The Basics Of Private Equity

They used to be known as “corporate raiders”: barbarians at the company gates ready to snatch up businesses, strip their assets, and run ‘em into the ground – all while making a fortune for the people at the top (like former Bain Capital boss Mitt Romney). And while the genteel “private equity” industry of today has mostly cleaned up its image, it’s still a murky world of backroom deals and controversial practices. But never fear: Finimize is here to shine a light in – and reveal how you and your money can get involved.

What is private equity? Traditional stock investments are in “public” companies: those listed on the stock market. But there’s a whole world out there of non-listed companies: firms that are either too small to have ownership openly traded, or that prefer to operate out of the public spotlight. And some of them are ripe with investment opportunity.

That’s where private equity firms come in. They invest in, well, private equity (another term for shares in a company). That can take the form of “venture capital”, where small investments are made in startups or other fast-growing companies, and there are other strategies too. But a lot of the time when you hear people talk about private equity (or PE for short), they’re referring to investors buying out a whole company. Their aim is to then transform the business, make it more valuable – and eventually sell it on for a profit.

In theory, it’s simple – but in practice, PE firms employ various unusual strategies and bits of complex financial engineering to deliver gains for their investors and themselves. In this Pack we’ll cut through the noise and delve into exactly how PE firms make money, turning you into a PEXpert (sorry).

But why should I care? You might not know it, but there’s a good chance you’re invested in private equity already: pension funds have become increasingly big fans of the industry in recent years. And if you want to get involved further, there’s evidence that backing private equity companies whose stocks are – ironically – themselves publicly listed could see you net market-beating returns. Even if you’re completely PE-free, the sector is just so massive (with a whopping $582 billion worth of deals in 2018 and $2 trillion in unspent funds) that it has big repercussions on almost all investments. As with so much in life, the really juicy stuff always goes down behind closed doors…

The takeaway: Private equity firms buy companies, increase their value, and try to sell them – and you’ve probably got a financial interest in them already.

How The Deals Work

How does private equity work? Private equity funds are run by “general partners” or GPs (no relation to the medical practitioners, British Finimizers). These GPs raise money for the funds from other investors – known as “limited partners” or LPs. These LPs could be wealthy individuals, or they could be institutions such as insurance companies, pension managers, and sovereign wealth funds. They’ll allot a portion of their investments to a PE fund in the hope of diversifying things a bit – and with any luck generating better returns than those on offer to any old Tom, Dick, and Harry. But with private equity, you’re investing for the long haul: it’ll typically take a few years for a return to be generated, and most funds now take over a decade to be wound up.

Once funds are raised (the average fund size in the US is $1.6 billion), the GPs get to work. They’ll start scouting for deals: either private companies with growth potential, or public companies that might do better in private hands. These aren’t hard to find – investment bankers and brokers constantly pitch PE funds with buyout opportunities.

But finding a good deal is harder. Private equity firms do tons of “due diligence” to figure out if the acquisition target is all it’s cracked up to be. That involves poring over financial statements, meeting with the management, and modeling future returns.

How do these acquisitions work? Although a company could be bought and paid for with cash, most private equity firms prefer to use debt. Say a company is worth $100 million: the PE firm might put up $20 million in cash, and borrow the remaining $80 million. But they won’t be on the hook for those borrowings – oh no. Instead, the debt gets added to the acquired company’s balance sheet. This is called a leveraged buyout, or LBO.

Why do PE firms do this? Using debt (especially when interest rates are low and debt is cheap) allows firms to get a higher return on their investment: a $100 million deal with $10 million profit is only generating a 10% return if it’s fully cash-financed – but that’s a 50% return if you’re only putting up $20 million (see our Using Leverage Pack for more on this).

But raising debt can be tricky, especially when you’re asking for so much. As an alternative, some PE firms use mezzanine financing: debt that can convert to equity in the case of a default. This is an awful lot riskier than normal debt: if things go wrong, standard lenders will be paid back before those holding mezzanine loans. Mezzanine financing costs more as a result – but in the absence of other money, PE firms might resort to it anyway.

Do PE firms make money any other way? They do. As well as buying and selling existing LP stakes in other private equity funds on the secondary market, or even going full meta and creating entire private funds of funds, investing in infrastructure projects has become big business: think toll roads, oil pipelines, and airports. Private equity giant Blackstone also has a huge real estate portfolio, and in recent years firms have started lending operations – including offering mezzanine financing. According to the Financial Times, three of the four biggest US firms now manage more debt than equity.

