The Private Equity Industry

I can barely remember when exactly I first encountered with the term “Private Equity”, however I can clearly trace that I heard it from “The David Rubenstein Show: Peer to Peer Conversations” on Bloomberg TV. Private Equity is the highest calling of human kind”, that is what the founder of The Carlyle Group, David Rubenstein said in a number of interviews he held with notable Industry names during the episodes. Despite being familiar with the Investment Banking terms and their respective application, I must admit I was not quite familiar with the world of Private Equity or how it works.

A quick research on google on what the firms in PE Industry have done and how they do it, I stumbled a little gem “Vault Guide to Private Equity. 2008 edition”, which gives you a basic broad introduction about the Industry. This was my first read on the history and application of PE, from which I have grown to be a disciple of the discipline following closely through various reports from credible sources such as Preqin, Pitchbook, McKinsey, Bain & Company and so many more. You can call it an epiphany or what, but I knew then working in the PE Industry is what I want to do in my life.

About two years ago I restructured my life and started devoting any ample time I had in increments towards studying the Industry whether through the reports, thought leaders interviews or even books. In the process, my curiousity developed into an obsession, as I am an avid watcher Bloomberg Money Undercover, Bloomberg Technology, Bloomberg Markets and sometimes even CNBC’S Mad Money as I have found them useful in advancing my knowledge on some of the issues, deals and activities of this Industry.

It is not an easy task to maintain the discipline of catching up on the trends and daily updates on acquistions, mergers, takeovers, rounds of financing and so much more, however the progress I have noticed in understanding the reports and shows keep me motivated. When am watching or listening one of the shows or reading one of the reports, I feel so alive and fulfilled and want to learn more each day, as the Industry is constantly evolving in respect to time and technology. So, given the insights learnt on the subject, might as well as try to explain in basic language about the Industry.

So what is Private Equity?

Private Equity is an alternative investment class that comprises of capital that is not listed on the public market. The PE Industry stems from the buy side of Investment, whereas firms acquire companies, and run them for a period span of four (4) to ten years(10), and then either exit via Initial Public Offering (IPO) or sell them to another corporate or PE Fund.

Recently the PE Industry has been strong, due to the amount of dry powder, they have amassed over the years and the number of companies wishing to stay private rather than going public to be traded on the stock market is much higher than before. Also, firms have found it more lucrative to remain in the investment for much longer (more than 4 years, not exceeding 10 years though), before exiting and closing the fund.

Big names such as The Carlyle Group, Blackstone, CVC have in the past years launch funds that acquire companies and hold them for 15 years or longer.

When companies choose the Private Equity, they avoid major public scrutiny on their financials, mainly because they are not obligated to disclose them to the public in the first place. Going private, has helped companies focus on creating and maintaining long term value, it also rids them off pressure from short term activists investors whom place importance on short term returns and good financials every quarter.

How do Private Equity Firms earn money?

Fees and Carried Interest!

PE firms generate revenue through charging fees from transactions deals they close. Normally most fees charge 1% of the amount the deal was closed for. They earn money through monitoring fees they charge portfolio companies for consulting and advisory services offered, during their investment.

PE firms also charge investors, who choose to put money into their funds, Management Fees. Normally, the investors often referred to as Limited Partners (LPs) pay 2% of committed capital, as an honor and prestige to invest with the respective PE Firm. The fees are used to fund daily operations of the firm.

Upon performance, these firms get to enjoy the performance fee which is based on the generated profits returns from a particular investment. These fees normally go up to 20% of profits generated from a particular fund.

Most PE firms acquire most of their revenue from capital gains generated by funds. Firm earn profits from their investments through either taking the company public through an IPO, or sell it to another PE firm, or let the company be acquired by another corporate. Firms are also eligible to a 20% interest, upon realizing a pre determined rate of return.

How does it work?

In simple logic, Private Equity collect money from bonafide investors and pool it together under a particular fund, with which they invest in various sectors or Industries. Investors considered to finance these funds include Institutional Investors such as pension funds, insurance companies and university endowments. PE firms also consider money from high networth individuals and high income earners.

The investors are often reffered to as Limited Partners (LPs) in the established fund and the private equity firm managing the fund is referred to as General Partner (GP). LPs are held liable upto the amount they have put (amount invested) in the fund, while the General Partner is fully liable to any debts or profits made by the fund.

Putting money in a Private Equity fund does not give room for easy liquid as compared to other investments, because there are restrictions imposed on withdrawal and also the money remains tied up in the fund for not less than three (3) years before return is realized on it.

The lifetime of any PE fund is normally to a maximum of ten (10) years. During that time, the firm organizes and forms a fund, then enters a period of raising funds (which can take from 1.5-2 years), then sourcing and investing in a deal, to managing portfolio of the assets under the fund, and then finally exiting via IPO or selling to a corporate or other PE fund.

Big PE names include The Carlyle Group, KKR & Co. Inc, The Blackstone Group Inc, Bain Capital LP, Vista Equity and so many more. These firms own mulitple funds directed in acquiring companies, work on them and sell them later at a profit. Over time, finds have been raised to be invested in various aspects such as Real Assets, Global Credit, Investment Solutions and so many more. Investments. PE manages to execute all this due to the talent they have possessing Industry expertise amassed from sectors including Healthcare, Technology, Financial Services, Consumer, Manufacturing & Industrials, Media, Retail, Aerospace and so many more.

