What is Private Equity?

What is Private Equity?

Private equity is a type of investment that is provided for a medium to long term period to companies who have high growth potential in exchange for a certain percentage of equity of the investee. These high growth firms are not listed companies on any exchange.

• Sometimes this type of investment is done to gain major or complete control of the company in anticipation of higher returns. Apart from making investments in private companies at times, PE investors buy out public companies resulting in their delisting.
• As an example, you may note from above, Lyft raised an additional $600 million Series G Private Equity funding that valued the firm at $7.5 billion, a steep increase from the $5.5 billion funding round last year. Being an entrepreneur myself, I love such growth and funding stories.

With this article, I aim to provide you with deeper insights on what is a private equity, its structure, fees, how it is like working as a private equity analyst, top private equity firms, and more.

Structure of Private Equity

Private equity funds are mostly structured as closed-end investment vehicles. Private is started as a limited partnership by a fund manager or general partner. The fund manager sets forth the rules and regulations governing the fund. General Partner contributes around 1% to 3% of the total fund investment size. The remaining investment is made by Investors such as universities, pension funds, families, and other investors. Each of these investors is a Limited Partner in the fund. So the liability of a limited partner is proportional to its capital contribution. Some private equity firms also have institutional sponsors or are captive units or spin-offs of other companies.

Limited partners make an agreed commitment for a specified time that is an investment period, which can be four to six years. Once a portfolio investment is realized, that is, the underlying company is sold either to a financial buyer or to a strategic investor or it has gone public via an IPO – the fund distributes proceeds back to limited partners.

Read more – Limited Partners vs. General Partners in Private equity

Fees of Private Equity

Just like hedge funds, Private equity fund charges, Management fees & Performance fees.

• Management Fee – This is a fee that is regularly paid by limited partners. It is calculated as a certain percentage of total AUM.  For example, if AUM is 500bn, then a 2% management fee would be $10bn. The need for this fee is for covering the administrative & operational expenses of the fund, such as salaries, deal fees paid to investment banks, consultants, travel expenses, etc.
• Performance fee – This is a share of net profit that is allocated to the General Partner. This, too, is a certain percentage of the profits made. For example, 20% of the total profit made. Most of the time, a general partner is able to earn it after the hurdle rate is achieved. For example, the limited partners may ask that the performance fees only gets paid if the return is over 10% p.a. So performance fee would be received by general partners after earning that 10%

Investors in PE

PE fund uses the money invested by Pension Funds, Labor Unions, Insurance companies, Universities Endowments, large wealthy families or Individuals, Foundations, etc. Public and private pension funds, university endowments, and foundations in the fund.

Deal Structuring in Private Equity

Private equity would fund a company in different ways. Common stock and convertible preferred stock are two basic ways in which a company is invested. The deal is structured after negotiations with the investee and laid down in a term sheet. Most of the time, the funding will have an anti-dilution provision. It protects an investor from stock dilution resulting from later issues of stock at a lower price than the investor originally paid.

Deal structuring can be done by way of

1. A Common Stock– The investee and investor agree on a certain amount that would be given as funds and the percentage of stock the investor will receive.
2. Preferred Stock– Private Equity firms are always keen to use Preferred Stock structures the most for funding in a Company. This investment in Preferred Stock can be converted to Common Stock at the option of the holder.
3. Debt financing with an Equity Kicker– Debt financing with an equity kicker can be used by investees who are already operational and also profitable or have reached Break-even. For example, If an Investee needs $100,000 to get him over the hurdle and make his company profitable. The investee can structure the $100,000 in a loan such that the loan would be for say 3 to 5 years, and then it would give the investor 10% of his company in common stock. The number of shares and percentage is based on the size of the loan and the value of the company.
4. Convertible Debt – If funding is done through convertible debt, then Investor has the option to convert it at their option into Common Stock of the company. Usually, Investors would exercise their right to convert when the investee goes public so that they can earn handsome returns on their investments.
5. Reverse Mergers – When an existing private company is merged into an already existing public company with a trading symbol, a reverse merger is said to happen. The public company is usually known as a “shell company.” A shell corporation is defined as a public company that is no longer operating a business but has a trade symbol and is in existence. The business of that public entity obviously has failed, and that company is out of business, but the public entity or shell still exists. This is the key factor in the Reverse Merger.
6. Participating Preferred Stock – Participating preferred stock is made up of two elements — preferred stock and common stock. Preferred stock gives a right to the owner to receive a certain sum of cash that is usually predetermined. This sum of money comprises of the original investment plus accrued investments. This cash is given if the company is sold or liquidated. The second element of common stock is the additional continued ownership in the company. Just like preferred stock, even participating preferred stock can be converted to equity without causing the participating feature to be activated when the company makes an initial public offering (IPO). Participation can either be equal, or it would be based on the seniority of rounds.
7. Multiple Liquidation Preference – In this arrangement, preferred stockholders of a specific round of financing get the right to receive a multiple of their original investment when the company is sold or liquidated. This multiple can be 2x, 3x, or even 6x. Multiple liquidation preferences permit the investor to convert to common stock if the company performs well and is able to generate a higher return.
8. Warrants – Warranties are derivative securities that give the holder the right to purchase shares of a company. The purchase is made at a pre-determined price. Generally, warrants would be issued by investees so as make the stocks or bonds more attractive to potential investors.
9. Options- Options gives the investor a right to purchase or sell shares of stock at a specific price within a specific period of time. The most commonly used are stock purchase options.
10. Full Ratchets – Full Ratchets is a mechanism of protecting investors for future down rounds. So a full ratchet provision would state that if a company in future issues stock which is at a lower price per share than existing preferred stock, in that scenario, the conversion price of the existing preferred stock would be adjusted downward to the new, lower price. This results in an increase in the number of shares of previous investors.

