What is Private Equity?
Private Equity involves buying, improving and selling private companies, i.e. companies that are not listed on the stock markets.
Ultimately, the Private Equity fund will seek to sell the company for a greater value than it originally paid, generally by floating on the stock market or selling to a strategic buyer.
Private Equity funds typically invest in high-quality established companies which have been tested through market cycles and offer the potential for significant future growth. These firms often have revenues greater than £100m, with international operations and hundreds of employees.
Understanding the Capital Structure
Any investment in a business with real value is made using a combination of equity and debt. One way to visualise a company is to think about the capital structure; of the total value, how much is financed by debt vs. equity.
Note: For illustrative purposes only. Actual capital structures and returns will vary by deal.
All investments involve an element of risk – investment theory states that an investor should expect to receive a return appropriate to the risk taken; i.e. the greater the risk, the greater the expected return (and vice-versa).
Private Equity funds invest in equity which, whilst the highest risk component of the capital structure, offers the potential for the highest returns. Put differently, unlike a debt investment, there is no theoretical cap on the return that can be generated – though there is limited downside protection.
What types of company do Private Equity Funds buy?
Private Equity funds generally focus on established businesses – the average size of a private equity deal in 2017 was $158 million (source: McKinsey).
These are not start-ups, but more mature high-quality businesses run by experienced management teams who work in partnership with the highly experienced Private Equity professionals.
Examples of companies that have been Private Equity owned include Formula 1, Dell, Hilton Hotels, Hackett, Rapha, Pret A Manger, Scott Dunn, Musto, The Cotswold Company, and Big Bus Tours.
Whilst each fund will have a specific strategy, most Private Equity funds generally seek to acquire businesses that display some or all of the following characteristics;
Note: For illustrative purposes only. Actual company characteristics will vary by deal.
What do Private Equity fund managers do?
Whilst each Private Equity fund is different, all funds follow the same high-level investment process:
1. Source Investments
The most senior team members at a Private Equity manager will spend a significant proportion of their time identifying companies for acquisition. The best managers have differentiated sourcing capabilities enabling them to buy high quality businesses in less competitive situations.
2. Due Diligence
Once a potential acquisition has been identified, the Private Equity manager will deploy the full resources of its team, complemented by third party consultants, accountants and lawyers, to undertake detailed due diligence on the company. This is to confirm the potential growth prospects for the company, and to ensure any risks are identified and understood.
3. Decision Making
If an investment opportunity is deemed sufficiently attractive following due diligence, then the Private Equity manager will seek the approval of its investment committee. Funds tend to be highly selective in the companies they seek to acquire, with most Private Equity funds ultimately investing in less than 10% of the companies they analyse. The investment committee is generally comprised of the most experienced members of the team, normally with 20+ years of experience buying, managing and selling companies. If the investment committee approves the deal, then the team will seek to finalise the acquisition.
4. Asset Management
and Value Creation
Once acquired, the manager will seek to increase the value of the business generally through a combination of the following;
To realise its investments, Private Equity funds must manage the exit (or sales process) for each company in the portfolio. The chosen exit strategy will depend on the business and market conditions at the time, and generally involve either (i) an IPO, (ii) selling to a strategic investor, or (iii) selling to another Private Equity fund.
How does this translate into performance?
We have discussed what a Private Equity manager does, from sourcing investments, implementing value-add strategies and achieving exits. How does this effort translate into performance for investors? There are three main mechanisms that drive the gains made by Private Equity investors;
Note: Capital is at risk. The value of Private Markets investments can go down as well as up. Past performance is not indicative of future returns.
Why invest in Private Equity?
Private Equity funds generally offer their investors exposure to a diverse portfolio of high performing, privately owned, established companies. Investors in a Private Equity fund expect to generate strong capital growth, in excess of that available from publicly listed stocks. Most Private Equity funds target a return of 2x invested capital. Note that target returns are not guaranteed.
Private Equity investments are illiquid (i.e. investors cannot easily sell their investments until the fund has been through its full cycle). This illiquidity allows Private Equity managers to focus on the long-term development of their portfolio companies - not worrying about reaching quarterly share price targets - which can allow these companies to be built in a more robust, sustainable and, ultimately, successful manner.
Private equity funds invest in established high quality businesses run by experienced management teams who work in partnership with the highly experienced private equity professionals to operationally improve the company.
Private equity has been a major component of leading institutional investors’ portfolios for decades. For example, one of the largest investors in the UK, The Wellcome Trust foundation, has $7 billion of its $28 billion portfolio invested in Private Equity (Source: Preqin, February 2017).