This is a very common question that we hear all the time. If you work in private equity, you can relate to the question asked at social functions, family gatherings or anyone you meet that does not work in finance.
Of course, more people have developed at least a fundamental understanding of private equity and buyouts in recent years for a number of reasons: first, in the United States, the presidential candidacy of former governor Mitt Romney elevated his private equity background to the forefront of a major election. Second, the so-called “mega-buyouts” of the last couple decades have introduced the world of leveraged buyouts and private equity to consumers around the world.
Considering the context of these two introductions to private equity (a highly partisan political election and a number of very different financial deals), there has been a lot of misinformation and confusion surrounding the question of what is private equity exactly? That is why we have created this easy tutorial to give you a fundamental understanding of what is private equity and why this industry matters. If you are a private equity professional looking for private equity training, be sure and look into the Certified Private Equity Professional certification program.
What is Private Equity?
What is Private Equity? Private Equity is an asset class that is associated with both buyouts (where a company’s equity is purchased by a private equity fund) and venture capital (where a venture capitalist or venture capital fund provides capital to a company in the early stages of that business). For the purposes of this tutorial, we are going to focus on the former definition, the private equity buyout business and leave venture capital to a later day (if you want to learn more about venture capital, you can watch this free video from Private Equity TV).
A private equity firm is the company that manages one or more private equity funds (typically structured as limited partnerships). In these private equity funds, the general partner (GP) is the private equity firm’s team operating the fund, evaluating, investing in and managing the companies in the fund’s portfolio. The limited partners (LPs) in the fund are the primary sources of capital for the investments, these are the investors. The GP almost always contributes capital to the fund to show the management team has “skin in the game” but most of the capital comes from these LPs.
Limited partners are accredited investors, meaning they meet the requirements to invest in this alternative fund vehicle by having the necessary net worth or capital under management required by law (for an individual) or the LP is a company that meets the criteria set forth in Rule 501 of Regulation D of the Securities Act of 1933. These institutional investors and high-net-worth individuals will consider the private placement marketed by the private equity firm and decide whether to commit capital to the fund. If the LP agrees to commit capital (almost always more than $1 million) then the fund will seek other commitments until it hits its target or closes the fund to new investors, signifying that the fund is ready to invest in companies.
At this point, the private equity fund’s general partner team will review potential investments, often attractive deals that had been sourced already, and determine whether the firm should invest in the company, what the potential risks are, at what price they company could be bought out for, what improvements or changes the operations team will make once the company is bought and how the fund will exit the investment. These questions and a number of others are raised by the team during the due diligence evaluation phase.
Once the fund identifies an attractive investment that satisfies the partners, they will make a buyout offer (often after testing the waters with the company’s management and board beforehand). For large buyout funds, these bids can be multi-billion dollar deals or at least hundreds of millions of dollars.
This may seem extraordinary to think that a newly formed private equity fund can make an offer to buyout a billion dollar corporation; however, this feat is not accomplished by the buyout fund alone. Most often, the buyout fund has partnered with an investment bank or other lender to finance the deal. The buyout fund may contribute only a small fraction of the total capital needed to buyout the target and borrow the rest. The equity portion (the capital committed by the fund directly) is often much smaller than the debt (also known as leverage) provided by the financing partner. Of course, a diligent lender would not lend millions of dollars or more if it didn’t believe that it would get that money back with interest and with significant hard assets from the acquired company for collateral in the event that the money is not paid back. This debt component is a hallmark of private equity and the reason that many private equity deals are referred to as “leveraged buyouts” or LBOs.
A buyout fund may make minority investments in companies but the primary pursuit of private equity funds is to purchase whole companies. In the case of a public corporation, such as Hertz, the rental car company, then the buyout fund will have to buyout all the shares of the company–often paying a premium on the current market value–in order to take the company private. For this reason, you may have heard of a private equity deal referred to as a “take private” because the private equity fund uses private capital to take a public company private (off the public exchanges).
Once the buyout fund has control of the target corporation, it becomes part of the private equity firm’s portfolio of investments. The goal, of course, is to improve the company through various means and then exit the company and receive a higher price than the cost of buying the company. This is where private equity makes its money.
It may be that the acquired firm was bought opportunistically at a time when the firm’s market valuation was depressed due to a down economic cycle, poor performance or other factor that enabled the private equity buyer to acquire the corporation at a discount to its true value. In this case, the buyout fund may need only hold for a better climate before selling the company at a profit. But most often, the buyout firm acquires the company because the GP team feels that the company could be improved in some significant way. Operational improvements come in a variety of ways: a strategic shift; selling of one or more of the company’s underperforming assets; breaking apart a conglomerate to sell the parts at a higher price than the valuation of the whole; replacing or adjusting the management team; financing a new or expanded division of the business; and many possible improvements. Taking a public company private also has the advantage of enabling the management team to execute long-term strategies or structural changes that may not have been well-received by analysts and public shareholders long enough to carry out as a public company. The private equity management team hopes that through its operational improvements, consulting and input, that the company’s value will increase significantly.
Private equity funds are limited partnerships and the private equity limited partners commit capital with the understanding that the partnership will eventually end and the fund will be dissolved. Unlike other traditional investments, a limited partner investor may have to wait years before profits are distributed from the investment because the fund will have to vet, buy and sell portfolio companies before the bulk of the profits are generated. Given the lack of liquidity and the lengthy commitment of capital, investors expect that the investment will outperform traditional investments, often measured against the returns of the S&P 500 index or other benchmarks. It is not always the case of course, but private equity funds have an impressive historical record of strong performance (according to research, “as of September 2012, private equity returned almost 14% annually over a ten-year period, whereas the S&P 500 Index returned approximately 8%”). So where do those returns come from?
Private equity funds generate returns in a number of ways, with some returns coming from the share of profits generated by the underlying companies in the portfolio. But the private equity fund looks to earn a significant premium on the price it paid for the company by selling the company through an exit. There are multiple exit routes including a sale to a corporate competitor, sale to another private equity buyer or large investor, and the initial public offering.
The initial public offering, or IPO, brings the buyout full-circle by returning the private corporation to the public markets so that the general public or select investors can once again buy shares of the company. An IPO is a difficult but often lucrative exercise completed with the help of an investment bank to sell shares at an attractive price for the private equity owner. A private equity firm may sell part or all of the company through the IPO, taking the total returns and paying off its debt and returning capital to investors (hopefully with a healthy ROI above what the investor committed). Whatever the exit, the private equity fund will take a significant cut of the profits from the deal (often 20% of profits, known as the performance fee or carry) with the rest going to investors. Once the fund has exited its investments, the private equity firm will close the fund and launch another, repeating the process all over again.
I hope that this tutorial provided you with a fundamental understanding of what is private equity, what is a private equity fund and how private equity firms operate. If you would like to learn more about private equity and take a significant step in your professional development, you can enroll in our Private Equity Training program.
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