The Private Equity (PE) industry has grown rapidly and has garnered vast attention from the likes of regular news outlets, financial press, as well as politicians. Why? It’s simple. The private markets have hit an all-time high at $6.5tn in 2020 as investors have shifted capital from public asset classes in search of upside, and as of November 2020, there were nearly 4,100 Private Equity deals (+5% from 2019) despite the recession and other economic uncertainties triggered by COVID-19. Undoubtedly, Private Equity firms, also known as financial sponsors, have a large and significant pool of capital to work with, which includes $1.5tn of unspent capital (also known as Dry Powder).
But why do investors pour money into Private Equity firms? Private Equity comes into place as an active investment strategy, targeting long-term value creation thanks to financial, operational, and managerial improvements. It conceives a rather flexible investment approach grounded in the private sphere of the markets. This, together with a promised diversification opportunity due to the expected uncorrelation with traditional asset classes, offers an alternative to the occasionally volatile returns of public markets, whose short-term-driven perspective could put pressure on companies’ management teams. Thanks to these advantages and to compensate its risk elements as financial Distress risk or illiquidity, PE investments promise above-average returns compared to public markets.
Historically, Private Equity returns outperformed their public market equivalents. In recent times we have seen an increasing debate on PE ability to deliver results (especially in the US), driven by an increasing amount of dry powder, intense competition, and a surge in public market valuations. Nonetheless, according to a report from Harvard economist Josh Lerner and Bain & Co., the public market positive momentum is hard to persist. While PE firms should not relax and should continue to look out for innovation opportunities in an increasingly mature industry, top quartile PE funds who are being able to drive the wave, are still delivering resilient returns.
In a typical PE investment, there are several parties at play. The Limited Partners (LPs) are the investors that have provided the capital for the fund but are not involved in the daily maintenance of the PE portfolio. LPs typically must inject a relatively high minimum ticket (as $250k or more), this being the reason why typical investors are Pension Funds, Insurance companies, University Endowments, or High-net-worth Individuals. In addition, the General Partners (GPs) are the PE firm’s investment professionals responsible for making the decisions with respect to the investments that are to be made. GPs are usually compensated for their activity following a model which usually goes by the name of “Two and Twenty”. GPs charge a Management Fee of around 2% of the total Asset Under Management (AUM) to LPs for their portfolio management activity. In addition to the Management Fee, the GPs are incentivised to perform well and align their interests with the LPs thanks to the concept of Performance Fee (also known as “Carried Interest” or “Carry”). The typical “Carry” averages 20% of profits over a set threshold return (referred as Hurdle rate), therefore the investment professionals can pocket a portion of the returns if they exceed expectations. Typically, Private Equity deals have a holding period ranging from 3 to 10+ years, with a targeted Internal Rate of Return (IRR) of 20-30%. After this holding period, the financial sponsor is expected to exit its investment by selling the asset to a strategic buyer through M&A, taking it public through an Initial Public Offering (IPO), or through a secondary transaction (selling to another financial sponsor).
Above the financial value creation element, the financial sponsors can also speed up the return generation process improving operational efficiency of the assets (through cost cutting, working capital management, et.) or undertaking organic top-line growth. Additionally, they can partake in inorganic or external growth through a buy-and-build strategy, improving revenues via Mergers & Acquisitions.
PRIVATE EQUITY STRATEGIES
Private Equity firms have different strategies available to deploy their capital and execute investments, being there many criteria to classify these strategies as sector or geographic focus, average fund size executed, and stages of investment. Among these criteria, a common one consists in categorizing these approaches by the target companies’ life-cycle stage: Early-Stage companies are usually target of Venture Capital deals, Expansion-Stage companies are on the eye of Growth Equity investments, Maturity-Stage companies represent the ideal target of most common Buyout deals and finally Decline-Stage companies usually find themselves being acquired from Distressed funds.
Venture Capital – Early Stage
Venture capital (VC) firms are on the lookout for equity investments in generally young, often technology-enabled and high-growth potential companies. The targets are usually non-cash-flow-generating businesses, which make them a less favourable candidate able to tap in debt financing. This relatively higher risk nature of the investment, with more volatility, but potentially unlimited upsides is more suitable for equity capital, allowing VC investors to obtain a relevant equity stake in the target. VC investments are usually deployed among multiple rounds of financing along the target company’s development (Seed, Serie A Financing, Series B Financing, Pre-IPO Financing), with latter stages resembling more Growth Equity investments.
