What it is: Private equity is a general term used to describe all kinds of funds that pool money from a bunch of investors in order to amass millions or even billions of dollars that are then used to acquire stakes in companies. Technically, venture capital is private equity. Think manufacturing, service businesses and franchise companies. How it works: Sometimes a private equity firm will buy out a company outright. Maybe the founder will stay on to run the business -- but maybe not.
Similar to a mutual fund or hedge funda private equity fund is a pooled investment vehicle where the adviser pools together the money invested in the fund by all the investors and uses that money to make investments on behalf of the fund. Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. In addition, GPs are only allowed to allocate a specific amount of money from the fund into each deal it finances. In a leveraged buyout LBOan investor purchases a controlling stake in a company using a combination of equity and a significant amount of debt, which must eventually be repaid by the company. Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast. Public pensions are a major source of capital for private equity funds. This fee covers Private equity funds basics fund's operational and administrative Private equity funds basics such as salaries, deal fees—basically anything needed to run the fund.
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The huge sums that private equity firms make on their investments evoke admiration and envy.
- What it is: Private equity is a general term used to describe all kinds of funds that pool money from a bunch of investors in order to amass millions or even billions of dollars that are then used to acquire stakes in companies.
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- Although the history of modern private equity investments goes back to the beginning of the last century, they didn't really gain prominence until the s.
The huge sums that private equity firms make on their investments evoke admiration and envy. Once that gain has been realized, private equity firms sell for a maximum return. A corporate acquirer, in contrast, will dilute its return by hanging on to the business after the growth in value tapers off. Public companies that compete in this space can offer investors better returns than private equity firms do.
Both options present public companies with challenges, including U. Private equity. The very term continues to evoke admiration, envy, and—in the hearts of many public company CEOs—fear. In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever larger acquisition targets. Public companies—which invariably acquire businesses with the intention of holding on to them and integrating them into their operations—can profitably learn or borrow from this buy-to-sell approach.
To do so, they first need to understand just how private equity firms employ it so effectively. However, as private equity firms have shown, the strategy is ideally suited when, in order to realize a onetime, short- to medium-term value-creation opportunity, buyers must take outright ownership and control.
In those cases, once the changes necessary to achieve the uplift in value have been made—usually over a period of two to six years—it makes sense for the owner to sell the business and move on to new opportunities.
Private equity firms raise funds from institutions and wealthy individuals and then invest that money in buying and selling businesses. A fund management contract may limit, for example, the size of any single business investment. Typically, private equity firms ask the CEO and other top operating managers of a business in their portfolios to personally invest in it as a way to ensure their commitment and motivation. In return, the operating managers may receive large rewards linked to profits when the business is sold.
In accordance with this model, operating managers in portfolio businesses usually have greater autonomy than unit managers in a public company. With large buyouts, private equity funds typically charge investors a fee of about 1. To ensure they can pay financing costs, they look for stable cash flows, limited capital investment requirements, at least modest future growth, and, above all, the opportunity to enhance performance in the short to medium term. Private equity firms and the funds they manage are typically structured as private partnerships.
The benefits of buying to sell in such situations are plain—though, again, often overlooked. For the public company, holding on to the business once the value-creating changes have been made dilutes the final return. In the early years of the current buyout boom, private equity firms prospered mainly by acquiring the noncore business units of large public companies.
Under their previous owners, those businesses had often suffered from neglect, unsuitable performance targets, or other constraints.
Even if well managed, such businesses may have lacked an independent track record because the parent company had integrated their operations with those of other units, making the businesses hard to value.
In public companies, easily realized improvements in performance often have already been achieved through better corporate governance or the activism of hedge funds. For example, a hedge fund with a significant stake in a public company can, without having to buy the company outright, pressure the board into making valuable changes such as selling unnecessary assets or spinning off a noncore unit. When KKR and GS Capital Partners, the private equity arm of Goldman Sachs, acquired the Wincor Nixdorf unit from Siemens in , they were able to work with the incumbent management and follow its plan to grow revenues and margins.
For one thing, because all businesses in a private equity portfolio will soon be sold, they remain in the spotlight and under constant pressure to perform.
In addition, because every investment made by a private equity fund in a business must be liquidated within the life of the fund, it is possible to precisely measure cash returns on those investments. That makes it easy to create incentives for fund managers and for the executives running the businesses that are directly linked to the cash value received by fund investors.
