Private equity is 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. It is also described as the business of taking a company into private ownership
in order to reform it before selling it again at a hoped-for profit.
Why Invest in Private Equity?
1. Long-term historical out-performance:
In 2016, buyout funds globally delivered returns that beat public equity markets by a sizable margin. Using the modified
public market equivalent (mPME), a metric developed by Cambridge Associates, it is possible to make an apples-to-apples
comparison of PE returns with public equity returns by replicating the timing and size of PE cash flows as if they had been
invested in public equities. Every region saw outperformance by buyout funds.
In the US, funds delivered a 6% end-to-end pooled IRR for the 12 months ending June 2016, compared with 4% for the S&P
500 using mPME. Buyout funds showed an even stronger performance in Europe over this same time horizon, with a 10%
IRR, while the MSCI Europe. roiled by the Brexit vote, plunged 11%. Asia-Pacifics combined buyout and growth funds rose
a modest 2% but fared much better than the 9% decline of the MSCI All Country Asia Pacific; that decline largely stemmed
from an overdue correction of the bubble in Chinas stock market.
PE firms rely on repeatable strategies to source good deals and create value after the close, and they also manage a companys
balance sheet much more aggressively than their public company counterparts. Together, these disciplines produce returns
that are consistently higher than public markets. For many institutions, such a premium over more conventional asset classes
justifies the different risk profile of the asset class.
Bain Global Private Equity Report 2017
2. True stock picking in a low inflation, low growth environment:
A low inflation environment creates a focus on growth stocks as a means of out-performance. One of the core skills of the
successful private equity manager is to pick companies with growth potential and actively to create the conditions for
growth in those companies. Since private equity funds own large, often controlling, stakes in companies, few, if any, other
private equity managers will have access to the same companies. Private equity managers are therefore true "stock pickers".
This contrasts to mutual funds, which will often hold largely the same underlying investments as their peer group, with
variations in weightings being fine-tuned to a few basis points.
3. Absolute returns:
Excessive volatility and poor investment performance experienced by quoted equity portfolios, many of which have index-
tracking strategies or are benchmarked to an index ("closet trackers"), have led to a swing in favor of strategies that seek
absolute returns. Demographic trends have compounded the desirability of such a change. The need to provide for an ageing
population has obliged many institutions to adopt a more absolute return oriented investment approach in order to meet
future liabilities. Private equity managers do seek absolute returns and their traditional incentivization structure, the "carried
interest", is highly geared towards achieving net cash returns to investors.
4. Portfolio diversification improves risk and volatility characteristics:
Within a balanced portfolio, the introduction of private equity can improve diversification. Although lower correlation of
returns between private equity and public market classes is widely debated and needs further investigation, the numbers do
indicate a lower correlation.
5. Exposure to the smaller company market
The private equity industry has brought corporate governance to smaller companies and provides an attractive manner of
gaining exposure to a growth sector that went out of favor with market investors in the mid-1990s for reasons of liquidity.
6. Access to legitimate inside information
A much greater depth of information on proposed company investments is available to private equity managers. This helps
managers more accurately assess the viability of a company's proposed business plan and to project the post-investment
strategy to be pursued and expected future performance. This greater level of disclosure contributes significantly to reducing
risk in private equity investment. Equivalent information in the public markets would be considered "inside information". By
definition, investors in public markets will know less about the companies in which they invest.
7. Ability to back entrepreneurs
The wider emergence in Europe of entrepreneurs as an important cog in the economy has been facilitated by a period of larger
company rationalization. This has reflected similar developments in the US that, for example, fostered rapid growth in
technological innovation and substantial knock-on benefits for the whole economy through the 1990s. Entrepreneurs have
also been at the heart of developments in Europe, creating value in both traditional and hi-tech industries. The private equity
asset class offers the ability to gain investment exposure to the most entrepreneurial sectors of the economy.
