Private equity (which is sometimes referred to as “buyout investing”) involves the purchase of a majority or complete ownership stake of an operating company, which is either privately-held or listed on an exchange. Generally, these companies have been in existence for five or more years.
The purchase typically has a small equity investment (from 5% to 20%) and a large amount of debt. The debt will usually include a mix of bank loans, notes and bonds.
Essentially, a private equity firm seeks companies that are underperforming. What’s more, the management team will have a significant amount of equity and perhaps invest their personal capital. This helps to incentivize management.
The private equity owners will probably have several board seats and as a result, take an active role in the company. This means taking actions like: cost cutting, adding to the management team, improving the product mix and so on.
These initiatives should help to increase cash flows, which is critical to paying down the debt load. It also will lead to increase shareholder value.
The exit for the equity holders can be either in:
- A sale to a company or another private equity firm
- An initial public offering (IPO)
Private Equity Firm Structure
In light of the massive sizes of some private equity firms – such as KKR, the Texas Pacific Group and Blackstone – they still tend to be fairly small organizations. For example a $1 billion fund may only have several dozen employees.
A key reason for the low headcount is that private equity firms typically outsource many functions, such as accounting, due diligence and back office functions.
A private equity firm is usually in the form of a partnership. Generally, the owners are individuals. But, in some cases, there may be institutions that have ownership. This is the case with the Carlyle Group, in which CalPERS (California Public Employees Retirement System) has a 5.5% ownership.
The managers of a fund are known as the general partners. They are the ones who identify buyout opportunities, structure the deals and try to extract value over time.
The investors of a fund are called the limited partners. These are usually major institutions, such as pensions, insurance companies, and college endowments. They are willing to lock-in their investments for five-to-seven years so as to achieve high rates of return.
Buyout Process
Step 1: Company seeks a buyer. This is often done by hiring an investment bank.
Step 2: A private equity firm agrees to sign a confidentiality agreement so as to review non-public information. Some key details:
- Sales pipeline
- Sales/profits by customer
- Projections
- New investment plans
Step 3: Due diligence
Step 4: The deal is negotiated and closed.
Step 5: Work with management to improve the operations of the company. This can last from one to five years or so.
Difference Between Venture Capital and Private Equity
There are key differences in venture capital and private equity. Basically, a VC looks for opportunities that are in the startup or early stages of development. What’s more, a VC tends to take a very active role in the development of the company.
Difference Between Hedge Funds and Private Equity
Just like private equity, the hedge fund industry has undergone massive growth (with roughly $1.4 trillion in assets among 8,000 funds). Yet, there are clear differences between the two vehicles.
For the most part, a hedge fund invests in stocks, bonds, commodities and derivatives. There is also much flexibility; that is, a hedge fund may also short securities.
However, the equity positions tend to be small and the holding period for an investment is usually short-term.
Although, some hedge funds engage in activist investing. This means it will buy a major position in a stock and agitate for change, such as through a proxy fight. The expectation is that the target will seek a white knight as a savior or to go private.
Keep in mind that some private equity firms – such as Blackstone – have their own hedge funds (and vice versa). -- tt
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