That is not the case with business unit managers or even for corporate managers in a public company. Their management is lean and focused, and avoids the waste of time and money that corporate centers, when responsible for a number of loosely related businesses and wishing to justify their retention in the portfolio, often incur in a vain quest for synergy. Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast.
Few public companies develop this depth of experience in buying, transforming, and selling. As private equity has gone from strength to strength, public companies have shifted their attention away from value-creation acquisitions of the sort private equity makes. They have concentrated instead on synergistic acquisitions. Conglomerates that buy unrelated businesses with potential for significant performance improvement, as ITT and Hanson did, have fallen out of fashion.
As a result, private equity firms have faced few rivals for acquisitions in their sweet spot. Conglomerates that acquire unrelated businesses with potential for significant improvement have fallen out of fashion. As a result, private equity firms have faced few rivals in their sweet spot. We see two options. The first is to adopt the buy-to-sell model.
Companies wishing to try this approach in its pure form face some significant barriers. One is the challenge of overhauling a corporate culture that has a buy-to-keep strategy embedded in it. That requires a company not only to shed deeply held beliefs about the integrity of a corporate portfolio but also to develop new resources and perhaps even dramatically change its skills and structures. In the United States a tax barrier also exists.
Whereas private equity funds, organized as private partnerships, pay no corporate tax on capital gains from sales of businesses, public companies are taxed on such gains at the normal corporate rate. This corporate tax difference is not offset by lower personal taxes for public company investors. Higher taxes greatly reduce the attractiveness of public companies as a vehicle for buying businesses and selling them after increasing their value. Note that two tax issues have been the subject of public scrutiny in the United States.
The first—whether publicly traded private equity management firms should be treated like private partnerships or like public companies for tax purposes—is closely related to the issue we raise. Despite the hurdles, some public companies have in fact successfully developed a buy-to-sell business model.
Those restrictions make such structures unattractive as vehicles for competing with private equity, at least for large buyouts in the United States. With the removal of the tax disincentives across Europe, a few new publicly quoted buyout players have emerged. The largest are two French companies, Wendel and Eurazeo. Both have achieved strong returns on their buyout investments. In the United States, where private companies can elect, like private partnerships, not to be subject to corporate tax, Platinum Equity has become one of the fastest-growing private companies in the country by competing to buy out subsidiaries of public companies.
The emergence of public companies competing with private equity in the market to buy, transform, and sell businesses could benefit investors substantially. In compensation for these terms, investors should expect a high rate of return. However, though some private equity firms have achieved excellent returns for their investors, over the long term the average net return fund investors have made on U. Private equity fund managers, meanwhile, have earned extremely attractive rewards, with little up-front investment.
Public companies pursuing a buy-to-sell strategy, which are traded daily on the stock market and answerable to stockholders, might provide a better deal for investors. From where might a significant number of publicly traded competitors to private equity emerge?
Their investors would be wary. Private equity partners typically are former investment bankers and like to trade. Public financial firms, however, may find it easier to follow a buy-to-sell strategy.
In addition, some experienced private equity managers may decide to raise public money for a buyout fund through an IPO. A strategy of flexible ownership could have wider appeal to large industrial and service companies than buying to sell. Under such an approach, a company holds on to businesses for as long as it can add significant value by improving their performance and fueling growth. The company is equally willing to dispose of those businesses once that is no longer clearly the case.
A decision to sell or spin off a business is viewed as the culmination of a successful transformation, not the result of some previous strategic error. A decision to sell or spin off a business is viewed as the culmination of a successful transformation, not the result of a strategic error. Take General Electric. The company has demonstrated over the years that corporate management can indeed add value to a diversified set of businesses.
Indeed, with its fabled management skills, GE is probably better equipped to correct operational underperformance than private equity firms are. To realize the benefits of flexible ownership for its investors, though, GE would need to be vigilant about the risk of keeping businesses after corporate management could no longer contribute any substantial value.
GE would of course have to pay corporate capital gains taxes on frequent business disposals. We would argue that the tax constraints that discriminate against U. Nevertheless, even in the current U. For example, spinoffs, in which the owners of the parent company receive equity stakes in a newly independent entity, are not subject to the same constraints; after a spinoff, individual shareholders can sell stock in the new enterprise with no corporate capital gains tax payable.