Private Equity type of investment, might be Venture Capital, Leveraged Buy Out (LBO), Distressed Debt, Mezannine Financing, Growth Capital, Real Estate, Fund of Funds.

Venture Capital

This subset of Private Equity is common and well-known. Under this, the investors known as “Venture Capitalists”. The investors put money in these companies (startups and early stage companies), in exchange of a minor equity stake. Most of these companies are not matured yet, some do not even have any profitability record, however show promising high growth in the future.

Large Venture Capital companies include;

  • Sequioa Capital (known for its investments in Apple, Google, Paypal, LinkedIn, Oracle, Yahoo, Instagram, Whatsapp, Github etc),
  • Founders Fund (invested in Airbnb, Spotify, Lyft, Stripe in their early stages),
  • also Bessemer Venture Partners (which is famous for its early investments in Pinterest, Mindbody, LinkedIn, Skype, Shopify, Yelp)
  • Other known names include Access, GGV Capital, Index Ventures and so many other more.

Distressed Debt

Private Equity employ this style of investing, when lending or putting money in a company that is in financial shumbles. When a company is facing financial difficulties, it is referred to as a “distressed”, where as the PE firm involved can buy its shares or debt at a low cost, help turn it around, to return it to it’s financial health, and exit either by selling it or taking it public.

PE firms can decide to either buy cheap debts trading at discounts, hold it till price rises and sell it to the highest bidder. Some firms buy debt to gain authority over the restructuring, or rather buy the fulcrum security so as to gain stake of controlling the company once restructuring is done. In some cases, the firms acquire equity of a distressed company, and attempt to turn it around to avoid bankruptcy.

Firms who are on a forefront of distressed debt investment include Oaktree Capital Management, Apollo, Cerberus, Fortress, Brookfield, Bain Capital, and so many other more.

Mezzanine Financing

Under this investment style, the private equity firm finances the acquired firm with both debt and equity, where as the company is required to pay the debt lendered on the agreed time, for which, upon failure the lender can convert the debt into equity stake of ownership.

Growth Capital

This strategy might seem similar to that of Venture Capital, however companies targeted under this, are one s which are mature, have a history of being profitable and have a clear strategy to expand its operations, enter new markets or even acquire another company to add to a platform company, they already own.

Real Estate

Some firms pool together capital to create a fund that invests in ownership of real estate properties. Some funds invest in low risk properties that generate low returns despite the stable cash flows, others invest in properties that require flipping and adding more value, so as it can be lucrative when they sell it at a profit to another prospect. And in some cases, PE firms go in with large Real Estate Developers to errect new commercial and residential properties or enhance a raw land into an amusement parks or another attractive hotspots that will generate returns and stable cash flows.

Fund of Funds

This is an investment strategy, whereas a PE firm puts money in a portfolio of assets of another PE fund. Investors of this fund of fund enjoys diversification and high returns, in exchange of additional fees charged on top of those management and performance fee, charged prior, hence making this strategy costly and only affordable by the elite.

Leveraged Buyouts (LBO)

I personally refer to LBO, as a stubborn child of Private Equity, the one that in the past years, has smeared the good name of this investment class, making it appear to be rude.

Under this strategy, PE firms combine investor funds and borrowed capital (primarily from large banks), which allows them to acquire large companies that would be tough to acquire with own capital. The debt is then dumped on the balance sheet of the acquired company for which it will likely continue servicing it throughout its’ lifetime using the steady cash flows. The assets of the acquired company serve as collateral against the loan.

An LBO transaction is complicated, as it has a high degree leverage due to the large amount of debt used to finance the acquisition. The PE firm can then earn return from selling parts/subsidiaries of the company or pay off the debt with steady cashflows an exit at a profit.

The use of LBO has been considered brutal and ruthless because a PE only puts in less than 30% to finance the transaction, while the rest of the weight is carried by debt to finance the transaction. This gives PE an advantage, as they get in, acquiring a company at a minimum costs and operate it to get maximum returns for their LPs. To turn in returns for their investors, firms strap these high servicing debt obligations to an acquired company forcing a cost cutting strategy, which in some cases has led to lay off of employees, so as the firm can manage to service the debt, at the same time generate returns for the PE arm that funds it.

Critics have been sure to point out well known cases such as Toys “R” Us, whose debt grew from $1.86 billion to over $5 billion after being acquired by Bain Capital, KKR and Vornado. The hero cape that these three musketeers dawned did not serve the flagship toy store, instead Toys “R” Us was liquidated, stores closed, and employees being laid off. The store’s real estate has since been put up for sale, in order to earn money to pay off its creditors

Private Equity is by no means perfect, however it is an alternative investment class offering returns to those investors who wishes and are willing to put their money in the funds created by these reputable firms. It has provided millions of jobs across the world and offered capital to good companies in times where there were seeking a turnaround or growth. It has fostered software, technology, bio-pharma, consumer, media, transport, energy and even financial companies that are at a core of human activities on a daily basis.

The PE firms now possess a high amount of dry powder (univested cash) that has attributed to high company valuations. As a result, most firms seeking expansion and growth choose the route to remain private through private equity, rather than going public through an IPO. The PE way is calmer, with less scrutiny but strong emphasis and focus on attaining long term returns, at a cost of course. Because at the end, no one wants to loose their money invested.