Buying and selling companies is still PE’s bread and butter: but it only works if they can improve the businesses and extract value. In the next session, we’ll look at how they do just that. Next time you read a Finimize news story about some big listed private equity firm buying a company, you’ll be better able to judge for yourself whether its strategy is a good one…

The takeaway: Private equity firms use other people’s money and lots of debt to buy companies. They’ve also branched out into other strategies in recent years.

Private Equity Strategies

How do PE firms transform companies? There are a few different strategies, depending on the kind of business being acquired. If the firm’s bought a small company, it might want to expand it into new activities or geographies: Bridgepoint bought café chain Pret A Manger in 2008, tripling revenues to $1.2 billion before selling it to conglomerate JAB. Combining it with other companies (known as bolt-on acquisitions) is one way to broaden a portfolio company’s horizons.

If the firm’s taking a public company private, they’ll take advantage of the new circumstances: management that isn’t beholden to flighty stockholders or dishing out impressive quarterly updates might be able to focus instead on the future of the business. Alternatively, funding a management buyout – where the bosses of a company take over a controlling stake – can help incentivize success too. If the PE firm wants (and it usually does), the ability to appoint people to the company's board – perhaps industry experts from other companies it’s invested in – can give it some sway over future strategy.

These techniques can help turn a company around – something of particular importance to funds that invest in distressed businesses. That’s where a struggling company gets bought out in the hope that it can be set back on track (and sold on for profit, of course). Such rescue missions aren’t easy: they might involve smart financial engineering to reduce taxes, or major cost cuts. The latter can be controversial: while some decisions are relatively innocuous (like switching suppliers), private equity firms coming in and sacking staff can raise hackles – and legal issues.

Divisions are sometimes spun off into new companies or sold to competitors in order to streamline a company – a practice known, disparagingly, as “asset stripping” – and that almost always means layoffs. Hundreds of people can be fired instantly in the new private equity owner’s quest for profit.

Why are costs cut so aggressively? Remember what we said about leveraged buyouts? When companies take on that much debt, their costs skyrocket: at one point PE-owned Toys “R” Us faced interest payments of around $400 million a year. Those costs can quickly overwhelm a business, which then finds itself in drastic need of trimming fat elsewhere.

But if a private equity firm is successful in spreading, streamlining, or saving a portfolio company, the next concern is cashing out. In the next session, we’ll look at just how PE pockets its profits – and what that might mean for you.

The takeaway: PE firms might try to grow a successful business, or save a failing one.

How PE Makes Money

How do private equity firms make money? Once a portfolio company is nicely fattened up, its owners’ next concern is taking it to market – and making off with their cut. There are a few options for “exiting” an investment, and one popular way out is to float it on the stock market. That process, known as an initial public offering or IPO, lets the PE firm sell its shares to anyone who wants them, including normal investors just like you. In fact, some research suggests that private equity-backed IPOs create more value for shareholders in the long run than other IPOs and the market as a whole – so they may be a good investment (more on this in our Evaluating IPOs Pack).

Another exit route is to sell the company on to someone else: either a competitor who wants to increase its hold on the market, a company that wants to expand… or another, bigger private equity firm that will pour in even more cash and debt to grow the company further. Indeed, some worry that the current private equity market is a dodgy game of pass the parcel, with the PE giants left holding companies praying for some candy…

If they don’t sell the company, are they out of pocket? Not normally. In addition to their share of the exit proceeds – the firm’s GPs normally takes 20% such “carried interest”, distributing the rest to the LP investors in the fund – the private equity managers also charge investors a management fee. The traditional industry standard of 2% may not sound like much – but with a billion-dollar fund, it’s not to be sniffed at.

Then there’s the controversial practice of having a company pay its private equity owner big dividends and fees. PE firm Sun Capital was lambasted for its handling of retailer Shopko: it charged consulting fees of $1 million every quarter and took massive dividends from the company’s dwindling profit (one payout was $50 million). Shopko, perhaps unsurprisingly, went bankrupt. This isn’t an uncommon practice, either: according to research company S&P Global, in 2011 private equity firms took out over $25 billion in loans (attributable to the portfolio company rather than the PE firms, natch) to pay themselves dividends.