We have not found any large public companies in the industrial or service sector that explicitly pursue flexible ownership as a way to compete in the private equity sweet spot. Managers need skills in investing both buying and selling and in improving operating management. The challenge is similar to that of a corporate restructuring—except that it must be repeated again and again.
There is no return to business as usual after the draining work of a transformation is completed. Can you spot and correctly value businesses with improvement opportunities? For every deal a private equity firm closes, it may proactively screen dozens of potential targets.
Private equity managers come from investment banking or strategy consulting, and often have line business experience as well. They use their extensive networks of business and financial connections, including potential bidding partners, to find new deals.
Their skill at predicting cash flows makes it possible for them to work with high leverage but acceptable risk. A public company adopting a buy-to-sell strategy in at least part of its business portfolio needs to assess its capabilities in these areas and, if they are lacking, determine whether they could be acquired or developed.
Do you have the skills and the experience to turn a poorly performing business into a star? Private equity firms typically excel at putting strong, highly motivated executive teams together. It may also entail hiring management talent from the competition.
Good private equity firms also excel at identifying the one or two critical strategic levers that drive improved performance. They are renowned for excellent financial controls and for a relentless focus on enhancing the performance basics: revenue, operating margins, and cash flow.
Plus, a governance structure that cuts out a layer of management—private equity partners play the role of both corporate management and the corporate board of directors—allows them to make big decisions fast. Over the course of many acquisitions, private equity firms build their experience with turnarounds and hone their techniques for improving revenues and margins.
A public company needs to assess whether it has a similar track record and skills and, if so, whether key managers can be freed up to take on new transformation challenges.
Free Excel Course. The same accounting rules you see in other companies still apply, but they often have to be modified to accommodate privately held companies. The accounting standard a private equity fund adopts also affects how partner capital is treated. Partners and Responsibilities. Maybe the founder will stay on to run the business -- but maybe not. Pension plans and insurance companies may invest some portion of their large portfolios in private equity funds.
Private equity funds basics. Private Equity Fund Accounting Essentials
A VC often invests in unproven, cutting-edge technologies. A VC investment is highly risky, but can be quite lucrative. Everyone wants to invest in the next Facebook, but the vast majority of startups completely fail. What is a Private Equity Firm? Simply stated: Private equity is an investment in a private company.
How does Private Equity compare as an asset class to Public Equity? All Rights Reserved. InvestX Financial Canada Ltd. This class of investors typically includes institutions—pension funds, university endowments, insurance companies—and high-net-worth individuals.
Limited partners have no influence over investment decisions. At the time that capital is raised, the exact investments included in the fund are unknown. However, LPs can decide to provide no additional investment to the fund if they become dissatisfied with the fund or the portfolio manager.
What separates each classification of partners in this agreement is the risk to each. LPs are liable up to the full amount of money they invest in the fund. However, GPs are fully liable to the market, meaning if the fund loses everything and its account turns negative, GPs are responsible for any debts or obligations the fund owes.
Private equity funds typically exit each deal within a finite time-period due to the incentive structure and a GP's possible desire to raise a new fund. However, that time-frame can be affected by negative market conditions, such as periods when various exit options , such as IPOs, may not attract the desired capital to sell a company. The LPA traditionally outlines management fees for general partners of the fund.
Investors are usually willing to pay these fees due to the fund's ability to help manage and mitigate corporate governance and management issues that might negatively affect a public company. The LPA also includes restrictions imposed on GPs regarding the types of investment they may be able to consider. These restrictions can include industry type, company size, diversification requirements, and the location of potential acquisition targets.
In addition, GPs are only allowed to allocate a specific amount of money from the fund into each deal it finances. Under these terms, the fund must borrow the rest of its capital from banks that may lend at different multiples of a cash flow, which can test the profitability of potential deals.
The ability to limit potential funding to a specific deal is important to limited partners because several investments bundled together improves the incentive structure for the GPs. Investing in multiple companies provides risk to the GPs and could reduce the potential carry, should a past or future deal underperform or turn negative.
Meanwhile, LPs are not provided with veto rights over individual investments. Multiple vetoes of companies may educe the positive incentives created by the commingling of fund investments. Private-equity firms offer unique investment opportunities to high-net-worth and institutional investors. But anyone who wants to invest in a PE fund must first understand their structure so he or she is aware of the amount of time they will be required to invest, all associated management and performance fees, and the liabilities associated.
