Private equity


Private equity is stock in a private company that does not offer stock to the general public. Instead, it is offered to specialized investment funds and limited partnerships that take an active role in managing and structuring the companies. In colloquial usage, "private equity" can refer to these investment firms rather than the companies in which they invest.
Private-equity capital is invested into a target company either by an investment management company, a venture capital fund, or an angel investor; each category of investor has specific financial goals, management preferences, and investment strategies for profiting from their investments. Private equity can provide working capital to finance a target company's expansion, including the development of new products and services, operational restructuring, management changes, and shifts in ownership and control.
As a financial product, a private-equity fund is private capital for financing a long-term investment strategy in an illiquid business enterprise. Private equity fund investing has been described by the financial press as the superficial rebranding of investment management companies who specialized in the leveraged buyout of financially weak companies.
Evaluations of the returns of private equity are mixed: some find that it outperforms public equity, but others find otherwise.

Key features

Some key features of private equity investment include:
  • An investment manager raises money from institutional investors to pursue a particular investment strategy.
  • * The fund's raised proceeds are placed into an investment fund, of which the investment manager acts as a general partner and the institutional investors act as limited partners.
  • The investment manager then purchases equity ownership stakes in companies by using a combination of equity and debt financing, with the goal of generating returns on the equity invested, including any subsequent equity investments into the target companies, over a target horizon based on the particular investment fund and strategy.
  • From a financial modeling perspective, the primary levers available to private equity investors to drive returns are:
  • * Revenue growth
  • * Margin expansion
  • * Free cash flow generation / debt paydown
  • * Valuation multiple expansion
  • Value creation strategies can vary widely by private equity fund. For example, some investors may target increasing sales in new or existing markets, and others may look to reduce costs through headcount reduction. Many strategies incorporate some amount of corporate governance restructuring, for example, setting up a board of directors or updating the target's managerial reporting structure.
  • The use of debt financing in acquiring companies increases an investment's return on equity by reducing the amount of initial equity required to purchase the target. Moreover, the interest payments are tax-deductible, so the debt financing reduces corporate taxes and thus increases total after-tax cash flows generated by the business.
  • * Following a series of high-profile bankruptcies, aggressive leverage usage by private equity funds has declined in recent decades. In 2005, approximately 70% of the average private equity acquisition represented debt, but it was closer to 50% in 2020.
  • * Firms that assume large operational risks will usually apply far lower leverage levels to acquired companies in order to provide management with more financial flexibility; firms taking fewer operational risks will often try to maximize available leverage and focus on investments that generate strong, stable cash flows needed to service the higher debt balances.
  • Over time, "private equity" has come to refer to many different investment strategies, including leveraged buyout, distressed securities, venture capital, growth capital, and mezzanine capital. One of the most noteworthy differences between leveraged buyouts and the other strategies is that buyouts are generally "control equity positions", as buyout funds usually purchase majority ownership stakes in their target companies, while other investment strategies typically purchase minority ownership stakes, reducing their ability to effect transformational changes across target companies.
  • For large deals, private-equity investors often invest together in a syndicate, in order to jointly benefit from exposure diversification, complementary investor information and skills, and heightened connectivity for future investments.

    Strategies

The strategies private-equity firms may use are as follows, leveraged buyout being the most common.

Leveraged buyout

Leveraged buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit, or business asset is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically mature and generate operating cash flows.
Private-equity firms view target companies as either Platform companies, which have sufficient scale and a successful business model to act as a stand-alone entity, or as add-on / tuck-in / bolt-on acquisitions, which would include companies with insufficient scale or other deficits.
Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt, which looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim on other investments managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage, but limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits an LBO's financial sponsor in two ways: the investor only needs to provide a fraction of the capital for the acquisition, and the returns to the investor will be enhanced, as long as the return on assets exceeds the cost of the debt.
As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according to the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit and the interest costs and the ability of the company to cover those costs. Historically the debt portion of a LBO will range from 60 to 90% of the purchase price. Between 2000 and 2005, debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.

Simple example of leveraged buyout

A private-equity fund, ABC Capital II, borrows $9bn from a bank. To this, it adds $2bn of equity – money from its own partners and from limited partners. With this $11bn, it buys all the shares of an underperforming company, XYZ Industrial. It replaces the senior management in XYZ Industrial, with others who set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the valuation of the company for an early sale.
The stock market is experiencing a bull market, and XYZ Industrial is sold two years after the buy-out for $13bn, yielding a profit of $2bn. The original loan can now be paid off with interest of, say, $0.5bn. The remaining profit of $1.5bn is shared among the partners. Taxation of such gains is at the capital gains tax rates, which in the United States are lower than ordinary income tax rates.
Note that part of that profit results from turning the company around, and part results from the general increase in share prices in a buoyant stock market, the latter often being the greater component.
Notes:
  • The lenders can insure against default by syndicating the loan to spread the risk, or by buying credit default swaps or selling collateralised debt obligations from/to other institutions.
  • Often the loan/equity is not paid off after the sale, but left on the books of the company for it to pay off over time. This can be advantageous since the interest is largely off-settable against the profits of the company, thus reducing, or even eliminating, tax.
  • Most buyout deals are much smaller; the global average purchase in 2013 was $89m, for example.
  • The target company does not have to be floated on the stock market; most buyout exits after 2000 are not IPOs.
  • Buy-out operations can go wrong and in such cases, the loss is increased by leverage, just as the profit is if all goes well.

    Growth capital

refers to equity investments, most often minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.
Companies that seek growth capital will often do so in order to finance a transformational event in their life cycle. These companies are likely to be more mature than venture capital-funded companies, able to generate revenue and operating profits, but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Because of this lack of scale, these companies generally can find few alternative conduits to secure capital for growth, so access to growth equity can be critical to pursue necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product development.
The primary owner of the company may not be willing to take the financial risk alone. By selling part of the company to private equity, the owner can take out some value and share the risk of growth with partners. Capital can also be used to effect a restructuring of a company's balance sheet, particularly to reduce the amount of leverage the company has on its balance sheet.
A private investment in public equity, refer to a form of growth capital investment made into a publicly traded company. PIPE investments are typically made in the form of a convertible or preferred security that is unregistered for a certain period of time.
The Registered Direct is another common financing vehicle used for growth capital. A registered direct is similar to a PIPE, but is instead sold as a registered security.