What is Private Equity?

by Barnaby Kalan

This article introduces you to the basics of private equity by exploring the size, scope and strategies of the industry. Although it’s designed for newcomers, much of the information will be of interest to seasoned veterans and will help in your private equity job hunt.

Understanding Private Equity – The Basics

Private equity is both an asset class and a source of investment capital that enables high net worth individuals, institutions, university endowments and governments to invest in the ownership of private companies.

Since many of these investors do not have the expertise or resources to find and manage these investments themselves, they work with private equity firms. Private equity firms raise the funds, identify suitable targets for investment, perform in-depth research and due diligence on target companies, and manage the investment on behalf of their investors.

The overall goal is to achieve an attractive rate of return for investors, perhaps exceeding the performance of public stock and bond markets. The typical timeframe for private equity investments ranges from five to seven years.

Private Equity Strategies

Private equity firms use a number of different strategies. The most common include leveraged buyouts, venture capital, growth capital, mezzanine capital and distressed investing.

In a leveraged buyout (LBO), a private equity firm buys a majority stake in a mature business, using financial leverage. The operating cash flows from the business are used to service the debt from the purchase. Leveraged buyouts were popularized by firms such as Kohlberg Kravis Roberts in the 1980s, culminating with the massive $31.1 billion dollar takeover of RJR Nabisco by KKR, which remained the largest LBO for many years.

Venture capital is a subcategory of private equity. Venture capitalists raise funds from high net worth and institutional investors to inject capital into start-up and early growth companies. Their goal is to uncover the next Google, eBay or Microsoft and get in on the ground floor as investors.

Venture capital can be further divided into early-stage (start-up) and later stage investments, when a company may be already generating cash flow and perhaps even be profitable.

Growth capital is an injection of cash into relatively mature companies which are looking for funds to expand or restructure their operations. These companies are generating revenue but perhaps do not have sufficient funds to finance a major expansion or make other investments needed for the business. Companies also use growth capital to reduce the amount of debt on their balance sheet. A growth capital investment by a private equity firm is often a minority stake in the business, rather than a controlling share.

Mezzanine capital is subordinated debt or preferred equity shares in a company that represents the most junior portion of a company’s capital structure. However, it is still senior to the company’s common shares. Private equity investors often use mezzanine financing to reduce the amount of equity capital needed to finance a leveraged buyout. Smaller companies use mezzanine financing to borrow additional capital when they are unable to access capital through traditional bank loans or the high-yield bond market.

Finally, there is distressed debt, a special situation within private equity that refers to investing in the debt of a company that has serious financial problems. This can entail a “distressed-to-control” strategy, where the private equity firm acquires the debt of a distressed company in the hopes of taking control when the company emerges from restructuring. Or “special situations” and “turnaround” strategies, where a private equity firm provides capital to help rescue a company going through restructuring.

How Does Private Equity Work?

The life of a private equity firm revolves around deal flow. Deal flow involves finding prospective companies that would be good candidates for investment. Some private equity firms rely on internal staff to identify and generate leads for deals. Others use outside consultants, or a combination of both.

As you might expect, cultivating deal flow requires an extensive network of contacts and relationships with industry leaders, investment bankers, mergers and acquisitions (M&A) advisors, and other high level executives in an effort to uncover potential target companies.

Once a potential acquisition candidate is identified, the investment committee at the private equity firm will analyze the business, look at the management team, financials, performance and forecasts for growth. One important metric they look at is EBITDA — earnings before interest, taxes, depreciation and amortization. EBITDA measures a company’s cash flow before these deductions have taken place. When a private equity firm purchases a company, its goal is to significantly increase EBITDA over a 5-7 year timeframe, thus increasing the value of their investment.

If the committee agrees to pursue the acquisition, they will propose an offer to the seller. If both parties agree to move forward, the private equity firm will assemble a team to conduct thorough due diligence on the company. This team may include lawyers, accountants, investment bankers and other consultants. They will examine the company’s operations and financial statements in detail, looking for any anomalies that could derail the deal. If there are no major obstacles, the transaction proceeds.

Passive versus Active Investors

Some private equity firms are passive investors, choosing to remain financiers who rely on the existing management of a target company to grow the business and improve profitability. Others prefer to become more actively involved, taking over the management of a company after purchasing a controlling share.

Active private equity professionals provide their expertise, extensive network of contacts and operational support to improve the finances of the target company. They have an extensive network of senior level talent that includes CEOs and CFOs in a particular industry, whom they bring on board to achieve operational efficiencies.

Exit Strategies

Since the overall goal of a private equity firm is to achieve an attractive return for investors, the principals of the firm will naturally be looking at the endpoint in the process and how to monetize their efforts.