8. Influence over management and flexibility of implementation
Private equity managers generally seek active participation in a company's strategic direction, from the development of a
business plan to selection of senior executives, introduction of potential customers, M&A strategy and identification of
eventual acquirers of the business. Furthermore, implementation of the desired strategy can normally be effected much more
efficiently in the absence of public market scrutiny and regulation. This flexibility represents another feature whereby risk can
be reduced in private equity investment.
9. Leveraging off balance sheet and finding synergies between portfolio companies
Buyout managers in particular are able to make efficient use of leverage. They aim to organize each portfolio company's
funding in the most efficient way, making full use of different borrowing options from senior secured debt to mezzanine
capital and high yield debt. By organizing the company's funding requirements efficiently, the equity returns are potentially
enhanced. In addition, because the leverage is organized at the company level and not the fund level, there is a ring-fencing
benefit: if one portfolio company fails to repay its borrowing, the rest of the portfolio is not contaminated as a result. Thus,
the investor has the effective benefit of a leveraged portfolio with less downside risk. Also, funds are able to find synergies
between portfolio companies. For example, better procurement deals due to mass procurement for portfolio companies.
Cons of Private Equity
1. Long-term investment:
In general, holding periods between investment and realization can be expected to average three or more years (although this
may be shorter when IPO markets are especially healthy). Because the underlying portfolio assets are less liquid, the structure
of private equity funds is normally a closed-end structure, meaning that the investor has very limited or no ability to withdraw
its investment during the fund's life. Although the investor may receive cash distributions during the fund's life, the timing of
these is normally uncertain. "Liquidity risk" is one of the principal risk characteristics of the asset class. Private equity should
therefore be viewed as a longer-term investment strategy.
2. Increased resource requirement:
As a result of the active investment style typical of the industry and the confidentiality of much of the investment information
involved, the task of assessing the relative merits of different private equity fund managers is correspondingly more complex
than that of benchmarking quoted fund managers. This makes investment in private equity funds a much more resource-
intensive activity than quoted market investment. Likewise, post-investment monitoring of funds' performance is also more
resource-intensive. Resource is a key issue in the development of a private equity program that is suitable for the investor.
3. "Blind pool" investing:
When committing to a private equity fund, the commitment is typically to provide cash to the fund on notice from the general
partner. Whilst launch documentation will outline the investment strategy and restrictions, investors give a very wide degree
of discretion to the manager to select the companies that the investors will have a share in. Unlike some real estate partnerships,
there is usually no ability at the launch of a private equity fund to preview portfolio assets before committing, because they
have not yet been identified. Also, there is generally no ability to be excused from a particular portfolio investment after the
fund is established.
Approaches to Portfolio Construction
Decision 1: The size of the private equity allocation
Investors in private equity should be able to accept the illiquid character of their investment, hence the extent to which liquidity
may be required is often a factor in the size of allocation. For this reason, it is often the case in the US that the investors who
make the largest proportional allocations to private equity from their overall portfolios are those who are able to invest for the
long term with no specific liabilities anticipated. These would include endowments, charities and foundations. Pension funds
also are often large investors in the asset class. Based on the requirement to increase targeted returns and/or reduce volatility,
the investor will determine the proportion of its overall portfolio that it believes is appropriate to allocate to private equity.
Decision 2: Number of funds to commit to
It is a challenge for investors to avoid concentration of risk within their private equity portfolio and to control portfolio
volatility. It is appropriate to aim for some diversification.
Decision 3 - Ways of achieving diversification
Stage: There is negative correlation between returns from different stages of private equity. Diversification can therefore
reduce risk within a private equity portfolio and this should be an important consideration.
Seed stage Financing provided to research, assess and develop an initial concept before a business has reached the start-up
phase.
Start-up stage Financing for product development and initial marketing. Companies may be in the process of being set up or
may have been in business for a short time, but have not sold their products commercially and are not yet generating a profit.
Expansion stage Financing for growth and expansion of a company which is breaking even or trading profitably. Capital may
be used to finance increased production capacity, market or product development, and/or to provide additional working capital.
