The term- Private Equity- has been a part of the trend, especially in the years after 1980. Some of you may be familiar with it, while the others may think of it as one of the many technical terms finance geeks carry along in their dictionary. However, I would like to take this opportunity to break this myth by trying to explain this term and some important concepts supplementing this fund via my article.
So, let’s break this down.
In the term ‘private equity’, equity means ownership or interest in any entity. Private means that such investment capital comes not in the conventional way of trading the shares in with the public on a stock exchange, but from certain high net worth individuals and firms. They purchase the shares of other private companies or public companies for the purpose of making them private, by delisting them from the public stock exchanges.
Now, since a direct investment is happening in the firm, quite a large capital outlay is required to gain a significant amount of influence over the firm’s operations, which is why retail or institutional investors with deep pockets are the big players in this industry.
Private equity firms raise funds and manage these funds to yield favourable returns, with an investment horizon of 4-7 years, after which they plan their exit strategy, by selling their stake.
Structure of private equity fund:
So let’s discuss the structure, a Private Equity firm acts as a General Partner which manages the fund, while the investors act as limited partners. They are mainly pension funds, insurance companies, high net worth individuals, endowments etc. General partners charge both, management fee as well as performance fee.
A typical management fee consists of 2% assets under management and performance fees of 20%. Limited Partners usually earn 8-10% fees, before the fee is paid to the general partner. Performance fee motivates the private equity firms to generate superior returns, in order to align the interests of GP and LPs.
Management of the Fund:
Oversight and management are some of the most important functions of a PE firm. They support a young company by providing them strategic planning and financial management.
When it comes to more established and old players, Private Equity firms believe they possess the expertise to turn their underperforming business into stronger ones by increasing their operational efficiencies. By taking the public companies private, PE firms assist to take down the constant public scrutiny of the quarterly and annual reports and returns.
This allows the acquired company’s management and the PE firms working in unison to better the fortunes of the company. This, along with some other mechanisms eventually lead to an increase in the acquired firm’s valuation, as compared to the time it was obtained, which helps the private equity firm to plan its exit, either through resale or Initial Public Offering (IPO).
Private Equity Investment Strategies:
- Leveraged Buyouts:
This is the most popular form of private equity funding. It involves buying out a company fully, with the intention of growing it and improvising its financial health.
But what does the term leverage mean here?
For the purpose of an LBO, a private equity firm creates an SPV (Special Purpose Vehicle), after identifying a potential target company. Then these firms use a combination of debt and equity to fund the takeover. However, the debt funding is 90% as compared to 10% equity only. This debt and equity is further transferred to the target company’s balance sheet. That is why it is called a leveraged buy-out.
- Distressed Funding (Vulture financing):
Funds in this type of transaction are used for investing in troubled companies, with underperforming results, for the purpose of turning them around. Companies that have filed under Chapter 11 of Bankruptcy in the United States are the potential targets for this type of funding. This type of private equity funding saw a huge rise after the 2008 financial crisis.
- Real estate:
After the 2008 financial crisis, there was a surge in this type of funding. Here, the funds are collected for commercial real estate and real estate investment trust (ReIT). They have a higher bar for minimum investment as compared to other private equity funds, and a larger lock in period.
- Fund of Funds:
This fund invests in other funds, primarily mutual funds and hedge funds. This is basically a backdoor entry to an investor who cannot afford minimum capital requirements in these funds. However, they carry a higher management fee and it is said that non-confined diversification into multiple funds, may not always serve as the optimal strategy to multiply returns.
- Venture Capital:
In this funding, angel investors provide capital to start-up owners, which have the potential for a rising growth trajectory. Seed financing refers to the investment capital injected into a start-up to bridge the gap between an idea and an actual product or service. Series A venture capital helps a company to actively compete in a market or create one.
Why Private Equity?
Certain advantages garnered by investors by pooling in their money in the basket of a private equity fund are:
- Long term growth potential: If money is invested for a long period of time, returns in the private market may outperform those in the public market.
- Private equity serves as a great way for diversification of funds. Factors like volatility, investor sentiment and reporting have little or no effect in the private equity market.
- Properly managed investments in companies allow for a long term strategic focus as compared to a public company, leading to capital appreciation.
- Due to the risk of illiquidity for some time period, General Partners conduct extensive due diligence, before shortlisting it.
Concerns regarding your investment in Private Equity:
The biggest disadvantage of investing in private equity is the lock up of your funds suffer for a considerable period of time, as private equity usually carries a medium term investment horizon (5-10 years). Also, utilising such a huge opportunity for the turnaround of the private company requires resource, infrastructure and expertise.
The due diligence required usually translates into high costs. Gaining a Limited Partnership in a private equity fund is many a times not a bed of roses. It is mainly accessible to institutional or sophisticated investors, with deep pockets.
Impact of Covid-19 on private equity:
Due to the ongoing Covid-19 pandemic, it is suspected that private equity and venture capital investments may decline up to 60% in 2020. According to EY, only $85 million have been raised in private equity and venture capital segments according to the March data.
Experts have remarked that travel restrictions and lack of in-person meetings have significantly slowed down the deals that are in process. Investors are more likely to play defensive by investing in sectors that are booming, for example IT, consumer goods and pharmaceuticals. Activity in fintech, infrastructure, real estate and luxury goods that usually attracted large amounts of PE/VC funding are expected to slow down and may take some time to find traction.
Another interesting thing to take note of is that exits from these funds have also considerably reduced. They are expected to shrink by 50-67% percent in 2020. As investors want to work through the crisis, and then sell at higher prices after economic recovery, as opposed to selling at deeply discounted valuations.
With trillions of funds under management, private equity has become an attractive tool of investments for many wealthy investors. While I acknowledge that this fund is gradually opening up to normal investors like us, understanding how it creates value and how it functions is of prime significance first.