What is Private Equity?
Private equity is an alternative investment class and consists of capital that is not listed on the stock exchange. Private equity is made up of funds and investors who invest directly in private companies or engage in buyouts of public companies, which results in the write-off of share capital. Institutional and retail investors provide capital for private equity, and capital can be used to finance new technologies, make acquisitions, increase working capital, and strengthen and strengthen a balance sheet.
A private equity fund has limited partners (LP), who generally hold 99% of the shares of a fund and have limited liability, and general partners (GP), who own 1% of the shares and have full responsibility. The latter are also responsible for the execution and operation of the investment.
Understanding Private Equity
Private equity investments come mainly from institutional and accredited investors, who can spend large sums for extended periods. In most cases, considerably long holding periods are often required for private equity investments in order to provide turnaround for distressed companies or to allow for liquidity events such as an IPO or a sale to a public company.
Benefits of Private Equity
Private equity offers several advantages to companies and startups. It is favored by companies because it allows them to access liquidity as an alternative to conventional financial mechanisms, such as bank loans with high interest rates or quotation on public markets. Certain forms of private equity, such as venture capital, also finance ideas and start-ups. In the case of companies that are delisted, private equity financing can help these companies to try unorthodox growth strategies far from the glare of public markets. Otherwise, the pressure of quarterly profits dramatically reduces the time available to senior management to turn around a business or experiment with new ways to reduce losses or make money.
Disadvantages of Private Equity
Private equity comes with its own unique riders. First, it can be difficult to liquidate holdings in private equity because, unlike public markets, a ready-made order book that combines buyers and sellers is not available. A company must undertake a search for a buyer in order to sell its investment or its company. Second, the price of a private equity firm’s shares is determined by negotiations between buyers and sellers and not by market forces, as is generally the case with publicly traded companies. Third, the rights of private equity shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that generally dictates the rights of their counterparts in public markets.
History of Private Equity
Although private equity has only come to light in the past three decades, tactics used in the industry have been perfected since the beginning of the last century. Bank magnate JP Morgan is said to have made the first leveraged takeover of Carnegie Steel Corporation, then among the country’s largest steel producers, for $ 480 million in 1901. He merged it with other large companies steelmakers of the time, such as Federal Steel Company and National Tube, to create United States Steel – the world’s largest company. It had a market capitalization of $ 1.4 billion. However, the Glass Steagall Act of 1933 put an end to these mega-consolidations designed by banks.
Private equity firms remained largely on the fringes of the financial ecosystem after the Second World War until the 1970s, when venture capital began to finance the American technological revolution. Today’s tech giants, including Apple and Intel, have obtained the funds to grow their businesses from the emerging venture capital ecosystem of Silicon Valley when they were founded. During the 1970s and 1980s, private equity firms became a popular avenue for struggling businesses to raise funds away from public markets. Their agreements made headlines and scandals. With greater awareness in the industry, the amount of capital available for funds has also increased and the size of an average private equity transaction has increased.
When it took place in 1988, the purchase of the RJR Nabisco conglomerate by Kohlberg, Kravis & Roberts (KKR) for $ 25.1 billion was the largest transaction in the history of private equity. He was overshadowed 19 years later by the $ 45 billion buyout of coal-fired power plant operator TXU Energy. Goldman Sachs and TPG Capital joined KKR to raise the debt required to buy the company during the private equity boom years between 2005 and 2007. Even Warren Buffett bought $ 2 billion worth of new company bonds. The purchase turned bankrupt seven years later and Buffett called his investment a “big mistake”.
The years of expansion of private equity occurred just before the financial crisis and coincided with an increase in their debt level. According to a Harvard study, global private equity groups raised $ 2 trillion between 2006 and 2008, and each dollar was raised by more than two dollars in debt. But the study found that firms supported by private equity perform better than their counterparts in the public markets. This was mainly evident in companies with limited capital and those whose investors had access to networks and capital which helped increase their market share.
In the years following the financial crisis, private credit funds have accounted for an increasing share of the activities of private equity firms. These funds collect funds from institutional investors, such as pension funds, to provide a line of credit to companies that cannot tap into the corporate bond markets. The funds have shorter periods and shorter durations than traditional PE funds and are among the least regulated sectors of the financial services sector. Funds, which charge high interest rates, are also less affected by geopolitical concerns, unlike the bond market.