This stage includes bridge financing and rescue or turnaround investments.
Replacement Capital Purchase of shares from another investor or to reduce gearing via the refinancing of debt.
Buyout A buyout fund typically targets the acquisition of a significant portion or majority control of businesses which
normally entails a change of ownership. Buyout funds usually invest in more mature companies with established business
plans to finance expansions, consolidations, turnarounds and sales, or spinouts of divisions or subsidiaries. Financing
expansion through multiple acquisitions is often referred to as a "buy and build" strategy. Investment styles can vary widely,
ranging from growth to value and early to late stage. Furthermore, buyout funds may take either an active or a passive
management role.
Special Situation Special situation investing ranges more broadly, including distressed debt, equity-linked debt, project
finance, one-time opportunities resulting from changing industry trends or government regulations, and leasing. This category
includes investment in subordinated debt, sometimes referred to as mezzanine debt financing, where the debt-holder seeks
equity appreciation via such conversion features as rights, warrants or options.
Geography: Geographical diversification can be secured in Europe through the use of country-specific, regional and pan-
European funds. Non-European exposure is also widely available, in particular through US funds, but also for example
through Global, Israeli, Latin American and Asian funds.
Manager: Selecting a variety of managers will reduce manager specific risk.
Vintage year: Timing has an impact on the performance of funds, as opportunities for investment and exit will be impacted
by external economic circumstances. For this reason, it has become a normal practice to compare the performance of funds
against others of the same vintage. There may be marked differences in performance from one vintage year to another. In
order to ensure participation in the better years, it is generally perceived to be wiser to invest consistently through vintage
years, as opposed to "timing the market" by trying to predict which vintage years will produce better performance.
Industry: In venture investing, most of the focus tends to be on technology based industries. These can be subdivided, for
example into healthcare / life sciences, information technology and communications. Buyout funds tend to focus on
technology to a lesser extent, providing exposure to such sectors as financial institutions, retail and consumer, transport,
engineering and chemicals. Some have a specific sector focus.
Decision 4: How to plan for the volatility of cash flows - the J-curve
Investors need to maintain sufficient liquid assets to meet drawdown obligations whenever called. Penalty charges
can be incurred for late payment or, in extreme cases, forfeiture of an investor's interest in the fund. This is even
more important for a firm that continuously invests in As portfolio companies mature and exits occur, the fund will
begin to distribute proceeds. This will take a few years from the date of first investment and the timing and amounts
will be volatile.
Decision 5: The principal means of private equity investment, these are:
Investing in private equity funds.
Outsourcing selection of private equity funds.
Direct investment in private companies.
While it is sometimes the ultimate objective of investors to make direct investments into companies, compared with investing
through funds it requires more capital, a different skill set, more resource and different evaluation techniques. Whilst this can
be mitigated by co-investing with a fund and the rewards can be high, there is higher risk and the potential for complete loss
of invested capital. This strategy is recommended only to experienced private equity investors. For most investors, the use of
private equity funds would be preferred.
While the strategies for managing each portfolio company can vary widely, the key features that PE experts believe leads to
success is picking the best fruit: A critical element of success comes at the earliest stages before the investment has even
closed with the careful selection of the portfolio firm. Most PE executives agree that the ideal target is not a train wreck
but a firm with just a few areas that need improvement. Sometimes a firm has grown too big and complex for the founder to
manage alone. The company may need financing, help in streamlining systems and operations, or advice on which products
or services to develop next. But at its heart, the ideal target firm is sound. The company may only have three or four areas that
present real opportunities. The target firm must not present too much risk of loss, he continued. If there is not enough downside
protection, we dont even talk about the upside. Thus, focus on pre-Investment activities such as Deal origination, screening
and due diligence is important. The key factors within these that influence decisions are mentioned below.