The Bottom Line. Key Takeaways Private equity funds are closed-end funds that are not listed on public exchanges. Their fees include both management and performance fees. Private equity fund partners are called general partners, and investors or limited partners. The limited partnership agreement outlines the amount of risk each party takes along with the duration of the fund.
The Strategic Secret of Private Equity
Private equity PE typically refers to investment funds , generally organized as limited partnerships , that buy and restructure companies that are not publicly traded. Private equity is, strictly speaking, a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange.
A private equity investment will generally be made by a private equity firm , a venture capital firm or an angel investor. Bloomberg Businessweek has called "private equity" a rebranding of leveraged-buyout firms after the s. Common investment strategies in private equity include leveraged buyouts , venture capital , growth capital , distressed investments and mezzanine capital.
In a typical leveraged-buyout transaction, a private-equity firm buys majority control of an existing or mature firm. This is distinct from a venture-capital or growth-capital investment, in which the investors typically venture-capital firms or angel investors invest in young, growing or emerging companies , and rarely obtain majority control.
Leveraged buyout, LBO, or Buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit, or business assets is acquired from the current shareholders typically with the use of financial leverage. 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 ultimately looks to the cash flows of the acquisition target to make interest and principal payments.
Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage but greatly limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits an LBO's financial sponsor in two ways: 1 the investor itself only needs to provide a fraction of the capital for the acquisition, and 2 the returns to the investor will be enhanced as long as the return on assets exceeds the cost of the debt.
It replaces the senior management in XYZ Industrial, and they set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the value of the company for an early sale. Taxation of such gains is at capital gains rates. Companies that seek growth capital will often do so in order to finance a transformational event in their life cycle. 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.
A Private investment in public equity , or PIPEs , 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, or RD, 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.
This form of financing is often used by private equity investors to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. Mezzanine capital, which is often used by smaller companies that are unable to access the high yield market , allows such companies to borrow additional capital beyond the levels that traditional lenders are willing to provide through bank loans.
Investors generally commit to venture capital funds as part of a wider diversified private equity portfolio , but also to pursue the larger returns the strategy has the potential to offer. However, venture capital funds have produced lower returns for investors over recent years compared to other private equity fund types, particularly buyout. In addition to these private equity strategies, hedge funds employ a variety of distressed investment strategies including the active trading of loans and bonds issued by distressed companies.
Secondary investments refer to investments made in existing private equity assets. These transactions can involve the sale of private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. Secondaries also typically experience a different cash flow profile, diminishing the j-curve effect of investing in new private equity funds.
In J. Morgan arguably managed the first leveraged buyout of the Carnegie Steel Company using private equity. The first leveraged buyout may have been the purchase by McLean Industries, Inc. In fact it is Posner who is often credited with coining the term " leveraged buyout " or "LBO" . Working for Bear Stearns at the time, Kohlberg and Kravis along with Kravis' cousin George Roberts began a series of what they described as "bootstrap" investments.
Many of these companies lacked a viable or attractive exit for their founders as they were too small to be taken public and the founders were reluctant to sell out to competitors and so a sale to a financial buyer could prove attractive. Their acquisition of Orkin Exterminating Company in is among the first significant leveraged buyout transactions.
The success of the Gibson Greetings investment attracted the attention of the wider media to the nascent boom in leveraged buyouts. During the s, constituencies within acquired companies and the media ascribed the " corporate raid " label to many private equity investments, particularly those that featured a hostile takeover of the company, perceived asset stripping , major layoffs or other significant corporate restructuring activities.
Bass , T. Carl Icahn developed a reputation as a ruthless corporate raider after his hostile takeover of TWA in It was, at that time and for over 17 years, the largest leveraged buyout in history. Many of the major banking players of the day, including Morgan Stanley , Goldman Sachs , Salomon Brothers , and Merrill Lynch were actively involved in advising and financing the parties.
In and , a number of leveraged buyout transactions were completed that for the first time surpassed the RJR Nabisco leveraged buyout in terms of nominal purchase price.
However, adjusted for inflation, none of the leveraged buyouts of the — period would surpass RJR Nabisco. By the end of the s the excesses of the buyout market were beginning to show, with the bankruptcy of several large buyouts including Robert Campeau 's buyout of Federated Department Stores , the buyout of the Revco drug stores, Walter Industries, FEB Trucking and Eaton Leonard.
