Market Basics: Private Equity

The sector of private Equity centres around acquiring organisations. The value of these organisations to the private equity firm is then placed into a portfolio with other acquisitions. This business model enables the organisations targeted by the private equity firms to gain funds and hence to become more hedged against cyclical revenue streams.

The industry is just over 100 years old. It started in 1901 when J.P. Morgan undertook the first buyout in history of Carnegie Steel. 50 Years later, Warren Buffet created and subsequently set up the first private equity fund. During 2006-2007 the financial sector experienced an all-time peak of private equity, but 1 year later the 2008 financial crisis sparked a drop in the volume of acquisitions. To showcase the importance of private equity as a market, approximately 5% of world capital is held in private equity.

Within private equity funds, there are three sub classes. First, venture capital which consists of start-ups and small businesses. The funds often cover large monetary amounts, but the stakes are spread over a large number of small financial commitments to hedge investments and reduce risk. The second sub class comprises the development capital made of firms in fast growing industries. The stakes are of medium size. Leverage buy-out funds constitute the final sub category. These funds are active in matured industries, predominantly investing into companies with steady cashflows. Due to the large cash flows involved, a small amount of large investments are made to gain high stakes in a fewer number of firms.

How does private equity create value?

Private equity generates value through leverage, multiple expansion and operational improvement. Leveraged buyout means that the private equity firm takes on debt to invest into companies through a combination of the cash available in the fund and the newly taken on debt. This enables organisations to grow and profit from debt, without having to take on any debt or risk itself. Multiple expansion is a form of private equity investing which entails that the organisation is acquired in a small state with low EBITDA’s and will have grown the organisation and pushed the EBITDA further up. The firm can then be sold at a premium compared to the initial purchase price. The final possibility of value creation occurs through working capital improvements and top-line growth within the acquired firms. In essence, this can be viewed as improved health of the target’s financials, with less short-term debt and higher revenues.

From where do private equity attract funds?

Bank debt is the largest source. Second, private equity funds frequently issue corporate bonds into the market. The third source of debt is mezzanines (shares with low-priority in dividend payouts). These mostly attract institutional or wealthy individuals.

What happens when the desired financial results have been achieved?

There are four exit strategies for the private equity fund. First, a trade sale can be made to a strategic buyer to further strengthen the company. This often occurs at an early stage of the company, giving it the necessary foundation to start growing further. The second type of sale is often made to another private equity firm, the goal of which will be to increase the value of the target company even more. An IPO is also a possibility. In this case the fund will remain a stakeholder and hence benefit from fluctuations. This typically occurs when the targeted firm has realised most of its growth potential from the funds provided by the private equity firm. The last strategy is to recapitalise and execute a one-time dividend. The fund provides the targeted firm debt to pay out dividend. This way, the firm realises a return while maintaining ownership of the company.

How do funds make money?

Fund management fees, which are usually 1%-3& of the total capital under management. The famous carried interest are usually around 20% of the profits made and retained by the fund, with the rest going to investors. The company management fees are 1-10M charged to the portfolio company. A medium portfolio company will pay the owners 1-3M in management fee per year.

What are typical trends in this industry?

After a deep drop in 2008, 2017 was a great year for exits as investors have been cash-flow positive for 6 years. EBITDA levels are skyrocketing after sales, with more than half of the buyouts are trading at more than 11x the EBITDA now. Furthermore, one can see that the returns tend to be superior compared to historical performances and losses are minimised.

What are the steps Private Equity firms go through?

First of all, private equity firms must identify the targets and develop the investment thesis based on the available findings. It must be noted that during such a valuation, the private equity firm has no access to any company-specific documents, but only what is directly available to them. If the valuation and analysis are positive, a deal process will take place. During the deal process, the market context of the firm and its competitive position will be assessed. Additionally, the required planning for the management strategy will be elaborated. The third and last step is the aforementioned value creation.