They typically pursue a number of different strategies: 1) selling the business at a higher price than they originally paid for it; 2) selling or merging the business with a strategic buyer – a company in the same industry that may achieve synergies or efficiencies by acquiring the company; 3) a recapitalization, meaning cash is distributed to the shareholders (the private equity investors) either through cash flow generated by the company or by issuing debt securities to fund the distribution; 4) an initial public offering (IPO) of stock in the company, offered to the public market.

Private Equity Firms – Who Are the Major Players?

The private equity industry has undergone tremendous growth over the past two decades. There are thousands of firms actively managing private equity funds.

Private equity firms are continually raising, investing and distributing funds. Amount of capital raised can be a way of measuring the total value or rank of a private equity firm, and a way of estimating the size of the firm’s portfolio and capital available for further investment.

Private Equity International, an industry publication, uses this approach to compile their annual ranking of the top 300 private equity firms in the world. The 20 largest private equity firms, based on the amount of direct-investment capital raised over a five-year window, include:

Top Private Equity Firms

Top 20 Private Equity Firms

Source: PEI Media

To put things in perspective, Texas Pacific Group (TPG), ranked number one on the list, is a global private investment firm with approximately $45 billion in capital under management across a family of funds. The Carlyle Group, at number three, has more than $86.1 billion under management, with 64 funds across four investment disciplines (buyouts, growth capital, real estate and leveraged finance). Kelso & Company, at number 47 on the list, is still a behemoth, managing more then $31 billion in funds invested in over 90 target companies.

As for geographic distribution, North America still accounts for the largest percentage of private equity firms at 53 percent, followed by Europe (27 percent). Asia and the rest of the world make up the remaining 20 percent of global private equity activity and investment, according to Preqin, a leading source of information for the alternative assets industry.

Why Private Equity vs. Other Financing Options?

When you read about a large corporate buyout in The Wall Street Journal, chances are one of the giant investment banks such as Goldman Sachs, JPMorgan Chase or Citigroup were involved in the transaction. These large banks focus their efforts on these mega-deals worth billions of dollars.

However, this leaves companies in the “mid market” range of $50 to $500 million somewhat underserved and in need of capital and advisory services for improving their operations. Hence, they are a fertile ground for private equity investment.

Mid-market companies need the type of operational improvements that the performance-oriented culture of private equity can bring. In return, mid-market companies provide the upside in higher valuations that private equity firms seek for their investors.

Private equity professionals, along with their network of advisors, have the financial acumen and management expertise to take these companies to the next level. In fact, there are management strategies, attitudes and techniques that non-private-equity owned companies can’t match.

Private equity firms buy companies as “portfolio” investments, with the goal of analyzing them, fixing what’s wrong, growing them, and increasing the company’s value within 3-7 years. Private equity professionals bring a sense of urgency to their mission of improving a company. They also have a distinct way of managing that’s different from most publicly-traded and family-run businesses.

Private equity firms have what Bain & Company calls a “performance culture,” meaning managers and employees are determined to do everything possible to increase the value of the companies in which they invest.

They are also free to make difficult, unpopular, yet often necessary decisions that a public company may avoid. Investing in new equipment, cutting staff, or taking a big write-off may be what’s best for the business. But it could cause a publicly-traded stock to plummet. A private equity owned management can make those tough decisions for longer-term growth without the constant scrutiny of investment analysts, quarterly reports and the media. They do not have to contend with the same government regulations, such as Sarbanes-Oxley, as public companies.

Private equity managers align their interests with those of their portfolio company. A large portion of executive pay is tied to performance. Senior managers may be required to put a portion of their own money into the deal, as well.

Sometimes a division within a larger corporation that’s spun off into a new entity by a private equity firm finally gets the attention it needs to thrive. All too often viable businesses with growing markets are ignored by corporate management, simply because they do not fit with the “core” business of the corporation.

Private equity firms also provide an extensive network of contacts that can open doors. For example, a global private equity firm with investors in Asia may be able to connect a portfolio company to distributors there, opening up new markets.

For all these reasons, private equity owned companies are often better managed and more profitable than companies with other ownership structures. Private equity owned companies outperform comparable publicly traded companies in sales growth, cash flow, profitability and productivity. And nearly three-quarters of this productivity growth comes from more effective management, according to research from the Private Equity Council.

Private Equity Jobs – Attracting the Best and the Brightest

Private equity investing has grown considerably in the past two decades, and now represents a significant portion – 5 to 15 percent – of the portfolios of many high net worth investors and institutions.

As the industry has grown, it has attracted many of the best and brightest financial professionals into private equity jobs from investment banking, consulting and accounting to identify and manage these investments.

The results are clear: private equity professionals bring unparalleled management experience and a sense of urgency to the companies they manage. This often results in greater productivity, efficiency and profitability than the companies could achieve on their own.