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Investment - Private Equity
Consider an entrepreneur who set up her new business five years ago. Back then, she went to her friends and neighbours for the money she needed. Now, five years later, her company is incredibly profitable. To raise the additional funds the company requires to support its expansion objectives, it could issue shares to the public via an initial public offering (IPO). But it was not yet ready to go public, and the company required more money to grow than the entrepreneur, her friends, neighbours, and banks were able or willing to supply. Who would have financed such a young and not well-established company? The answer is venture capitalists. The entrepreneur sold some of her company’s shares to a venture capital firm, a sort of private equity firm, to receive the additional funds essential to build her business.
Private equity firms invest in private companies that are not publicly traded on a stock exchange. Although people typically refer to private ‘equity’, private investments can include both equity and debt securities. Private debt is debt provided to private companies. Private debt comprises direct lending (private loans provided without intermediaries), mezzanine debt (private subordinated debt), venture debt (private loans to start-up or early-stage enterprises), and distressed debt lending (financing given to companies that are at risk of failing).
Private Equity Strategies
Private equity comprises numerous ways that may help offer money to companies at different phases of their development. The most often employed strategies are venture capital, growth equity, buyouts, and distressed.
Another private equity investment approach, which is independent to the stage of a company’s development, is called secondaries.
Venture Capital
As stated in the introduction, venture capital is a private equity investment strategy that consists of supporting the early stage of companies that have an original business plan. Venture capitalists regularly invest in ‘start-up’ enterprises that exist merely as an idea or a business strategy. The company may have only a few workers, have little or no revenue, and still be developing its product or business plan.
Entrepreneurs are typically looking not only for funding to start their firm (e.g., seed money), but also for guidance and knowledge about how to create and maintain their company.
Venture capital is regarded the riskiest sort of private equity investment strategy because more companies fail than succeed.
It can take many years before a company becomes successful, and most venture capital–funded enterprises have years of unprofitable activity before they reach the point of producing money. So, venture capital investing demands patience. And those companies that do prosper tend to significantly reward their investors.
Growth Equity
Growth equity is a private equity investment strategy that usually focuses on financing companies with proven business concepts, good client bases, and positive cash flows or profits.
These companies frequently have potential to grow by adding new production facilities or by making acquisitions, but they do not generating adequate cash flows from their activities to sustain their expansion goals. By contributing additional money in return for equity in the company, growth equity investors assist these enterprises expand and become more established.
Some growth equity investors specialise in helping companies prepare for an initial public offering. These investors give additional money at a later stage of a company’s development.
Additional equity dilutes existing shareholders’ ownership because there are more investors sharing the company’s cash flows. But because the later-stage growth equity investors often have expertise in structuring initial public offerings, they may bring financial rewards that offset the downsides of dilution. Initial public offerings, such as Facebook in 2012 (still the leader in the past decade for most amount raised) and Uber and DoorDash in 2020, are an opportunity for founders and existing shareholders to convert some or all of their investment in the firm into cash. So, the late inclusion of equity investors that have successful track records in structuring first public offerings may be useful for founders and existing shareholders.
Buyouts
Buyouts are a private equity investment strategy that consists on financing established companies that require money to restructure and facilitates a change of ownership.
Buyout agreements often include taking a publicly traded company private. For example, such corporations as UK-based Alliance Boots or US-based Twitter, Hertz, and Hilton Hotels were once public companies, but they underwent buyouts and are now privately owned companies.
Buyouts for which the financing of the deal involves a high proportion of debt are commonly called leveraged buyouts that financial leverage refers to the proportion of debt relative to equity in a company’s capital structure.
Because the high level of debt means hefty interest payments and principle repayments, companies that undertake a leveraged buyout must be able to generate robust and sustainable cash flows. So, they are frequently well-established enterprises with solid competitive standing in their field. Buyout investors generally seek companies that have lately underperformed, but that provide potential through restructuring to boost revenues and profitability.
When corporations suffer financial issues, they may be at danger of not being able to make full and timely payments of interest and/or principle. This risk, which is known as credit or default risk, was explored in the module on Debt Securities.
Distressed investment focuses on purchasing the debt of distressed companies that may have defaulted or are on the brink of defaulting. Frequently, investments are undertaken at a large discount to par value – that is, the amount repaid to the lenders upon maturity. For example, an investor who purchases the debt of a struggling company may only offer the existing lenders 20% or 30% of the amount they are due.
