A form of alternative investments (something that doesn’t fall into “traditional” investment categories such as stocks and bonds), Private Equity involves making direct investments in order to take publicly traded companies private, or invest directly into private companies. Private equity investments are often illiquid, with cash being tied up in companies for an extended period of time (usually 5+ years).
How does it work?
The (very) general idea is that the private equity fund manager, known as the General Partner, will identify potentially undervalued companies, buy them and manage them to get them performing better, thereby increasing the value of the company and earning a return for the fund once it has been sold on.
The General Partner uses various tools and techniques to increase the company’s value, depending on which areas of the business could be doing better. Usually this involves some combination of the following:
Combining existing business units to create internal synergies
Breaking up the company and selling off non-essential parts of the business to refocus on its core business
Changing the management team, or reducing staff costs by increasing the level of automation within the business
Investing in marketing to build the company’s brand and improve its positioning in the market
Adjusting the company’s leverage to achieve an optimal capital structure (mix of debt and equity) in order to maximise the equity value of the company
Combining the business with other companies via mergers and acquisitions in order to capture market share / benefit from economies of scale
Private equity funds are generally structured with a General Partner (GP) and often many Limited Partners (LP)
GP: The General Partner is the private equity fund manager, who operates and manages investments within portfolio companies owned by the fund. The GP usually owns a small percentage of shares in the fund and earns a management fee for the duration of the fund.
LP: The Limited Partners are often institutional investors such as pension or hedge funds who choose to lock up their capital for the duration of the fund, in the hope that the GP will make investment decisions which earn healthy returns over time.
Types of Private Equity funds
Leveraged Buyout funds:
These funds look for relatively mature businesses which have stable and predictable cash flows / earnings. They look to buy these companies with relatively little cash being invested from the fund, and a significant amount of debt. The idea is that the company’s strong cash flow generation will help to pay off the debt in time and in turn create value for the equity holder (the fund itself).
Real Estate Private Equity funds:
These funds look to purchase undervalued land, residential and/or commercial properties. The fund will then seek to increase the value of their property holdings by renovating, changing the classification of the property (from residential to commercial or vice versa, for example), and/or finding tenants in order to earn a yearly income for the fund during the lifetime of the fund.
These funds have received the most attention over the past decade given the plethora of start-ups coming to market. The GPs of these funds raise capital from angel or seed investors and seek to invest in high growth companies at a relatively early stage within the company’s life cycle. The goal of these funds is to invest in future “FAANGs” or very successful industry defining companies and make extraordinary returns in the process, which would ideally more than offset any losses from investments made in start-ups which do not go on to progress as hoped.
Distressed Credit funds:
These funds look to purchase the debt of companies which are close to entering or have entered bankruptcy. They purchase debt relatively cheap and usually go through bankruptcy courts to seize the equity of the company before either restructuring it / attempting to rebuild the company or selling off the company’s assets such as buildings and machinery in order to make a return on their investment
Note: This is a very generalised description of distressed credit funds, which can be quite complex in the real world
Fund of Funds:
These funds look to invest in multiple private equity funds. The idea here is to diversify 1) GP exposure and/or 2) strategy exposure. Investing in multiple funds means investing with multiple General Partners, which reduces the risk of making a loss if one GP makes the wrong investment decisions. Investing in multiple funds can also mean investing in a variety of strategies: a range of different real estate strategies, or a mix of real estate and venture capital strategies, or both (or none – you get the idea – it can be a mix of whatever you like!)
At the end of a fund’s life-cycle (which is usually pre-determined at the time of its creation), the GP will need to sell all assets held within it in order to return capital to LPs and the GP itself.
These “exits” are usually achieved via one or more of the following:
Selling the assets to other companies
Selling the assets to other private equity funds
Selling the assets to institutional investors in the public equity markets – via an IPO
While a lot of private equity investment may be difficult for you to access as an individual investor, it’s worth being aware of private equity and how it operates in order to have a better understanding of the financial world, as well as being in-the-know when you see private equity IPOs coming to market!
On the topic of private equity IPOs – funds rarely ever sell the entire company at IPO, instead usually selling a stake (usually 20% – 50% of the company) followed by further sell-downs over the course of the following 1-3 years. This structure can be reassuring for institutional equity investors because it means the private equity fund maintains a shared interest in the stock’s ongoing success – “skin-in-the-game”. That said, not all private equity IPOs go well and each should be judged on a case-by-case basis!
Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.
Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.
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