By Mike Casterllarin
Private Equity Consultant
DEFINITION
Private equity is medium to long term finance provided in return for an equity stake in potentially high growth private (unquoted) companies. Some commentators use the term private equity to refer only to the management and leveraged buyout investment sector. Others use the term venture capital to cover all stages i.e. synonymous with “private equity”. In North America, venture capital refers only to investments in early stage and expanding companies. To avoid confusion, the term private equity is used in this document to describe the industry as a whole, encompassing both venture capital (the seed to expansion stages of investment) and management and leveraged buyouts.
WHAT IS PRIVATE EQUITY?
Private equity provides long-term, committed share capital, to help private companies grow and succeed. Raising private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of the company. Private equity is invested in exchange for an equity stake in a company and, as shareholders, the investors’ returns are dependent on the growth and profitability of the company.
Investors whose memories go back more than fifteen years will recognize a familiar name lurking behind the veil of private equity – leveraged buyouts (LBOs). In the 1980s, a typical LBO would buy an undervalued company using money obtained by issuing junk bonds (or senior debt from a bank). The target company then would be broken into pieces (divisions) that could be sold off for more than the target was worth as a whole. This strategy – dubbed buy and bust – worked well until the junk bond market collapsed, thus ending LBO firm’s access to cheap debt capital. Many of the target companies went bankrupt when they were unable to service the high interest junk bonds as the economy slowed after the October 1987 stock market crash. Furthermore, as time passed, fewer and fewer undervalued companies were available for acquisition.
LBO firms today use less debt, making their acquisitions less risky. They also employ a more constructive buy and build strategy. This strategy, as the name implies, involves purchasing similar businesses and combining them into a larger, more profitable entity. Typically the LBO firm will buy a core, or platform company to start with and will build on its strong foundations (i.e. excellent management depth, strong competitive position) with additional, complementary acquisitions. In addition to increasing sales, the LBO firm is trying to improve profitability by reducing costs and increasing efficiencies. The result is a consolidated company that is much larger than the original platform firm, and potentially several times more valuable.
LBOs are only part of the private equity universe. Venture capital investing analyze, finance and manage start up companies. Typically, entrepreneurs will sell a major stake in their company to venture capitalists in exchange for much needed cash and expertise unavailable elsewhere. For example, venture capital firms in the seed stage often provide financial backing as well as office space and administrative support. Several more financing rounds can occur before the “exit” event occurs. During each new round, the venture capitalists new investment tends to be larger while each incremental ownership stake is smaller. The reason is simple – less risk – a company that has overcome successive hurdles and achieved new rounds of financing has a far better chance of succeeding.
BENEFITS OF PRIVATE EQUITY
Private equity backed companies have been shown to grow faster than other types of companies. This is made possible by the provision of a combination of capital and experienced personal input and pressure from private equity executives and board members, which sets it apart from other forms of finance. The private equity firms will seek to increase a company’s value to its owners, without taking day-to-day management control. Although an entrepreneur may own a smaller equity stake, within a few years, that stake should be worth more than the whole stake was worth before taking on the private equity partner.
Therefore, the allure of private equity investing is a direct result of the above average returns achieved by many private equity firms. The private equity asset class has outperformed the public equity markets. The active investing methodology of private equity firms provides for greater opportunities to improve growth and profitability.
CHARACTERISTICS OF COMPANIES THAT ARE A FIT FOR PRIVATE EQUITY
* A company with high growth prospects and an ambitious management team
* A company with a competitive advantage in the market and a track record of success
* A management team with equity capital at risk
* An owner that is will to sell a meaningful stake in his/her company
ADVANTAGES OF PRIVATE EQUITY OVER SENIOR DEBT
A provider of debt (generally a bank) is rewarded by interest and capital repayment of the loan and it is usually secured either on business assets or the entrepreneur’s own assets. As a last resort, if the company defaults on its repayments, the lender can put the company into receivership, which may lead to the liquidation of any assets. A bank may in extreme circumstances even bankrupt the entrepreneur, if he/she has given personal guarantees.
By contrast, private equity is not secured on any assets although part of the non-equity funding package provided by the private equity firm may seek some security. The private equity firm, therefore, often faces the risk of failure just like the other shareholders. The private equity firm is an equity business partner and it is rewarded by the company success, generally achieving its return through realizing an “exit” which may include:
* Selling their shares back to the management,
* Selling their shares to another investor,
* A sale of the company to a strategic (trade) buyer,
* The company achieving a stock market listing.
PRIVATE EQUITY INVESTING
Potential investors should know about how private equity firms operate. Most private equity firms create limited partnerships to hold a series of private equity investments – investors in these funds are the limited partners and the private equity firm is the general partner. A LBO private equity partnership typically has 10-20 portfolio companies. A seed stage venture capital firm will hold many more companies.
When an investor subscribes to a private equity partnership, he or she agrees to commit a specific amount over the life of the fund. The investor may only contribute 10% to the fund initially. Over the next three to four years, the private equity firm will generally draw down the rest of the money committed as it is needed. The investor agrees to meet these capital calls within a few days of the request for cash. The fund’s term usually lasts for ten years.
Because the investments held by a private equity fund are not publicly traded, fund managers must estimate the value of their holdings periodically in order to give investors some idea of how they are doing. The moment of truth, however, comes when each private company is sold, taken public, or fails. After these realizations, the fund’s true performance can be tallied. Most funds distribute their profits after each such realization event.
Of course, investing in private equity funds costs investor’s money. In a typical arrangement, the private equity firm, as general partner, will charge the limited partners an annual fee of 1-2% of committed assets to manage the fund. The firm also will take about 20% of the funds’ profits from successful endeavors.
The minimum investment for many of these funds is $20 million. You do not need to be a centimillionaire to play the private equity game, however. Investors can invest through funds-of-funds whose minimums are much lower, in the $250,000 to $500,000 range.
A fund-of-funds does add an additional layer of fees to the already large cut the private equity partnership takes. Fund-of-funds often charge a 1% annual management fee and take a 5% share of the private equity partnership’s distribution.
A fund-of-funds may invest in several private equity partnerships or may invest directly in one partnership. Fund-of-funds investors need to decide if they want to invest in a pre-selected or a blind fund. In the former, the investor will know in advance which private equity manager or managers will actually make the investments. In the latter, the private equity fund-of-funds decides at a future date how to invest the money, so investors are relying on the fund-of-funds manager to select good LBO or VC firms.