If the company can continue and grow, the value of the investment will increase — frequently by the conversion of such debt into equity of the new, surviving company — and the investor will realise significant value. Distressed investing does not often involve a cash flow to the company.
Structure and Mechanics of Private Equity Partnerships
As noted in the preceding section, private equity investments are frequently arranged in funds managed by partnerships. A private equity partnership usually contains two categories of partners.
A general partner (GP) is often a private equity firm that puts up the partnership. It is responsible for raising cash, locating acceptable investments, and making choices. General partners have unlimited personal liability for all the debts of the partnership – that is, general partners could lose more than their investment in the partnership since, if necessary, their personal assets could be utilized to settle the business’s debts.
Limited Partners
Limited partners (LPs) are investors who contribute capital to the partnership. They are not involved in the selection and management of the investments. Limited partners have limited personal liability – that is, limited partners cannot lose more than the amount of cash they put to the partnership
A private equity firm may create different private equity funds for different sorts of investments. The investments are normally not managed by the general partner itself, but by professional fund managers who are employed by the general partner. Each private equity fund may have its own fund manager who is responsible for the day-to-day management of the investments in the funds.
The private equity firm makes money through two mechanisms.
Management costs are fees that limited partners must pay general partners to reimburse them for managing the private equity assets. Management fees are often established as a proportion of the amount of money the limited partners have committed rather than the amount of money that has been invested. Additionally, limited partners must pay management fees even if an investment is underperforming and must continue paying management fees even if an investment has collapsed.
Carried Interest
Carried interest: This is a share of the profit on a private equity investment. It is a sort of incentive charge that general partners deduct before sharing to the limited partners the profit gained on investments. Carried interest is aimed to ensure that general partners’ interests are matched with limited partners’ interests.
Investments in private equity partnerships tend to be illiquid. That is, once the limited partners have committed capital to the partnership, it is difficult for them to exit the investment before the conclusion of the commitment term.
The following example explains the structure and mechanics of a private equity partnership.
Example: Structure and Mechanics of a Private Equity Partnership
Assume that a private equity firm has launched a USD4 million private equity fund to invest in start-up companies. As described previously, this private equity investment method is called venture capital investing.
The private equity firm is the general partner, and its first responsibility is to raise funds from investors. Suppose that it identifies four investors who are ready and able to contribute USD1 million each. These investors are the limited partners — represented by A, B, C, and D in the picture. The limited partners do not transfer USD1 million each to the general private equity firm immediately; initially, they merely pledge to contribute USD1 million each throughout the commitment term of the private equity fund’s tenure, say 10 years.
When the private equity business has secured the USD4 million, it can start investing. Assume that it discovers a suitable investment in Company W for USD400,000. The private equity firm contacts the limited partners and issues a capital call of USD100,000 per limited partner; capital calls sometimes happen with short notice. Limited Partners A, B, C, and D send USD100,000 apiece to the private equity business, which invests the USD400,000 in Company W. A few months later, the private equity firm identifies another appropriate investment in Company X for USD600,000. It makes another capital call, this time of USD150,000 per limited partner. This procedure may continue for several years until the private equity group has invested the USD4 million.
As depicted in the illustration, the private equity firm makes investments in four companies. These investments are often managed by a professional fund manager who costs the private equity company fees for his or her services, usually a combination of a fixed fee and an incentive fee. In turn, the private equity firm charges the limited partners management fees to pay the fund manager fees and other administrative fees. For example, assume that the annual management charge is 1.5% of the pledged capital. So, each limited partner who committed USD1 million must pay the private equity company an annual management fee of USD15,000, regardless of how much capital the private equity firm has already contributed. Thus, in the early years of the private equity fund’s life, the limited partners may be paying management fees on funds that have not really been invested.
After several years, say that the private equity company sells its interest in Company W for USD1 million. It can now distribute money plus earnings to the limited partners. Before it does so, it deducts a share of the profit, which is carried interest. Recall that carried interest is a sort of incentive charge that is designed to ensure that the private equity firm and the fund manager make the best possible decisions on behalf of the limited partners.
