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Private equity: categories, benefits, and risks

Private equity means investing in privately-owned companies or in public companies with an intent to take them private. Its classifications include leveraged buyouts, venture capital, development capital and distressed investing.

A leveraged buyout is a strategy adopted by private equity firms in which they acquire public companies or established private companies by raising debt using the company’s assets as collateral. After the transaction, the debt forms part of the acquirer’s capital structure and its cash flows are used to service it.

Venture capital provides funding to private high-growth companies typically in the early stages of growth.

Development capital aims at obtaining minority stakes in mature companies that are looking to grow further, enter new markets, undergo restructuring, etc.

Distressed investing focuses on buying debt of companies undergoing financial stress. Some funds invest in companies which have cash flow problem but a good business plan in an attempt to earn a profit when the company’s credit quality improves. Such investors may participate actively in the company’s management.

Activity in private equity investments is cyclical.

Private equity structure and fees

Private equity funds are structured like hedge funds, with the fund manager being the general partner and a number of limited partners who commit capital.

They charge management fees (in the range of 1-3%) and an incentive fee, which is typically 20% of profits in excess of the hard hurdle rate. However, the management fee calculation is based on committed capital, not invested capital until all the committed capital is utilized. Once committed capital is fully invested or when investments are exited, the management fee is charged only on funds remaining in the investment vehicle. Incentive fees are typically paid once the initial investment has been paid back to investors. However, if distributions are made as the profits are earned, a claw-back provision is incorporated which requires the general partner to return any excess profit received. LBO funds may also receive additional fees.

Private equity strategies

Private equity strategies include LBOs, venture capital, development capital and distressed investing. LBOs and venture capital are dominant.

Leveraged buyouts

Leveraged buyouts (LBOs) invest in private companies and/or takes public companies private using debt capital in an attempt to add value by improving its operations, profitability and cash flow through revenue growth, cost reduction/restructuring, etc. Successful LBOs depend on the availability of cheap debt. Different types include management buyout (MBO) in which existing management buys out a company and management buy-in, in which new management replaces existing management.

LBOs are characterized by the use of a high level, i.e. proportion of debt, typically leveraged loans and high yield debt (or mezzanine financing in some cases). Leveraged loans are (senior secured) bank loans that carry significant covenants. High-yield bonds are typically unsecured bonds paying high coupons used to finance an LBO. Mezzanine financing involves the use of debt-securities with some equity features, such as preferred stock, convertible bonds, which are junior to and pay higher coupons than even the high-yield bonds. The optimal capital structure for each LBO deal is different.

Companies which are typical candidates for an LBO have:

  • Undervalued/depressed stock price: because this allows private equity funds to buy the stock at the premium required for obtaining shareholders’ approval.
  • Willing management and shareholders: current owners or management may have identified ways to drive the company’s growth but require support of private equity firms in securing capital.
  • Inefficient companies: because they have the potential to improve performance if managed better.
  • Strong and sustainable cash flows: because this enables taking on the debt required.
  • Low leverage: because it is easier to obtain debt.
  • Unencumbered assets: because they can be used as collateral to raise debt.

Venture capital

Venture capital provides funding to high-growth companies. VC strategies are classified based on the stage of growth of the portfolio company. The return required on later-stage investment is lower because the risk is lower. VC funds typically receive an equity position and are actively involved in management. Categories include:

  • Formative stage financing applies to companies that have yet to start commercial production/sales. Growth of formative-stage companies encompasses different stages: (1) angel investing refers to investment by friends and family as soon as a business idea is conceived; (2) seed-stage is the earliest stage in which VC funds are involved in providing capital for product development and/or market research; and (3) early-stage financing is provided to companies moving towards commercial production and sales.
  • Later-stage financing is provided when commercial production begins but before the IPO.
  • Mezzanine financing represents bridge financing provided to prepare a company to go public.

Formative-stage financing is typically in the form of preferred stock and convertible bonds while the management retains full control.

Later stage financing typically involves management selling control to the VC fund and may involve both equity and debt. Debt financing is typically aimed at recovery and control of assets in a bankruptcy situation instead of income generation.

Due to the non-availability of income and cash flow history, the valuation of venture capital firms is complex.

Other private equity strategies

Other private equity strategies include development capital (also called minority equity investing), in which management sells some equity stake to PE fund to generate funds for business growth, and distressed financing (also called vulture financing), in PE fund buys debt of troubled companies and actively attempts to turn them around and generate return when its credit quality improves, even though some funds are passive.

Exit strategies

The main model of private equity funds is to improve new or underperforming companies and then exit the investments at higher valuations. Hence, it is important to consider the dynamics of the industry, economic cycles, interest rates, etc. Common exit strategies include:

  • Trade sale: a sale of a company to a strategic buyer, such as a competitor either through auction or direct negotiation. It offers immediate cash flow, typically offers higher valuation (because the strategic buyer may have synergies), fast and simple execution, low transaction costs, and lower disclosure requirement. However, it may be opposed by the company’s management, employees, and the valuation may potentially be low when the number of potential buyers is limited.
  • IPO: a sale of a company’s share to the public. Its advantages include management approval, high price potential, publicity for private equity firm, and the ability to retain a significant stake. Its disadvantages include high transaction costs, long lead time, higher volatility, higher disclosure requirement, lockup period requirement. Further, it is appropriate for large companies with a good growth profile.
  • Recapitalization: not a pure exit strategy in which PE fund refinances debt at a low interest rate and pays itself dividends. Most appropriate when interest rates are low.
  • Secondary sales: a sale to another private equity fund or group of investors.
  • Write-off/liquidation: when a transaction has not gone as intended.

These exit strategies may be applied individually or in combination.

Private equity diversification benefits, performance, and risk

Private equity may offer higher returns than traditional investments due to their ability to invest in private companies, influence the company’s operations and/or use of leverage and may offer diversification benefits to a portfolio of stocks and bonds.

Private equity performance is compared with the public market equivalent index, which calculates the internal rate of return by investing private equity fund cash flows in the public market. But these indexes are prone to biases just like hedge funds. They tend to overstate return and understate volatility and correlation with other asset classes.

Despite these risks, private equity is a good addition to a portfolio if an investor can identify good private equity fund managers (who can identify good investments). It is because performance persistence may exist in private equity, hence it is crucial to identify good PE managers.

Portfolio company valuation

Portfolio companies may be valued using market multiple, discounted cash flow or asset-based approaches. Market multiple approach uses relative valuation. EV/EBITDA, which compares enterprise (sum of market capitalization and market value of debt minus cash) to EBITDA is a popular multiple for large capital-intensive and/or leveraged companies. Other companies may be valued using net income or revenue multiples. Discounted cash flow approach discounts future cash flows to find the company’s true worth. FCFF is discounted at WACC and FCFE is discounted at the cost of equity. Asset-based valuation finds the value of net assets of a company either on a fair value basis (in an orderly transaction) or liquidated values basis (in case of distressed sale).

Private equity investment considerations and due diligence

Economic conditions, particularly the level of interest rates and capital availability (which affects refinancing risk) are critical for private equity. The return also depends on the extent to which committed capital is utilized. Private equity investors must have a long-term approach and ability to withstand illiquidity because there is a significant lag between investment and exit. Some investors also require a liquidity risk premium. Many due diligence considerations that apply to hedge funds also apply to private equity funds.

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