Read More: Term sheet in Private Equity.

Overview of Private Equity Trends

This industry saw tremendous growth post-1970s. As of now, the total asset under management of all PE funds together is USD 2.5 trillion  (src: www.preqin.com). This growth has been due to the consistent and strong fundraised over the years by them.

Annual global PE fundraising 1996-2016

source: valuewalk.com

PE industry is a cyclical industry, and fundraising trends, as seen above, prove that. Fundraising was also indirectly impacted by credit cycles in debt markets on entry and exit multiples.

Over the years, this industry has undergone consolidation, and hence the number of funds has fallen from 1,666 funds in 2000 to 594 in 2015. Over the years, apart from traditional investors such as family offices and university endowments, PE fund has also been able to attract non-traditional investors such as sovereign wealth funds.

Successful Private Equity Firms of World

Below is the table of a few successful PE funds which survived the 2008 recession and have performed well since inception.

Name of PE	Founded by	Founding Year	AUM	Remarks
Apollo Global Management	Leon Black	1990	$169 bn	LBOs & Distressed securities
Blackstone Group LP	Peter George Peterson Stephen A. Schwarzman	1985	$310 bn	A broad range of Market Sectors
Carlyle Group	William E. Conway, Jr. Daniel A. D’Aniello David M. Rubenstein	1987	$158 bn	Operates from 30 offices across the world
KKR	Jerome Kohlberg Jr., Henry R. Kravis, and George R. Roberts	1976	$98 bn	First to use LBO
Ares Management LP	Antony Ressler	1997	$99 bn	Acquisitions
Oaktree Capital Management LP	Howard Marks & Bruce Karsh	1955	$97 bn	High yield & distressed debt situations
Fortress Investment Group LLC	Wesley R Edens & Randal A. Nardone	1998	$ 69.6 bn	Key investments – RailAmerica, Brookdale Senior Living, Penn National Gaming, and Newcastle Investment Corporation
Bain Capital LLC	Bill Bain & Mitt Romney	1984	$ 75 bn	acquisitions include such well-known companies as Burger King, Hospital Corporation of America, Staples, the Weather Channel, and AMC Theatres
TPG Capital LP	David Bonderman, James Coutler & William S. Price III	1992	$70 bn	Focused on LBOs, Growth capital & leveraged recapitalization
Warburg Pincus	Eric M Warburg Lionel Pincus	1966	$ 40 bn	Raised 15 private equity funds which have invested $58 billion in over 760 companies in 40 countries

Read More – Top Private Equity Firms

Performance Measures of Private Equity Firms

It is not easy to measure illiquid investments like Private Equity Investments as compared to measuring the performance of the traditional asset classes.

As such, the Internal Rate of Return (IRR) and investments multiples are the two measures that are used to assess the performance of private equity investments.

The below table provides us with the types of Private Equity Investments along with its IRR Return Expectations.

Conclusion

Performance in the past does not guarantee similar success in the future. The PE industry has come a long way since the 1970s. The industry has now spread across the globe to Europe and emerging markets. The globalization of PE firms shall continue in the future. PE faces a threat from direct investing done by Institutional investors than co-investing with PE firms.

As the industry will grow, it will face more regulations from the government & increased scrutiny.

Emerging markets have been the recent attraction of PE funds, but they still need to be careful about immature regulatory and legal systems apart from not so transparent policies. Other attractive investing destinations include Financial institutions, Public equity, etc.

Recommended Articles

This article has been a guide to What is Private Equity. Here we discuss the structure of Private Equity Firms, Deal structuring in Private Equity, Fees, and Performance Measures. You may have a look at the following articles to learn more about Private Equity –

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