Unveiling the Secrets of Private Equity

Unveiling the Secrets of Private Equity: A Beginner’s Guide

The estimated reading time for this post is 8 minutes

Are you intrigued by the world of private equity but find it confusing? Whether you’re a novice investor or an entrepreneur exploring funding options, this initial guide is tailored just for you. Hopefully after reading my thoughts I’ll have revealed enough of the world of private equity, so that you’ll understand its nuances, and gain insights that can empower your investment journey.

Dive into the depths of private equity with this beginner’s guide, making sense of complex concepts and offering a roadmap for those looking to navigate the lucrative yet intricate landscape of private equity investing.

1. Understanding the Basics of Private Equity

Private equity is more than a buzzword in financial circles; it’s a powerful investment strategy that involves investing in private companies rather than publicly traded ones. Before we dive deeper, let’s establish some foundational knowledge:

  • Private vs. Public: Private equity involves investing in non-publicly traded companies, providing investors with direct ownership stakes. This exclusivity allows investors to have a more hands-on approach to managing their assets, often leading to greater influence over the companies’ they invest in.
  • Long-Term Commitment: Unlike stocks, private equity investments often require a longer commitment, with funds typically tied up for several years. This prolonged engagement allows investors to actively participate in the growth and development of portfolio companies, fostering a deeper understanding of the business’ operations. 

    In general, professional PE investors maintain their funds for a period of at least ten years, of which the first 3 to 5 are designed for deployment and investment in their best ideas. The balance of the time is for supporting the “winners” and “harvesting” of returns during the period until the eventual wind down of the fund. 

    In contrast, for most public equity investors, their time horizons are measured in quarters or months, thus a 10  year time horizon is described as a “long term” investment.

  • Use of Debt to Fund Purchase and Continued Operations:  Most PE fund General Partners (GPs) or sponsors use a combination of debt and equity to fund their initial purchase and subsequent operations.  This combination is much like how a lever allows an individual to handle a larger object than physically possible.

    The addition of debt onto the balance sheet of a PE portfolio company (Portco) provides the fund sponsor the opportunity to create multiples of return on that are significantly greater than if such operations were exclusively funded with equity and retained earnings. 

  • Risk and Reward: Layered onto the standard business, geopolitical and market risks, the illiquidity of private investments and use of leverage (described above) comes with risks, but the potential for high returns often attracts investors seeking substantial gains. The illiquidity of these investments means that investors must be prepared to lock in their capital for an extended period, with the promise of significant rewards if the portfolio companies thrive.

2. Navigating the Private Equity Ecosystem

Before we begin the discussion of the industry and structure, let’s explore the intricate web of players and roles within the private equity landscape:

  • Limited Partners (LPs): Investors contributing capital to private equity funds. LPs often include institutional investors like pension and endowment funds, sovereign wealth funds and high-net-worth individuals (usually in the form of family offices). They seek higher risk adjusted return and volatility reduction in their portfolio construction and thus benefit from diversification across various fund types, gaining exposure to a broad spectrum of industries and geographies.
  • General Partners (GPs): Are the Fund managers responsible for making investment decisions and managing portfolio companies. GPs play a crucial role in identifying investment opportunities, conducting due diligence, and implementing strategic initiatives to increase the value of their investments.

  • Portfolio Companies (Portcos): Businesses in which personnel within the GP recommend to acquire or invest with the aim to enhance value and generate returns. The active involvement of operations teams and assigned GP partners from private equity firms in the management of these companies distinguishes them from passive investors, creating a symbiotic relationship geared towards growth. 

  • Fund of Funds: Entities that invest in multiple private equity funds usually in the form of an LP, providing diversification for investors. This approach allows investors to spread their risk across various fund managers and investment strategies, reducing exposure to the performance of a single fund.

  • Compensation: There are multiple forms of compensation but they are segmented into those relating to the LP and the GP.  The LPs receive all revenues returned to the fund from its portcos including, but not limited to, management fees, capital gains from sales, dividends. 

    The GPs receive fees in the form of an annual management fee (between. 0.20% and 3%) on the capital assets that have been deployed and invested (not committed), a portion of the capital gains or dividends received by the fund from the Portcos (usually between 10 and 20%), often called the “carry” because it is not paid to the GP until all invested capital has been returned to the LPs or some hurdle rate has been met. 

