Private Equity

What is Private Equity top

Private Equity (PE) is another major subset of private market investments. It is a form of financing where money, or capital, is invested into a company, typically in mature businesses, in exchange for equity, or ownership stake. In 2021, private equity buyouts totaled a record $1.1 trillion, doubling from 2020 (Source: Bain & Company. "The Private Equity Market in 2021: The Allure of Growth.")

PE firms use the capital raised from limited partners (LPs) to invest in promising private companies. Unlike VC firms, PE firms often take a majority stake—50% ownership or more—when they invest in companies.

Private equity firms usually have majority ownership of multiple companies at once. A firm's array of companies is called its portfolio, and the businesses themselves, are portfolio companies.

Private Equity is similar to Venture capital (VC) investing except VCs invest in startup companies that are early in the development stage with high growth potential. They invest far smaller amounts than buyout or growth funds (<25 m) but generally hold a larger portfolio of companies (see illustration below)

PE Firm Perspective

Leverage: Private equity investments are often financed using debt - ‘leveraging’ the transaction, hence the private equity industry is often referred to as the “leveraged buyout” industry. The practice allows for the fund to put down smaller amounts of cash, but magnify the gains if they sell at a profit. The reverse is also true and there is significant downside risk.
Value-add operations: A strong motivation to add value. Value-creation initiatives may include reorganization, cost reduction, technological improvements, or ESG frameworks, all of which will be planned out before any investment is made.
Higher risk / higher reward: Investing in private markets gives private equity firms access to companies that are untested, without the strict reporting that public companies offer. To manage this risk, firms operate large research and due diligence operations, closely examining the data rooms that potential companies make available to them.

Company Perspective

Alternative funding access: Seeking capital through private equity funding offers an alternative using loans with high interest or having to go public.
Less scrutiny: Many innovative companies operate progressive growth strategies that may be too radical for public investors. A private equity firm is more likely to accept the risks, especially in venture capital.
Less Reporting Requirements: Public companies adhere to tight reporting regulations, while private companies don’t have the same requirements. By accessing capital through private equity companies can pursue more innovative growth strategies.

PE funds vs. hedge funds top

Both private equity funds and hedge funds are restricted to accredited investors. However, the biggest differences between PE funds and hedge funds are fund structure and investment targets.

Hedge funds tend to operate in the public markets, investing in publicly-traded companies while PE funds focus on private companies.

PE funds vs. mutual funds
The biggest differences between PE funds and mutual funds are where capital comes from, the types of companies the fund invests in, and how the firm collects fees.

PE funds raise capital from LPs, which are accredited, institutional investors, and mutual funds leverage capital from everyday investors.

PE funds typically invest in private companies whereas mutual funds typically invest in publicly-traded companies.

And mutual funds are only allowed to collect management fees, whereas PE funds can collect performance fees.

Investor Drawbacks top

Higher Fees The General Partner is usually heavily involved with both the strategic goals of the company and its day-to-day operations. Hence, fees tend to be higher than those for a managed portfolio of public equity.

The most common structure in private equity is “2 and 20”, where the General Partner receives a 2% annual fee, as well as 20% ‘carry’ of profits above a predefined performance threshold. Many funds operate other structures, with lower fees to incentivize investment, or higher carry to ensure the General Partner is motivated to increase the value of the company - commonly referred to as “skin in the game”.

Low liquidity Limited Partner stakes are subject to a ‘lock-up period’, during which the General Partner will use the committed capital to make the strategic changes to target companies within the portfolio. This means that investors cannot liquidate their position until the end of the fund’s term, usually ten years with optional extensions. Because of its highly illiquid nature, investors receive a liquidity premium in return. If investors want to liquidate their positions before the end of the fund’s term, secondary markets may provide a solution (see below).

High minimums Traditionally, an investor must put forward a relatively larger amount of capital to become a Limited Partner of a fund when compared to traditional public market vehicles. Depending on the fund, investment minimums are usually in the tens of millions, though a minority of funds require ‘only’ minimums in the hundreds of thousands.

Delayed cash flows Private equity investors commit capital at the opening of the fund and the General Partner calls this capital periodically as investments are made, but Limited Partners cannot expect to receive cash flows in return until late in the fund’s life.

Investor Risks top

There are, broadly, five key risks to private equity investing:

1. Operational Risk The risk of loss resulting from inadequate processes and systems supporting the organization.

2. Funding Risk This is the risk that investors are not able to provide their capital commitments and is effectively the ‘investor default risk’. PE funds typically do not call upon all the committed investor capital and only draw capital once they have identified investments. Funding risk is closely related to liquidity risk, as when investors are faced with a funding shortfall they may be forced to sell illiquid assets to meet their commitments.

3. Liquidity Risk This refers to an investor's inability to redeem their investment at any given time. PE investors are ‘locked-in’ for between five and ten years, or more, and are unable to redeem their committed capital on request during that period. Additionally, given the lack of an active market for the underlying investments, it is difficult to estimate when the investment can be realized and at what valuation.

4. Market RiskThere are many forms of market risk affecting PE investments, such as broad equity market exposure, geographical/sector exposure, foreign exchange, commodity prices, and interest rates. Unlike in public markets where prices fluctuate constantly and are marked-to-market, PE investments are subject to infrequent valuations and are typically valued quarterly and with some element of subjectivity inherent in the assessment. However, the market prices of publicly listed equities at the time of sale of a portfolio company will ultimately impact realization value.

5. Capital risk The capital at risk is equal to the net asset value of the unrealized portfolio plus the future undrawn commitments. Capital risk is the possibility of having a realized loss of the original capital at the end of a fund's life. This can be due to the fund manager's selection of portfolios and the timing of the exit.

Return Profile - The 'J-Curve' top

The LP in a PE fund will commit capital to a fund at the start of its life, then start paying capital into the fund as cash.

At this point, the return on investment return drops below zero. It is not until the fund begins exiting investments during the harvesting period (which could be many years later) that the fund will start to return cash in the form of distributions. If the investments are successful then the return could be substantial. Once the harvesting period slows and all distributions are made, the return levels out as the fund’s life end.

The shape of the return profile experienced by the investor is known as the “J-Curve” (see illustration below).