What is private equity?
What do private equity firms actually do?
Which are the different types of strategies
they pursue and what is the typical structure of a private equity firm?
These are some of the questions we would try
to answer in this article, but first things first why the name “private equity”?
Let’s break it down, private because these are
funds that are mainly interested in acquiring private companies that have not
been listed on a stock exchange and equity because PE funds are exclusively
focused on equity investments.
What about specialization? Can we say that
certain PE funds prefer engaging with a specific type of target companies, the
short answer is “yes” Most private equity firms specialize in deals with a
specific type of targets based on the life cycle stage of these targets. Some PE’s
are interested in young firms with high growth perspectives and a promising
management team while others are focused on established companies with stable
cash flows.
Leverage Buyout (LBO) transactions, in
addition, it isn’t rare to see Private equity investments in distressed
companies. Actually distressed investments are one area of activity where there
is some overlap between private equity and hedge funds. Both types of funds
could invest in a distressed company, which is public. Hedge funds are unlikely
to engage with a non-public firm.
The main difference however is their
investment horizon, a private equity would typically try to:
1. Acquire all the shares of the target
2. Delist it
3. Change management
4. Introduce measures oriented towards improving financial
performance
5. And then be patient for at least a couple of
years before exiting the investment through a sale or a new listing
6. Duration is mostly more than two years
A hedge fund investment on the other hand
would likely have a very short term duration, the fund would:
1. Buy the securities of distressed companies
when they believe that there is a good chance of reselling these securities and
had a profit in the near term.
2. Duration is not longer than two to three months.
This comparison provides a pretty good insight
of what most private equity deals try to achieve. Following is just a summary
of how does a private equity firms works.
1. Acquire a large stake in a business preferably
a hundred percent but not less than 50 percent.
2. Position the business for growth through active
involvement, advisory, and if necessary management rotations and substitutions
3. Have the patience to grow the business.
4. Improve its profitability
5. And then Exit the investment in a five to ten year
period.
Of course, the art of the private equity
profession is to bet on the right companies and then successfully provide
guidance in order to optimize their chances of being successful.
Great! let’s talk about fund structure, there
are two main ways in which private equity firms are typically structured
Limited partnership or a Closed-end fund
· Limited partnerships are much more popular in
the US while closed-end funds are prevalently used in Europe.
· In a limited partnership we have two types of partners,
general and limited. General partners are involved with the management of the
fund target company’s portfolio selection and post investment advisory. Limited
partners 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
percent compensation structure, where 2% is paid as a management fee even if
the fund isn’t successful and then 20% of all proceeds after break-even are
received by general partners.
· In some cases a hurdle rate is added to the
partnership agreement which defines a certain minimum rate of return that needs
to be achieved before accruing carried interest to general partners.
· Limited partners receive all of the funds proceeds
minus what has been paid to general partners.
· A closed-end fund is different, it has
typically involves a newly created entity. Investors provide the required capital to that
entity and the management firm signs a confidential management contract with the entity. Compensation
schemes 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.
Very well the typical lifecycle of a
PE fund looks in the following way:
· A period allowing for the collection of
investments in the fund, which can be as short as a couple of months and as
long as two or three years.
· Largely this depends on the reputation of the
management firm and the demand for their services within the investment community.
Established players in the industry have a significant edge.
· The next stage of a funds life is the investment
period, which typically lasts up to five years. In this time, the general
partners or management company depending on the type of fund structure chosen
would search for suitable target companies fitting the funds strategy.
· Once an investment has been successfully made it would be
up to the fund managers to decide which is the best way to approach the business
and optimize its performance.
· Advice for the management panel and even management
substitutions are very frequent to improve the governance when a private equity takes control.
· Most PE firms are very hands-on throughout the
entire lifecycle of the investment, they meet frequently with management and
are keen on ensuring that the business is on the right track of being ready to
be sold or listed on a stock exchange
· Of course the final stage is “divestiture” and
understandably it could last several years in some cases even five years.
· Various factors are undertaken to determine when is the best time to exit the business.
· A few examples our 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 and 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
I hope this article allowed you to gain a good
understanding of What is private equity? and What do private equity firms
actually do?
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