (P.E.) firms do? What are the different strategies they use, and what is the typical structure of a private equity firm? These are some of the questions which I’ll try to answer in this blog. But first things first, why the name private equity? So let’s break it down.
5 Second Takeaway
- Private equity is a source of investment capital not listed on a public exchange.
- Money companies receive from firms or accredited investors instead of the stock market is known as private equity.
- P.E. funds often target a specific type of company based on where that company is in its lifecycle.
- Only institutional and accredited investors can put money into a private equity fund.
- Unlike hedge funds, Private Equity funds are not looking for short-term returns.
- Private Equity firms generally acquire a controlling equity interest in the companies they invest in.
An Alternative to Conventional Financing Methods
Conventionally, companies looking to raise money turn to banks to take out loans, issue stock, or sell bonds. However, The private equity market offers an alternative to these more conventional capital-raising methods.
What is private equity? Private equity (P.E.) is a collection of investment funds that invest in or acquire private companies not listed on a public stock exchange.
What is a private equity fund? Well, let’s break the name down. Firstly, it’s private because these funds are mainly interested in acquiring private companies not listed on stock exchanges. Secondly, we use the term equity because P.E. funds focus exclusively on equity investments.
What Do Private Equity Firms Do?
Certain PE firms’ funds prefer engaging with a specific type of company depending on where it is in its lifecycle. For example, some P.E. firms are interested in young firms with high growth potential and solid management teams. Typically, private equity invests in mature businesses in more conventional industries in exchange for an equity stake.
In contrast, others focus on established companies with stable cash flows and leveraged buyout transactions. Likewise, it isn’t rare to see private equity investments in distressed companies.
Private Equity vs. Hedge Funds
As a quick refresher, hedge funds use pooled money and various tactics to earn returns for their investors. Distressed investments are one area of activity where there is some overlap between private equity and hedge funds. For example, both funds could be invested in a distressed public company. However, hedge funds are unlikely to engage with a non-public firm. The main difference, however, is their investment horizon.
A private equity firm would typically try the following:
- acquire all the shares in the company,
- de-list it,
- change management,
- introduce measures orientated towards improving financial performance, and then,
- be patient for a few years before exiting investment through a sale or a new listing.
On the other hand, a hedge fund investment has a shorter-term duration, not longer than 2 to 3 months. More specifically, the hedge fund buys securities of distressed companies when they believe there is a good chance of reselling them at a profit soon.
The Goal of Most Private Equity Deals
Most private equity deals try to achieve a significant stake in a business. They prefer 100%, but no less than 50% as a bare minimum. And because of this substantial holding, they can position the business for growth through active involvement. Management restructuring and other substitutions are required to grow the business if necessary.
Ultimately, their goal is to exit the investment in 5 to 10 years after they improve their profitability. So how do they structure this? Limited partnerships or closed-end funds are two main ways to structure private equity funds.
A Limited Partnership
Limited partnerships are much more popular in the U.S., while closed-end funds are prevalently used in Europe. In a limited partnership, we have two types of partners, General and limited.
General partners manage the fund and select the portfolio of the target company along with post-investment advisory. Alternatively, the Limited partner’s role is to provide investment capital.
General partners charge the partnership a management fee and have the right to receive carried interest. This is the famous 2 to 20% compensation structure where 2% is paid as a management fee even if the fund isn’t successful.
Furthermore, general partners receive 20% of all proceeds after breakeven. Limited partners receive all of the fund’s proceeds minus what’s been paid to general partners.
Closed-End Funds
A closed-end fund is different as it typically involves a newly created entity. Investors provide capital to that management firm, which signs a management contract with the entity. Compensation schenes remain very similar under this type of structure. In most cases, the classical 2-20 arrangement plus a hurdle rate for management, after which are accrued 20% of carried interest.
Lifecycle of a Private Equity Fund
The typical lifecycle of a P.E. fund looks like the following:
- Formation
Forming a private equity fund can be as short as a couple of months and as long as two or three years. During this time, money is collected. Largely the timing depends on the reputation of the management firm and the demand for the services. Established players in the industry have a significant edge.
- Investment Period
The next stage of a fund’s life is the investment period which typically lasts up to five years. At this time, the general partners or management company depending on the type of fund structure chosen, would search for suitable target companies fitting the fund’s strategy. Once investments have been made, it would be up to fund managers to decide how to approach the business and optimize its performance. Advice for management and even management substitutions are commonplace when private equity takes control.
Most PE firms are very hands-on, and throughout the entire life cycle of the investment, they frequently meet with management and are keen on ensuring that the business is on the right track to being ready to be sold or listed on the stock exchange.
- Divestiture
Of course, the final stage is divestiture; understandably, it can last several years, sometimes even five. Various factors determine when is the best moment to exit the business. A few examples are the general state of the economy, market volatility, and, quite importantly, finding the right buyer willing to pay the right price.
Once the entire portfolio is divested, the fund closes. All proceeds are distributed among general and limited partners in a partnership structure. Or among investors and the management company in a closed-end fund.
Leaders in the Private Equity Industry
Companies like Apple (AAPL), Toys R Us, RadioShack, and Payless Shoes have all played in the private equity sandbox. That’s unsurprising since many of the world’s top private equity firms are in the U.S.
Some of the leaders in the private equity game include:
- The Blackstone Group: Blackstone is a leading global investment business investing capital for pension funds, large institutions, and individuals based in New York City. Shockingly they’ve evolved into a buyout firm with assets surpassing $684 billion!
- The Carlyle Group: With 26 offices across five continents and $169 billion in assets under management, the Carlyle Group is nothing to sneeze at.
- KKR: KKR’s Private Equity platform invests in and partners with industry-leading franchises and companies poised for significant improvement or growth that attract high-quality management. Did I mention they had $471 billion in assets under management as of December 31, 2021?
Final Thoughts
Private equity allows companies at every level a chance to raise money without heading to the bank for a loan or placing their company up for public offer on the stock market.