    On occasion, certain members of the GP will receive board membership fees or other fees from the Portco for their operations work during the ownership period by the fund.  When planning an investment in a PE fund, it’s important to ensure that the fund GP’s interests are aligned with yours as reflected by the type and amount of fees charged.

3. The Art of Due Diligence

Due diligence (DD) is the process where the personnel investigate the operations, marketing and opportunities for a Portco.  Generally, DD is most intensive before the GP makes their initial investment, but can continue throughout the investment holding period.  

  • Financial Due Diligence is a thorough review of the target company’s financial health, assessing revenue streams, expenses, and growth projections.  This includes an extensive “quality of earnings analysis” wherein the actual receipts are reviewed from first source documents like bank statements and receipts.

    For companies with material financial assets such as goodwill, intellectual property or accounts receivables, each asset is assigned a valuation by both internal teams and independent valuation experts.  Thorough financial analysis is essential for evaluating the company’s historical performance and its potential for future success.
  • Operational Due Diligence Assessment: Evaluate the efficiency and effectiveness of a company’s operations, identifying potential areas for improvement. This in-depth analysis goes beyond financial metrics, focusing on the day-to-day operations that impact the company’s overall performance and scalability.  As a result of this work, the GP makes an assessment on strengths and weaknesses of the business operations and can then form an investment thesis on the operations and market environment.

  • Legal Due diligence Scrutiny: Usually left to the external counsel of the GP, but all contracts, liabilities, and potential legal issues that could impact the investment are assessed. A comprehensive legal review ensures that there are no hidden risks or obstacles that could hold back the success of the investment. Understanding the legal landscape is crucial for mitigating unforeseen challenges. For investments in asset intensive industries, chains of title are included as part of the legal DD process. 

4. Types of Private Equity Investments

Explore the diverse range of private equity investment strategies:

  • Portco: With the aim to enhance operations, profitability and thus Enterprise Value. Buyout strategies focus on optimizing the performance of mature companies, often involving operational restructuring and strategic initiatives to drive value.

  • Growth Investing: Often the existing management of a target Portco is seeking additional capital, financial and operations acumen to aid in the acceleration of growth of their existing operation.  Such investments result in the GP taking a minority but significant equity position (say 30%) and a role in daily operations and governance.

  • Distressed Investing: Capitalizing on the financial distress of companies, often resulting in significant returns if successful. Distressed investing involves identifying companies facing financial challenges and implementing turnaround strategies to revitalize their operations and profitability. 

    Most distressed investors focus on the acquisition of the debt of the Portco because it provides them with the greatest leverage over the current board and equity holders in these situations.

5. Mitigating Risks and Maximizing Returns

Given that there are additional risks related to the general nature of private company investment, how does an investor optimize their returns in private equity investments?

  • Diversification: Spread investments across different industries and geographies to reduce the impact of a single underperforming asset. This could also include investments by GPs who invest in certain stages of companies (often called small, mid and large market).  Diversification is a fundamental risk management strategy that enhances the resilience of any private equity portfolio.

  • Active Portfolio Management: Actively engage with portfolio companies, providing strategic guidance and operational support. Hands-on involvement allows private equity investors to influence key decisions, implement improvements, and drive the success of their investments.  The majority of such transactions occur in the form of managed account or “side-car” agreements that allow LPs to invest additional funds into specific Portcos that will be managed by the GP.
  • Exit Strategies: As first coined by Stephen Covey “Begin with the end in mind”.  Develop clear exit plans, whether through IPOs, mergers, or selling to other investors, to secure returns. A burgeoning secondary acquisition market for initial LP fund positions is expanding in today’s market and will continue to do so. Planning exit strategies in advance ensures that investors can capitalize on the appreciation of their portfolio companies and realize significant returns on their investments. 

Call to Action:

While PE investing is not for those seeking simple and understandable investments, it  is a way to create long term wealth and improved risk-adjusted returns on your total portfolio.  While we’ve covered some of the basics in this article about your journey into private equity, you can dive deeper into specific areas of interest, connect with seasoned professionals, and consider seeking advice from advisors specializing in private equity. Remember, education is the key to unlocking the vast potential of private equity investing. 

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