Suppose that carried interest is 15%. The profit on the investment in Company W is USD600,000 — that is, the difference between the selling price of USD1,000,000 and the initial investment of USD400,000. So, the private equity firm and the fund manager can keep USD90,000 (15% of USD600,000) in carried interest, which means that the amount of profit to be distributed amongst the limited partners is USD510,000 ($600,000 – $90,000). Thus, ignoring management expenses, each limited partner receives a cash distribution of USD227,500 — that is, USD100,000 of capital plus USD127,500 of profit, which implies a return on investment of 128% [($227,500 – $100,000) ÷ $100,000].
This return on investment is high, but remember that venture financing is hazardous. Assume that Company X meets financial problems, and the private equity firm wants to sell its ownership position in Company X. Another private equity firm is eager to buy this ownership interest, but for only USD100,000; note that such a transaction is called a secondary transaction.
The investment in Company X turns out to be a loss of USD500,000 (the selling price of USD100,000 minus the initial investment of USD600,000), hence there is no carried interest. Each limited partner receives a cash payout of USD25,000, which provides a return on investment of -83% [($25,000 – $150,000) ÷ $150,000], ignoring management fees. As indicated earlier, limited partners are not excluded from paying management fees on their whole commitment, including the USD150,000 payment to Company X, even if the venture is underperforming or fails.
Analysing Patterns
As indicated in the example, each limited partner’s capital of USD1 million is drawn down gradually over the commitment term of the private equity fund’s life. In the early years of the fund, the limited partners have negative cash flows since they get frequent capital calls to fund investments, and they must pay management fees on the committed capital. In later years, when investments produce dividends or are sold, the private equity firm provides cash distributions to the limited partners. When cash distributions net of carried interest exceed capital calls and management costs, the limited partners have positive cash flows.
A typical pattern of cash flows for a limited partner is represented in the example below. This image depicts a potential investment of USD1 million in a private equity fund with a life of 10 years. It is believed that the private equity firm makes investments in 10 companies between Year 1 and Year 6, these investments start producing dividends in Year 4, and they get sold between Year 6 and Year 10.
The blue bars reflect the sum of the capital calls and management fees, which are considered to be 1.5% of the committed capital. The green bars indicate the cash distributions, ignoring carried interest. The line indicates the cumulative net cash flow to the limited partner — that is, the sum of the cash distributions less the sum of the capital calls and management fees. This line is known as a J curve because its shape resembles the letter J.
Consider an entrepreneur who set up her new business five years ago. Back then, she went to her friends and neighbours for the money she needed. Now, five years later, her company is incredibly profitable. To raise the additional funds the company requires to support its expansion objectives, it could issue shares to the public via an initial public offering (IPO). But it was not yet ready to go public, and the company required more money to grow than the entrepreneur, her friends, neighbours, and banks were able or willing to supply. Who would have financed such a young and not well-established company? The answer is venture capitalists. The entrepreneur sold some of her company’s shares to a venture capital firm, a sort of private equity firm, to receive the additional funds essential to build her business.
Private equity firms invest in private companies that are not publicly traded on a stock exchange. Although people typically refer to private ‘equity’, private investments can include both equity and debt securities. Private debt is debt provided to private companies. Private debt comprises direct lending (private loans provided without intermediaries), mezzanine debt (private subordinated debt), venture debt (private loans to start-up or early-stage enterprises), and distressed debt lending (financing given to companies that are at risk of failing).
Private Equity Strategies
Private equity comprises numerous ways that may help offer money to companies at different phases of their development. The most often employed strategies are venture capital, growth equity, buyouts, and distressed.
Another private equity investment approach, which is independent to the stage of a company’s development, is called secondaries.
Venture Capital
As stated in the introduction, venture capital is a private equity investment strategy that consists of supporting the early stage of companies that have an original business plan. Venture capitalists regularly invest in ‘start-up’ enterprises that exist merely as an idea or a business strategy. The company may have only a few workers, have little or no revenue, and still be developing its product or business plan.
Entrepreneurs are typically looking not only for funding to start their firm (e.g., seed money), but also for guidance and knowledge about how to create and maintain their company.
Venture capital is regarded the riskiest sort of private equity investment strategy because more companies fail than succeed.
It can take many years before a company becomes successful, and most venture capital–funded enterprises have years of unprofitable activity before they reach the point of producing money. So, venture capital investing demands patience. And those companies that do prosper tend to significantly reward their investors.
Growth Equity
Growth equity is a private equity investment strategy that usually focuses on financing companies with proven business concepts, good client bases, and positive cash flows or profits.