Deal Origination:
Sourcing for investment opportunities can be difficult and grueling, but it is an essential skill one needs if aspiring to have a
successful career in the PE industry. Depending on the PE firms preference, a deal may be sourced through a variety of
channels: internal analysis, networking, detailed research, and cold-calling executives at attractive companies, for example.
Other sources include meeting with various companies, company screens through databases for specific criteria, industry
conferences, and conversations with industry consultants and experts. Opportunities sourced through any of these means is
referred to as proprietary sourcingi.e., internally sourced.
Another common way to receive potential investment opportunities is through a financial intermediary, such as an investment
banker. Companies often hire investment banks to sell businesses via Confidential Information Memorandums (CIMs), which
are distributed to potential acquirers, possibly including both financial sponsors (private equity firms) and strategic buyers.
This is typically characterized as a public auction. While searching for potential opportunities, an associate would need to
ensure that the investment opportunity fits into the firms investment strategy, such as a minimum EBITDA, industry, potential
value creation strategy, or a minimum (or maximum) equity check.
Commercial Due Diligence includes understanding the companys value proposition, market position, historical
performance, and industry trends in order to assess the targets ability to achieve its forecasted projections.
Competitive Landscape and Market Position: It is important to understand how sustainable the targets business model is and
where it is positioned relative to its competitors.
Industry Growth/Addressable Market: When evaluating the industry, it is crucial to understand the market environment and
the external factors affecting the business.
Customer Base/Suppliers: This entails understanding the stickiness of customers and the companys reliance on suppliers.
Capital Requirements of the Business: A good understanding of the total capital needed to run the operations of a business is
needed, especially during difficult times.
Financial Performance (Historical & Projected): This analysis provides a deeper look into the companys historical
performance in order to understand how realistic the companys forecasted projections are.
Financial due diligence confirms that all the financial information provided is accurate and helps PE firms understand some
of the unique dynamics of the company from a financial reporting perspective. The firms typically hire accountants and/or
auditors to review the financials, operations, customers, markets, and tax issues in detail. This is usually referred to as
transaction advisory services.
Quality of earnings: The PE firms need to confirm the historical earnings of the company excluding non-recurring
costs/expenses, as this will affect the valuation of the company. These adjustment types include management adjustments,
business-related adjustments, and pro forma adjustments.
Debt and debt-like items: During the review, firms need to calculate the companys total debt-like items outstanding, because
it will impact the total amount given to the sellers (Total purchase price less debt = cash given to sellers). All liabilities will
be categorized as either working capital or debt, not both.
Normal working level of capital
Tax structure: This process entails looking at the tax structure of the company and providing a detailed analysis of the federal,
state, local, and international tax situation (both historical and anticipated).
Legal due diligence is mainly confirmatory. It is focused on confirming that the target company is not subject to any future
liabilities including regulatory issues, threatened or ongoing lawsuits, and unusual or onerous contract provisions.
Corporate filings: This component of the legal due diligence process is to confirm that all corporate filings have been filed
correctly (corporate organization and documents) and to understand the legal organization of the company.
Material contracts: Prior to acquiring a company, it is important to look at past and current material contracts. This includes
the debt structure, acquisitions and other liabilities, and it may include key customer, or supplier agreements.
Property, plant and equipment: It is important to consider the companys property, plant and equipment to study its assets and
liabilities. One example of this is a detailed review of key operating or capital leases.
Health and welfare plans: The firm reviews the health benefit plans, retiree health plans, and retirement plans to understand
any regulations or legal issues surrounding the benefits.
Lawsuits/litigation/patents: A look at the companys lawsuits/litigation provides a summary of any pending litigation, history
of past litigations, and what may arise in the company, such as environmental, employment, customer or worker compensation
or intellectual property issues.
Information Technology and Human Resources are important for smooth transition for payroll and internal systems.
In present times environmental, social and governance may be a significant criterion for some the funds.