The investment thesis of a VC could be seen as buying a stake into an entrepreneur’s idea, nurturing it for a short or mid-term horizon and then exiting once the company has reached sufficient size and credibility to be sold to a corporation or to allow institutional public-equity markets to step in. This strategy leverages on high-risk and high-return targets that have not realized yet their revenue potential but have a strong product-market fit and power for disruption. While a relevant amount of these deals is likely to fail, on the flip side, the VC investments that prove to be successful are on track for blockbuster returns. VC deals have an average holding period of 5-10 years. Given the nature of their approach, many VC funds generally go into building the infrastructure required to grow the target’s business as product development activities, marketing foundation or working capital management.
Among the most known and established VC firms are names as Accel, Global Founders Capital, Index Ventures, Institutional Venture Partners and Sequoia Capital.
Growth Equity – Expansion Stage
Growth Equity (or Growth Capital) firms target investments in generally more developed companies (compared to VC) with already proven markets and business models and looking for capital to finance specific expansion strategies. Although this investment strategy could result less risky due to the already profitable nature of the target, it also puts investors on track of relatively moderated returns compared to other approaches. Growth Capital investors hunt for companies that are already on track for growth, with the intention of making them established players or leaders in their industry, adding significant value thanks to new growth trajectories derived from the additional capital deployed.
The value creation usually comes from strategic guidance, management expertise and efficient capital allocation, other than operational support. Growth Equity entry strategies usually consist in acquiring secondary stakes in the target by acquiring shares from employees or other investors, with an average holding period of 3-7 years.
Representative large investment firms focusing on Growth Equity are TA Associates, General Atlantic, Summit Partners, TPG Capital and Warburg Pincus.
Leveraged Buyout – Maturity Stage
Leveraged Buyout (LBO) or simply Buyout, is the landmark Private Equity strategy representing 40% of global private capital raised as of 2019 (Bain). A traditional Buyout, with an average investment horizon of 5-7 years, consists in acquiring a private (or de-listing a publicly traded) mature and highly cashflow-generating business, usually taking a controlling interest. The acquisition is financed by a relatively small equity investment and a substantial amount of debt (or leverage) up to 70+% of total financing. This significant proportion of leverage, which usually sees the firm’s assets used as collateral, allows a Buyout fund to exploit the effects of debt to the extreme.
Generically speaking, debt has a lower cost of capital than equity financing. The tax deductibility of debt interest payment allows company to reduce the amount of taxes to be paid, and the rigorous nature of the debt repayment schedule allows investors to tightly incentivize the target’s management towards an efficient behaviour. In a successful LBO, the debt obligations are smoothly paid off using the stable cashflows generated from the acquired company and once the PE firm is ready to sell the company (by a trade sale or an IPO), it could collect most of the proceeding, being the majority equity owners. Since a small equity investment was needed up front due to the high level of debt, this can result in substantial returns for Buyout funds. On top of that, this increase in the equity value of the investments usually comes with a small increase in the overall value of the business. If the PE firm is even able to grow the firm or improving its operations, returns are further increased.
To put it in plain terms, imagine buying a house. For instance, let’s imagine that the house costs $100k – to purchase this asset, $30k of cash are used to buy the ‘equity’, and $70k of debt to pay the rest of the value are financed through a mortgage. With this scenario, if the house is kept for 5 years, and the $10k yearly rent payments (including interest) are paid down by renting out the house to someone else, in the end of the 5 years, would remain: the house, assuming it at the original $100k value, comprised of $80k worth of equity in the house, and a remaining $20k in debt. If the house were sold, the seller would cash in $80k of equity value in comparison to the $30k initially invested, getting a valuable return. This serves as an example of a Buyout deal as a fund purchases asset with stable cash flows to pay down debt to increase the equity value of the asset which they can cash in at the end of the deal.
Of course, everything comes at a cost and on the flip side of the coin, increasing the amount of leverage on a company to the utmost can easily put the business in financial distress, with the risk of not being able to repay debt and incurring huge losses. An extension of Leveraged Buyouts are Management Buyouts (MBO) and Management Buy-Ins (MBI), where the acquirer is respectively the management team of the company itself or an external management team which replaces the existing one.
Acknowledged firms with a significant focus on Buyouts are Apollo Global Management, Bain Capital, Blackstone, The Carlyle Group, Kohlberg Kravis Roberts (KKR) and CVC Capital Partners.