These companies frequently have potential to grow by adding new production facilities or by making acquisitions, but they do not generating adequate cash flows from their activities to sustain their expansion goals. By contributing additional money in return for equity in the company, growth equity investors assist these enterprises expand and become more established.
Some growth equity investors specialise in helping companies prepare for an initial public offering. These investors give additional money at a later stage of a company’s development.
Additional equity dilutes existing shareholders’ ownership because there are more investors sharing the company’s cash flows. But because the later-stage growth equity investors often have expertise in structuring initial public offerings, they may bring financial rewards that offset the downsides of dilution. Initial public offerings, such as Facebook in 2012 (still the leader in the past decade for most amount raised) and Uber and DoorDash in 2020, are an opportunity for founders and existing shareholders to convert some or all of their investment in the firm into cash. So, the late inclusion of equity investors that have successful track records in structuring first public offerings may be useful for founders and existing shareholders.
Buyouts
Buyouts are a private equity investment strategy that consists on financing established companies that require money to restructure and facilitates a change of ownership.
Buyout agreements often include taking a publicly traded company private. For example, such corporations as UK-based Alliance Boots or US-based Twitter, Hertz, and Hilton Hotels were once public companies, but they underwent buyouts and are now privately owned companies.
Buyouts for which the financing of the deal involves a high proportion of debt are commonly called leveraged buyouts that financial leverage refers to the proportion of debt relative to equity in a company’s capital structure.
Because the high level of debt means hefty interest payments and principle repayments, companies that undertake a leveraged buyout must be able to generate robust and sustainable cash flows. So, they are frequently well-established enterprises with solid competitive standing in their field. Buyout investors generally seek companies that have lately underperformed, but that provide potential through restructuring to boost revenues and profitability.
When corporations suffer financial issues, they may be at danger of not being able to make full and timely payments of interest and/or principle. This risk, which is known as credit or default risk, was explored in the module on Debt Securities.
Distressed investment focuses on purchasing the debt of distressed companies that may have defaulted or are on the brink of defaulting. Frequently, investments are undertaken at a large discount to par value – that is, the amount repaid to the lenders upon maturity. For example, an investor who purchases the debt of a struggling company may only offer the existing lenders 20% or 30% of the amount they are due.
If the company can continue and grow, the value of the investment will increase — frequently by the conversion of such debt into equity of the new, surviving company — and the investor will realise significant value. Distressed investing does not often involve a cash flow to the company.
Structure and Mechanics of Private Equity Partnerships
As noted in the preceding section, private equity investments are frequently arranged in funds managed by partnerships. A private equity partnership usually contains two categories of partners.
A general partner (GP) is often a private equity firm that puts up the partnership. It is responsible for raising cash, locating acceptable investments, and making choices. General partners have unlimited personal liability for all the debts of the partnership – that is, general partners could lose more than their investment in the partnership since, if necessary, their personal assets could be utilized to settle the business’s debts.
Limited Partners
Limited partners (LPs) are investors who contribute capital to the partnership. They are not involved in the selection and management of the investments. Limited partners have limited personal liability – that is, limited partners cannot lose more than the amount of cash they put to the partnership
A private equity firm may create different private equity funds for different sorts of investments. The investments are normally not managed by the general partner itself, but by professional fund managers who are employed by the general partner. Each private equity fund may have its own fund manager who is responsible for the day-to-day management of the investments in the funds.
The private equity firm makes money through two mechanisms.
Management costs are fees that limited partners must pay general partners to reimburse them for managing the private equity assets. Management fees are often established as a proportion of the amount of money the limited partners have committed rather than the amount of money that has been invested. Additionally, limited partners must pay management fees even if an investment is underperforming and must continue paying management fees even if an investment has collapsed.
Carried Interest
Carried interest: This is a share of the profit on a private equity investment. It is a sort of incentive charge that general partners deduct before sharing to the limited partners the profit gained on investments. Carried interest is aimed to ensure that general partners’ interests are matched with limited partners’ interests.
Investments in private equity partnerships tend to be illiquid. That is, once the limited partners have committed capital to the partnership, it is difficult for them to exit the investment before the conclusion of the commitment term.
The following example explains the structure and mechanics of a private equity partnership.
Example: Structure and Mechanics of a Private Equity Partnership
Assume that a private equity firm has launched a USD4 million private equity fund to invest in start-up companies. As described previously, this private equity investment method is called venture capital investing.