Value Creation in Private Equity
Private equity firms focus on core value begins with the due diligence conducted before the acquisition. General partners
carefully choose each target company and explicitly define in an investment thesis how they will create incremental value and
by when. This assessment does not stop after the acquisition they periodically evaluate the value creation potential of their
portfolio companies and quickly exit those that are flagging to free up funds for more remunerative investments.
Within a portfolio company, PE firms make it their business to understand how each activity contributes to value creation and
diligently cut costs on low-value activities. That can often mean exiting entire lines of business that are simply not
drawing on the companys core strengths and differentiating capabilities.
Cash is king: Private equity firms, formerly known as leveraged buyout firms, typically finance 60 to 80 percent of an
acquisition with debt.3 This high-leverage model instills a focus and sense of urgency in PE firms to liberate and generate
cash as expeditiously as possible. Since portfolio companies carry such high levels of debt, they pay scrupulous attention to
cash flow, closely monitoring spending levels, debt repayment schedules, and real-time financial metrics. To improve cash
flow, PE firms tightly manage their receivables and payables, reduce their inventories, and scrutinize discretionary expenses.
To preserve cash, they delay, or altogether cancel, lower-value discretionary projects or expenses, investing only in those
initiatives and resources (including human) that contribute significant value.
Time is money: Time is money Consistent with the imperative to generate cash quickly to pay down debt is the constant
reminder among private equity firms that time is money. There is a bias for action captured most vividly in the 100 day
program that PE firms invariably impose on portfolio companies during the first few months of ownership. There is little
appetite for the socialization and consensus building common at many large public companies private equity firms and
their management teams feel the burning platform and make decisions to change rapidly. It helps that the management team
is heavily invested in the company compensation of portfolio company managers is heavily weighted toward equity and
performance-based bonuses, so their interests are fully aligned with those of the PE general partners. Also,
portfolio company executives are extraordinarily empowered and have close working relationships with their actively involved
boards. They do not need to navigate or appease layers of oversight and external stakeholders.
Use a long-term lens: The best private equity firms not only cut costs but also invest in the highest-potential ideas for creating
core value, and this is a lesson that public companies can learn the art and science of making these judicious choices.
Because private equity firms are often cash constrained, they cannot fund every superficially attractive initiative they must
rigorously focus on those that promise the best return and are consistent with the investment thesis for that company.
Have the right team in place: Private equity investors waste no time getting the right team in place after an acquisition, but
once that team is established, they delegate to it a great deal of authority and accountability. PE general partners
intuitively understand that strong, effective leadership is critical to the success of their investment in fact, they often invest
in a company based on the strength of its existing management talent. The assessment of talent begins as soon as due diligence
commences and intensifies after closing, and once made, the verdict is swiftly executed. A third of portfolio company CEOs
exit in the first 100 days, and two-thirds are replaced during the first four years.
Get skin in the game: The CEO and senior managers at a private equity portfolio company are deeply invested in the
performance of their individual business their fortunes soar when the business succeeds and suffer when it fails to
achieve objectives, and that is a very deliberate and widely recognized part of the private equity business model. Management
has a substantial stake (equity and bonus) in the performance of the business. PE firms pay modest base salaries to their
portfolio company managers, but add in highly variable and rich annual bonuses based on company and individual
performance, plus a long-term incentive compensation package tied to the returns realized upon exit. This package typically
takes the form of stock and options, which can be quite generous, especially for CEOs.
Select stretch goals: Private equity firms believe that a broad set of measures complicates management discussions and
impedes action. They set clear, aggressive targets in a few critical areas and tie management compensation directly to those
targets. The vision and long-term strategy should drive a set of specific initiatives. These initiatives and their financial
implications should, in turn, drive annual plans and budgets and the development of aggressive but achievable
targets. These targets should measure progress against these initiatives and, ultimately, the strategy.
The metrics should be explicitly reviewed at regular intervals (for example, monthly). During these reviews, management
should ask three questions:
1) Are we doing what we agreed to do?
2) Are we getting the results we expected?
3) If results are lagging, how can we rectify? If results are exceeding plans, how can we build on this success?