Drexel reached an agreement with the government in which it pleaded nolo contendere no contest to six felonies — three counts of stock parking and three counts of stock manipulation. Milken left the firm after his own indictment in March Brady , the U. Marked by the buyout of Dex Media in , large multibillion-dollar U. As ended and began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of having been announced in an month window from the beginning of through the middle of In , private equity firms bought U.
In July , turmoil that had been affecting the mortgage markets , spilled over into the leveraged finance and high-yield debt markets. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led many companies and investment banks to put their plans to issue debt on hold until the autumn.
However, the expected rebound in the market after 1 May did not materialize, and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill during a week in Nevertheless, private equity continues to be a large and active asset class and the private equity firms, with hundreds of billions of dollars of committed capital from investors are looking to deploy capital in new and different transactions.
As a result of the global financial crisis, private equity has become subject to increased regulation in Europe and is now subject, among other things, to rules preventing asset stripping of portfolio companies and requiring the notification and disclosure of information in connection with buy-out activity.
Although the capital for private equity originally came from individual investors or corporations, in the s, private equity became an asset class in which various institutional investors allocated capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets. In the s, insurers were major private equity investors.
US, Canadian and European public and private pension schemes have invested in the asset class since the early s to diversify away from their core holdings public equity and fixed income. Instead, institutional investors will invest indirectly through a private equity fund.
Returns on private equity investments are created through one or a combination of three factors that include: debt repayment or cash accumulation through cash flows from operations, operational improvements that increase earnings over the life of the investment and multiple expansion, selling the business for a higher price than was originally paid.
A key component of private equity as an asset class for institutional investors is that investments are typically realized after some period of time, which will vary depending on the investment strategy. Private equity investments are typically realized through one of the following avenues:. Large institutional asset owners such as pension funds with typically long-dated liabilities , insurance companies, sovereign wealth and national reserve funds have a generally low likelihood of facing liquidity shocks in the medium term, and thus can afford the required long holding periods characteristic of private equity investment.
The median horizon for a LBO transaction is 8 years. The private equity secondary market also often called private equity secondaries refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors.
For the vast majority of private equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private equity assets. Increasingly, secondaries are considered a distinct asset class with a cash flow profile that is not correlated with other private equity investments. As a result, investors are allocating capital to secondary investments to diversify their private equity programs.
Driven by strong demand for private equity exposure, a significant amount of capital has been committed to secondary investments from investors looking to increase and diversify their private equity exposure.
Investors seeking access to private equity have been restricted to investments with structural impediments such as long lock-up periods, lack of transparency, unlimited leverage, concentrated holdings of illiquid securities and high investment minimums. According to an updated ranking created by industry magazine Private Equity International  published by PEI Media called the PEI , the largest private equity firm in the world today is The Blackstone Group based on the amount of private equity direct-investment capital raised over a five-year window.
Because private equity firms are continuously in the process of raising, investing and distributing their private equity funds , capital raised can often be the easiest to measure. Other metrics can include the total value of companies purchased by a firm or an estimate of the size of a firm's active portfolio plus capital available for new investments. As with any list that focuses on size, the list does not provide any indication as to relative investment performance of these funds or managers.
Additionally, Preqin formerly known as Private Equity Intelligence , an independent data provider, ranks the 25 largest private equity investment managers. Invest Europe publishes a yearbook which analyses industry trends derived from data disclosed by over 1, European private equity funds.
The investment strategies of private equity firms differ to those of hedge funds. Private equity specialization is usually in specific industry sector asset management while hedge fund specialization is in industry sector risk capital management.
Private equity strategies can include wholesale purchase of a privately held company or set of assets, mezzanine financing for startup projects, growth capital investments in existing businesses or leveraged buyout of a publicly held asset converting it to private control. Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself.
As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund in which it has invested. As fundraising has grown over the past few years, so too has the number of investors in the average fund. In there were 26 investors in the average private equity fund, this figure has now grown to 42 according to Preqin ltd. Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles.
The amount of time that a private equity firm spends raising capital varies depending on the level of interest among investors, which is defined by current market conditions and also the track record of previous funds raised by the firm in question.
Firms can spend as little as one or two months raising capital when they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest.
It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months. Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for new investors to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.