Distressed – Decline Stage
Distressed Private Equity deals (generally paired with Private Debt transactions) focus their investments on companies undergoing a decline, taking control during bankruptcy, or restructuring processes. The funds going for this investment strategy leverage on the troubled status of the target, aiming to acquire it at lower prices relative to similar companies in healthier conditions. After gaining control, Distressed firms generally start a Turnaround process (or continue the one already in place) to restore operations and financial conditions of the target and then exit from the investment by selling their stake or taking the company public. Private Equity investors executing Distressed deals generate value through change of management, target’s corporate re-organization, capital structure adjustment or corporate governance optimization. The risk element of this strategy lies under the already precarious condition of the target, which usually implies inability to finance the acquisition through additional leverage and requires a careful investment approach and honed crisis management skills. Beyond shadow of doubt, the opportunity for Distressed deals significantly increases during market downturns.
Among the most distinguished Distressed firms are Avenue Capital Group, Centerbridge Partners, Cerberus Capital Management, and Oaktree Capital management.
Although this classification of Private Equity approaches contains a large portion of the main typologies of funds, the private markets environment is much more granular and variegated. Two strategies worth mentioning, and which deserve further consideration include Credit, also known as Private Debt (investments with similar features of Private Equity, but which use debt securities as a mean of investments) and Private Equity Funds of Funds (firms that do not directly invest in companies’ equity or debt, but instead invest in a usually diversified pool of other Private Equity firms, which in turns execute direct Private Equity investments).
AN EYE ON THE FUTURE OF THE PRIVATE EQUITY ENVIRONMENT
As the public markets faced volatility and uncertainty in COVID times, Private Equity has been relatively robust due to limited means of short-term investments and less players on the field to disrupt transactions. As 2020 closed with a record deal value of $560bn since 2007, Buyout activity is poised for growth based on several indicators. Investor confidence is somewhat deviating based on region. APAC investors report higher levels of scaling investments compared to peers in EMEA and LATAM according to an S&P Market Intelligence report. Nevertheless, escalations in US-Chinese relations are the single most relevant risk factor to be monitored according to APAC LPs and GPs.
Investors have some crucial support to their confidence when looking at the macroeconomic environment, as prerequisites for investments are present. Lowered interest rates across the global markets including the US’ zero-interest rate has contributed to the continued access to inexpensive debt, a pivotal component in deal making. Monetary policies as aforementioned are expected to continue in 2021 as APAC countries are expected to cut rates further while rates in Western Economies are expected to remain at current levels. As cheap debt is here to stay for the foreseeable future, PE firms are able to leverage on this. Nevertheless, this favours the notion of “patient capital”, and the need to diversify value for impatient investors arises. Causal or not, the rise for asset diversification is evident as GPs seek to create opportunities of larger scale and seek higher returns on niche markets by increasing exposure in niche segments (i.e., life sciences), private debt, and impact investing.
Despite the notable transactional volume of 2020, the level of dry powder among firms is high. Notwithstanding high cash reserves among firms, external fundraising activities are still poised to grow. One of the underlying factors behind the $330bn projected total in capital raised for 2021, which constitutes a $14bn increase from 2020, are Special Purpose Acquisition Companies (SPACs). The quicker access to public markets through SPACs as an investment vehicle in combination with an appetite for SPAC as an asset class for investors seeking diversification leads to a positive outlook for this area of Private Equity with respect to deal value and raised capital.
However, the low-priced debt, access to dry-powder, and overall increase of deals and transactions on the market are not necessarily diluting the relative cost of transactions. The Private Equity market is in a state of bifurcation as a fifth of Buyouts are expected to be priced at +20x EBITDA, thus inferring a high use of leverage and high demand across a limited pool of certain assets. An associated risk is that transactions achieved at higher valuations have a considerably lower likelihood of ever appreciating their original mark. This provides funds with two return levers: revenue increase or extension of the EBITDA margin, which are priorities in the current macroeconomic cycle.
On the other side of the sword are lucrative deals in Distressed companies at low valuations with promising exit opportunities that are experiencing the need for equity to finance its assets and operations. Sound business models in hospitality, retail, and transportation are all potential targets for companies looking to add Distressed investments at low multiples to the portfolio. Furthermore, corporate Carve-Out is on the verge of 2021 as over-leveraged corporations seek to mitigate liquid risks, deleverage balance sheets and pay down debts and streamline value offerings by divesting non-core business divisions. For 2021, a majority expects Carve-Out activities to increase.
Authors: Seint Shin Ne Myo, Giuseppe Bucalo, David Sigant-Båtman.
 A carve-out is the partial divestiture of a business unit in which a parent company sells a minority interest of a subsidiary to outside investors