Private Equity – What is it?

Private equity (PE) has gained a great amount of influence in today’s financial marketplace, but only few people actually understand the ins and outs of the industry.

This quick article (less than “360” seconds long!) breaks down the topic, discussing in brief (i) the different types of PE strategies; (ii) the main PE firms out there and (iii) the current momentum of the industry.

First things first. What is a PE firm?

To make an (extremely) long story short, PE Firms are essentially asset-management companies (AMC) advising, managing and investing investor’s money through registered investment vehicles called “funds”, each having a different investment scope. AMCs need to comprise skilled and trustworthy Investment Professionals able to raise capital and attract investors promising in exchange solid and constant returns.

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PE investments range from listed and non-listed companies to physical assets (i.e. real estate), offering returns much less correlated to indexes than the returns available in classic public market investment opportunities. However, the tradeoff is that these investments are illiquid (i.e. 3-7 years to generate attractive returns) and thus require longer investment periods.

PE Firms can invest in a wide mix of private investment strategies, with the mix varying greatly from firm to firm depending on the firm’s size, stated strategy, geographical scope, industry and transaction expertise. There are many different types and sizes of PE firms / Funds specialised in either a specific industry or a specific geography.

 

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7 PE strategies – The key elements

Here are the main PE strategies everyone should be aware of:Venture capital (VC) – startups and young companies / little to no track record of VC investments are made with the goal of generating outsized returns by identifying and investing in the most promising companies and profiting from a successful exit (the most desired being an IPO)

  • Growth capital – mature companies / proven business models / looking for capital to restructure their operations, enter new markets or finance an acquisition. Typically, these are minority investments in more mature companies than for a VC scope
  • Buyouts – mature companies / generating significant and steady cash flows. PE firms make buyout investments when they believe that they can extract value by holding and managing a company for a period of time and exiting the company after significant value has been created. This strategy typically involves debt (i.e. usually above 50% of the total acquisition value) to finance the acquisition, enabling the PE Firm to generate high returns while only risking a small amount of capital
  • Fund of Funds (FoF) – investments are made in PE funds rather than directly in the equity of companies. By investing in a fund of funds, investors are granted diversification and the ability to hedge their risk by investing in various fund strategies
  • Debt/Mezzanine – consists of both debt and equity financing to support a company’s Companies that take on mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan. A key reason of why a company may prefer mezzanine financing, is that it allows it to receive the capital injection needed for business without having to give up a lot of equity ownership
  • PE Real Estate – investing in ownership of real estate properties. The 3 common strategies are: (i) investments in low-risk / low-return assets with predictable cash flows requiring some form of value added element; (ii) medium-risk / medium-return investments involving the purchasing of properties to improve and sell at a gain; (iii) high-risk / high-return investments in properties requiring massive amounts of enhancements (i.e. investments in development, raw land, and mortgage notes)
  • Special situations & Distressed funds – target companies that need restructuring, turnaround, or are in any other unusual circumstances. Investments typically profit from a change in the company’s valuation as a result of the special situation. (i.e. company spin-off, tender offers, bankruptcy proceedings…). Besides PE Firms, Hedge Funds also implement this type of investment

 

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The main players – American legends vs. European firms

Henry Kravis (KKR), Steve Schwarzman (Blackstone), David Rubenstein (Carlyle) and Leon Black (Apollo). These four men run the world’s largest private-equity firms.

Billionaires all, they are at or well past the age when CEOs of public companies move on, either by choice or force. Apple, founded the same year as KKR (1976), has had seven bosses; Microsoft, founded the year before, has had three. On average, public companies replace their leaders once or twice a decade. In finance executives begin bowing out in their 40s, flush with wealth and drained by stress.

 

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One thing is clear, the fame of the big names in the industry resides in the US!                    But Private Equity is not just an American thing. The “Old Continent” defends itself well. The UK leads the table when it comes to PE, placing 7 Firms in the European Top 10.

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The current momentum – why does everyone want PE?

Last year was a massive year for private-equity fundraising, and there is little indication that the flow of money into the asset-class will wane any time soon. A staggering 48% of European investors plan to put more money into private equity this year, compared with 2% who plan to trim their allocation, according to a survey published in December by Coller Capital.

“As long as the demand from investors is there, we will see firms looking to raise bigger funds,” she said. “Some private-equity managers will try to raise as much as possible; others will try to remain more disciplined. Some managers, such as Vitruvian Partners and Partners Group, more than doubled their fund size last year.” – Britta Lindhorst, MD at HQ Capital

As of December 2017, there were 1,038 new private-equity funds (less in number but way bigger in size) in the market filled with $415bn of fresh capital (+6.5% vs 2016), compared to 1,324 funds seeking $390 billion a year earlier, according to Preqin. In brief, 2017 was another record-year for PE (i.e 7th year of consecutive growth), the tough times post 2009 financial crisis are long gone.

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Reasoning on why PE gained so much attention in the last decades, one thing pops up quite immediately bringing us back to the title of the article: Private Equity is simply the most profitable asset-class of the past 25 years!

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Authors

Massimiliano Marchisio

Nikita Kuzmich

Paul Theilig

Felix Schafer

 

Glossary

AMC = Also called General Partner “GP”, is a financial institution approved and supervised by the local authority, whose task it is to manage the fund.

Fund = a fund is a “bucket” filled with investors’ money and managed by the AMC. The amount of money collected can be used to invest into any type of asset

Investors = Also called Limited Partners “LP”, are banks, insurance companies, pension funds, family offices, corporations, governments, HNWI…

 

Suggested readings

Barbarians at the Gate: The Fall of RJR Nabisco – Bryan Burrough and John Helyar (1989)

 

Sources

  • The Economist
  • Cambridge Associates Private Equity Benchmark
  • Street of Walls
  • Private Equity News
  • Private Equity International
  • Financial Times
  • Preqin – Research Center
  • Macabacus – Finance
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