The private equity firm is the general partner, and its first responsibility is to raise funds from investors. Suppose that it identifies four investors who are ready and able to contribute USD1 million each. These investors are the limited partners — represented by A, B, C, and D in the picture. The limited partners do not transfer USD1 million each to the general private equity firm immediately; initially, they merely pledge to contribute USD1 million each throughout the commitment term of the private equity fund’s tenure, say 10 years.
When the private equity business has secured the USD4 million, it can start investing. Assume that it discovers a suitable investment in Company W for USD400,000. The private equity firm contacts the limited partners and issues a capital call of USD100,000 per limited partner; capital calls sometimes happen with short notice. Limited Partners A, B, C, and D send USD100,000 apiece to the private equity business, which invests the USD400,000 in Company W. A few months later, the private equity firm identifies another appropriate investment in Company X for USD600,000. It makes another capital call, this time of USD150,000 per limited partner. This procedure may continue for several years until the private equity group has invested the USD4 million.
As depicted in the illustration, the private equity firm makes investments in four companies. These investments are often managed by a professional fund manager who costs the private equity company fees for his or her services, usually a combination of a fixed fee and an incentive fee. In turn, the private equity firm charges the limited partners management fees to pay the fund manager fees and other administrative fees. For example, assume that the annual management charge is 1.5% of the pledged capital. So, each limited partner who committed USD1 million must pay the private equity company an annual management fee of USD15,000, regardless of how much capital the private equity firm has already contributed. Thus, in the early years of the private equity fund’s life, the limited partners may be paying management fees on funds that have not really been invested.
After several years, say that the private equity company sells its interest in Company W for USD1 million. It can now distribute money plus earnings to the limited partners. Before it does so, it deducts a share of the profit, which is carried interest. Recall that carried interest is a sort of incentive charge that is designed to ensure that the private equity firm and the fund manager make the best possible decisions on behalf of the limited partners.
Suppose that carried interest is 15%. The profit on the investment in Company W is USD600,000 — that is, the difference between the selling price of USD1,000,000 and the initial investment of USD400,000. So, the private equity firm and the fund manager can keep USD90,000 (15% of USD600,000) in carried interest, which means that the amount of profit to be distributed amongst the limited partners is USD510,000 ($600,000 – $90,000). Thus, ignoring management expenses, each limited partner receives a cash distribution of USD227,500 — that is, USD100,000 of capital plus USD127,500 of profit, which implies a return on investment of 128% [($227,500 – $100,000) ÷ $100,000].
This return on investment is high, but remember that venture financing is hazardous. Assume that Company X meets financial problems, and the private equity firm wants to sell its ownership position in Company X. Another private equity firm is eager to buy this ownership interest, but for only USD100,000; note that such a transaction is called a secondary transaction.
The investment in Company X turns out to be a loss of USD500,000 (the selling price of USD100,000 minus the initial investment of USD600,000), hence there is no carried interest. Each limited partner receives a cash payout of USD25,000, which provides a return on investment of -83% [($25,000 – $150,000) ÷ $150,000], ignoring management fees. As indicated earlier, limited partners are not excluded from paying management fees on their whole commitment, including the USD150,000 payment to Company X, even if the venture is underperforming or fails.
Analysing Patterns
As indicated in the example, each limited partner’s capital of USD1 million is drawn down gradually over the commitment term of the private equity fund’s life. In the early years of the fund, the limited partners have negative cash flows since they get frequent capital calls to fund investments, and they must pay management fees on the committed capital. In later years, when investments produce dividends or are sold, the private equity firm provides cash distributions to the limited partners. When cash distributions net of carried interest exceed capital calls and management costs, the limited partners have positive cash flows.
A typical pattern of cash flows for a limited partner is represented in the example below. This image depicts a potential investment of USD1 million in a private equity fund with a life of 10 years. It is believed that the private equity firm makes investments in 10 companies between Year 1 and Year 6, these investments start producing dividends in Year 4, and they get sold between Year 6 and Year 10.
The blue bars reflect the sum of the capital calls and management fees, which are considered to be 1.5% of the committed capital. The green bars indicate the cash distributions, ignoring carried interest. The line indicates the cumulative net cash flow to the limited partner — that is, the sum of the cash distributions less the sum of the capital calls and management fees. This line is known as a J curve because its shape resembles the letter J.
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