How does Private Equity investment work?

The Private Equity (PE) industry boasts trillions of dollars in assets under management, enjoying a golden age since the 2008 financial crisis.

As the COVID-19 pandemic pushes the world into the deepest recession since Second World War, the PE industry is again experiencing a resurgence in deal-making and investment interests.

PE firms are well positioned to take advantage of the opportunities abound in these unusual times to acquire quality assets at deep discounts, while savvy investors keen on the higher returns that PE firms generate compared to traditional investments are also turning to this alternative asset class.

But what is it that private equity firms do? How exactly does PE investment work?

A Primer on Private Equity

PE investors raise pools of capital from limited partners to form PE funds.

Once the fundraising target is met, these funds will then invest that capital in promising companies operating outside of the public market.

The goal is to increase the value of these companies over time before selling it at a profit, and then distributing the returns to the limited partners who invested in its fund.

The fee structure varies from fund to fund, but a PE firm typically collects roughly 2% in management fee plus 20% of the profits gained from the sale of the portfolio company.

In the US, private equity produces annual returns of 10.48% on average over the 20-year period ending 30 June 2020, outperforming the Russell 2000, the S&P 500, and venture capital.

The lucrative return is one of the reasons why PE tactics and strategies have been mimicked by public company CEOs and managers of hedge funds, pension funds and even sovereign funds, and taught in business management spheres.

The art of deal-making aside, the success of the PE industry lies in its ability to refine value in its portfolio companies.

Determining and Creating Value

The types of companies PE funds invest in range from start-ups to mature companies, often experiencing a period of stagnation or potentially distressed, but still showing good growth potential – companies that can benefit from the cash and knowledge infusion provided by PE fund managers.

The potential company’s price-to-earnings ratio, the capability of its management team as well as the inherent risks and opportunities of its industry and market are all taken into consideration, before venturing in with an ambitious but realistic growth and exit plan.

The structure of investments the PE fund undertakes can vary, although leveraged buyouts (LBO) tend to be the most common type of deal-making. With LBOs, the PE fund purchases a controlling stake in the company using a combination of equity, i.e. capital from the fund, and leverage, i.e. borrowed capital.

The PE fund managers then work to improve its profitability, now considered a portfolio company, backing an experienced management team to execute the growth plan. It’s a hands-on approach to investment, providing not just capital, but McKinsey-style business consulting knowledge and oversight.

Gone are the days of ruthless cost-cutting and layoffs as the prime means of profitability. Rather, PE firms are taking the lead in realising value from financing ideas and attempting unorthodox growth strategies, often helping its portfolio companies carve a unique niche in their chosen market.

PE firms, with their controlling stake, will usually overhaul the business operationally, putting in place governance functions, reorganising, trimming, funding acquisitions and assisting with senior hires as needed to turn previously struggling companies into profit-making machines.

Return on Investment

Due to the complexity of the undertaking, PE investments in its portfolio companies usually range anywhere between 5 to 10 years from entry to exit, depending on the state of the companies at the start of the investment as well as their growth potential. Hence the holding period of the invested sum is considerably longer than conventional assets.

The plan is to essentially leave companies better off than when they found them, and the approach is akin to mentorship of companies, putting in place the expertise and resources to help the companies under its management to continue on its path of growth and “graduate” out of the portfolio.

Once the target growth has been met, the PE firm will then look for interested buyers, selling it to another company, investor and perhaps even taking it public for a healthy gain.

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