Even when these payouts aren’t funded by loans, excessive distribution of money to investors – rather than, say, investment in growth – can damage a company. The “asset stripping” we talked about last session is a great way for PE firms to ensure they’re delivering a return to their investors and themselves. Selling off a company’s real estate can boost its bank balance… unless the PE firms drain the account for themselves.

But not all private equity firms are bad: Pret A Manger gave every employee a big bonus when its PE owner exited. And even suspect practices can end up delivering good returns. In the final session we’ll look at why anyone invests in private equity – and how you can get involved if you so wish.

The takeaway: Private equity firms make money when they sell a company – though they also charge management fees and take dividends.

How To Invest In Private Equity

Why do people invest in private equity? The same reason they invest in anything: returns. But it's up for debate what exactly private equity can offer over and above the stock market. Private equity did outperform US stocks between 1986 and 2017 – but if you look at just the smaller companies that PE firms most frequently bought over that period, private equity underperformed the public market.

What private equity does offer is access to leverage. The industry’s use of debt means your cash’s impact gets magnified (more on how this works in our Using Leverage Pack). But that exposes an investor to more risk, too – and if a PE deal goes wrong, the fund could rack up heavy losses.

So what’s the real benefit of PE? Because private equity holdings aren’t publicly traded, their value is measured fairly infrequently. And when their value is measured, it’s self-reported. That means the value of a private equity fund doesn’t fluctuate all that much – and compared to public markets, PE funds are much less volatile.️

Investments in private equity look smooth – and for institutions that need to deliver consistent returns (like pension funds), including private equity stakes can make a portfolio look safer than if it were all in publicly traded investments. But bear in mind that this is artificial smoothing: the actual value of a private equity fund fluctuates just as much as public stocks do, it’s just that the reporting is less frequent.

Are more people investing in PE? They are. A decade of low interest rates has helped underpin the sector’s debt-fueled model – and with investors of all stripes struggling to find returns in bonds or cash, private equity can offer a nice alternative. In particular, pension funds anxiously searching for higher returns in order to fund ever-longer retirements (more on that in the Our Aging Planet Pack) have ploughed cash into the market. Between 2016 and 2018, the number of LP investors with more than $1bn invested grew by 18%, while the number of so-called megafunds (those with more than $5 billion to spend) has soared in recent years.

How can I invest? As mentioned, if you’ve got a pension pot, you’ve probably got some stake in private equity already. And if you’re extremely wealthy, you could become an LP yourself directly: you’ll normally need at least $100,000 or $1 million in assets. As well as the traditional players, flashy tech startups like Moonfare are making a name for themselves – but the ante remains high.

For the less loaded among us, however, buying shares of listed private equity firms remains the easiest way to get exposure to the sector. These include giants like Blackstone, KKR, and The Carlyle Group. Buying these companies’ shares gives you a stake in their success, and buying a mix of them will hopefully protect you from any one business’s bad decisions. Most investors value these firms based on the strength of their recurring fund management fees, rather than performance-related revenue (i.e. the 2%, rather than the 20%).

An index fund like the iShares Listed Private Equity UCITS ETF gives you access to a bunch of firms in one go, spreading your risk, while the Thomson Reuters Private Equity Buyout Index replicates the performance of private equity portfolios by investing in a similar mix of publicly traded stocks. You could also act like a pro and buy a listed fund of funds entirely composed of LP stakes – like the UK’s Pantheon International. As with any investment trust, however, it’s worth looking closely at the value of the shares versus the value of the fund’s underlying investments.

The world of private equity remains a secretive one – but now you’ve read this Pack, you’re more clued up than most. And with US regulators currently considering opening up private equity funds to everyone, you’ll be in a prime position to act if things suddenly become a lot less private.

In this Guide, you’ve learned:

🔹Most private equity funds make money by buying companies, increasing their value, and then selling them

🔹Debt is often used in the form of a “leveraged buyout”, letting PE firms get more bang for their buck

🔹Growing businesses is one way to increase value – the other is to slash costs through asset stripping and layoffs

🔹Funds make money by selling their companies to other funds, or to the general public

🔹There are several ways for average Joe’s to invest indirectly in private equity, including listed firms and indexes.

Now test your knowledge on what you’ve learned in this guide with our quiz.