How does Private Equity work?
Private equity firms collect funds from institutional investors and accredited investors for funds that invest in different types of assets. The most popular types of equity financing are listed below.
- Financing in difficulty: Also known as vulture financing, the money from this type of financing is invested in companies in difficulty whose business units or assets are underperforming. The intention is to redress them by making the necessary changes to their management or operations or to sell their assets at a profit. In the latter case, assets can range from physical machinery and real estate to intellectual property, such as patents. Companies that have filed for Chapter 11 bankruptcy in the United States are often candidates for this type of financing. There was an increase in distressed funding for private equity firms after the 2008 financial crisis.
Leverage financing operations: this is the most popular form of equity financing and involves the complete takeover of a business in order to improve its commercial and financial health and resell it at a profit at an interested party or proceed with an IPO. Until 2004, the sale of non-core business units of publicly traded companies was the largest category of leveraged buyouts for private equity. The leveraged buyout process works as follows. A private equity firm identifies a potential target and creates a special purpose vehicle (SPV) to finance the takeover. Typically, companies use a combination of debt and equity to finance the transaction. Debt financing can represent up to 90% of total funds and is transferred to the balance sheet of the acquired company for tax benefits. Private equity firms employ a variety of strategies, from reducing the number of employees to replacing entire management teams, to turn around a business.
Real estate private equity: this type of financing saw a strong increase after the financial crisis of 2008 which made fall the prices of the real estate. Typical areas where funds are deployed are commercial real estate and real estate investment trusts (REITs). Real estate funds require a higher minimum investment capital compared to other categories of private equity financing. Investor funds are also frozen for several years at a time in this type of financing. According to research firm Preqin, real estate private equity funds are expected to grow 50% by 2023 to reach a market size of $ 1.2 trillion.
Fund of funds: As the name suggests, this type of financing mainly focuses on investing in other funds, mainly mutual funds and hedge funds. They offer a backdoor to an investor who cannot afford the minimum capital requirements in such funds. But critics of these funds point to their higher management fees (as they are accumulated from multiple funds) and the fact that unhindered diversification may not always result in an optimal strategy for multiplying returns.
Venture capital: Venture capital funding is a form of private equity in which investors (also called angels) provide capital to entrepreneurs. Depending on the stage at which it is provided, venture capital can take many forms. Seed financing refers to the capital provided by an investor to move an idea from a prototype to a product or service. On the other hand, early stage financing can help an entrepreneur to further develop a business while Series A financing allows him to actively compete in or create a market.
How do private equity companies make money?
The main source of income for private equity firms is management fees. The fee structure for private equity firms generally varies, but generally includes management fees and performance fees. Some companies charge a management fee of 2% per year on the assets under management and require 20% of the profits from the sale of a business.
Positions in a private equity firm are in high demand and for good reason. For example, consider that a business has $ 1 billion in assets under management (AUM). This business, like the majority of private equity firms, should have no more than two dozen investment professionals. The 20% of gross profits generate millions of firm fees; as a result, some of the main players in the investment sector are attracted to positions in these companies. At an intermediate level of $ 50 million to $ 500 million in transaction value, associate positions are expected to drive wages up to the lowest six digits. A vice-president of such a company could potentially earn close to $ 500,000, while a principal could earn more than $ 1 million.
Key points to remember
- Private equity is an alternative form of private financing, far from public markets, in which funds and investors invest directly in companies or engage in buyouts of these companies.
- Private equity firms make money by charging management and performance fees to fund investors.
- Among the benefits of private equity are easy access to other forms of capital for entrepreneurs and founders and less stress related to quarterly performance. These benefits are offset by the fact that private equity valuations are not determined by market forces.
- Private equity can take many forms, from complex leveraged buyouts to venture capital.
Private equity concerns
Starting in 2020, a call was made for more transparency in the private equity sector mainly due to the exorbitant amount of income, profits and wages earned by the employees of almost all private equity firms. Since 2020, a limited number of states have lobbied for draft laws and regulations allowing a larger window on the internal functioning of private equity firms. However, Capitol Hill lawmakers are backing down, demanding restrictions on access to information from the Securities and Exchange Commission (SEC).