What is Private Equity?

Private Equity Tutorials

What is Private Equity? – Lyft raised an additional $600 million Series G Private Equity funding that valued the firm at $7.5 billion, a steep increase from $5.5 billion funding round last year. Being an entrepreneur myself, I love such growth and funding stories.

Private Equity can be broadly defined as private funding in an unlisted growing company by assuming higher risks and hoping for substantial returns. If you enjoy meeting people, love valuations, conducting due diligence and managing the portfolio for people, then Private Equity is for you!

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

What is Private Equity?
Structure of Private Equity
Fees of Private Equity
Deal Structuring in Private Equity
Current Trends in PE Industry
Who is a Private Equity Analyst?
Private equity analyst Skills
Typical working day of a private equity analyst?
Successful Private Equity Firms of World
Performance Measures of Private Equity Firms
Private Equity – Future?

Private equity is a finance which is provided for medium to long term period to companies who have high growth potential. These companies are those companies which are not listed companies on any exchange.

This investment is done in exchange of a certain percentage of equity of the investee. 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.

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.

History of PE

Private equities came into existence through leverage buy-outs in late 1970’s. This happened due to Michael Milken and others who created LBOs for using it as leverage. They used to leverage a company with equity capital & debt capital so as to buy them. PE firms today are nothing but what LBOs were in past.

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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 this investor 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 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.

Fees of Private Equity

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

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 than 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 General Partner. This too is a certain percentage of the profits made. For example, 20% of the total profit made. Most of the times 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%

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 term sheet. Most of the times, the funding will have an anti-dilution provision. It protects an investor from equity dilution resulting from later issues of stock at a lower price than the investor originally paid.

Deal structuring can be done by way of

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.
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.
Debt financing with an Equity Kicker– Debt financing with an equity 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.
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.
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 “shell company”. A shell company is defined as a public company who 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.
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 original investment plus accrued investments. This cash is given if the company is sold or liquidated. The second element 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 seniority of rounds.
Multiple Liquidation Preference – In this arrangement preferred stock holders 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 permits the investor to convert to common stock if the company performs well and is able to generate a higher return.
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 investee so as make the stocks or bonds more attractive to potential investors.
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.
Full Ratchets – Full Ratchets is a mechanism to 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 increase in number of shares of previous investors

Current Trends in PE Industry

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 consistent and strong fund raised over the years by them.

Annual global PE fundraising 1996-2016

source: valuewalk.com

PE industry is cyclical industry and fundraising trends as seen above proves 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.

Who is a Private Equity Analyst?

Private Equity analysts keep an active tab on the current business environment and simultaneously work on many aspects –

Raising capital is primarily done by the senior General Partners partners
A private equity firm generally has 3-4 key markets where they invest into. Private Equity Analysts pr0-actively follows the industry to identifies opportunities
PE Analysts discusses with companies on their business model, growth, focus areas, opportunities and create a pipeline for deal flow. With this, they conduct detailed ratio analysis, Financial modeling and valuation analysis.
Selection of Investment Companies is done in discussion with the senior partners of the Private Equity firm
Once the decision of Investments in taken, analysts do the deal structuring, due diligence, negotiation and provide finance to the company.
Additionally, Private Equity Analyst continuously nurtures the company by conducting periodic review meetings with the management on the company’s strategy and growth and provide them with their valuable feedback.
Once the company grows in 4 to 6 years, analyst job is to identify potential plan to exit from the company thereby providing returns to the Limited Partners.

Private equity analyst Skills

Strong industry Knowledge – Private Equity analysts job is to keep an active check on the market. They should understand the business nuances of the sector, business models and should be up to date with the latest changes in the business environments.
Analytical Skills – This is the core of Private Equity Analyst. They should be masters of Ratio Analysis, Financial modeling, and valuations. Additionally, they should be able to details research on the company along with sensitivity analysis to the change sin the assumptions.
People Skills – Private Equity Analysts interact a lot with the business managers to understand their business and evaluate deals. An analyst must possess excellent spoken and writing skills, leadership skills, negotiation skills etc to get the work done.
Valuation Skills – This is the core skillset private equity analysts are expected to possess. Companies from different sectors are valued differently and analysts are expected to master this art.
Other additional Skills – Along with the above skills, Private Equity Analysts are expected to master Excel and Powerpoint.

Typical working day of a private equity analyst?

If you compare working hours of a Private Equity Analyst with Investment Banking, you will find that Private Equity is a much more enjoyable place!

Typically, the day may start at around 9:00 am and end at around 7 pm – 9 pm. In most cases, weekends will be off, however, in the case of urgent deals you may be called over the weekend.

Below infographics provides you with how a private equity associate would spend his day.

Successful Private Equity Firms of World

Below is the table of 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	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 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

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.

Below table provides us with the types of Private Equty Investments along with its IRR Return Expectations.

Private Equity – Future?

Performance in the past does not guarantee similar success in 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. Globalization of PE firms shall continue in future. PE faces 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 government & increased scrutiny.

PE would now need to manage their relationship with investors with utmost care. An investor that is the LPs are not immune from the general downturn. So when recession happened in the US they too suffered. GPs need to be flexible enough to give them better terms when they are experiencing difficulties which are short-term.

Apart from this PE needs to find new ways to invest. As the size of the industry grows, it would be challenging to deploy committed capital. So the PE funds need to find new investing opportunities.

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.

Comments

Raghavan Sivadasan says

Excellent . I propose to advise my grandson to get the USD 99 Investment Banking training module next year when he completes his Engineering degree .

- Dheeraj Vaidya says
  
  thanks! 🙂
  
MANOJ KUMAR says

Its always awesome to read your blogs sir and thank you very much for providing such a valuable knowledge in a very simplified understandable language.

- Dheeraj Vaidya says
  
  thanks Manoj for your kind words!

What is Private Equity?