What is Private Equity?

[Dennis Ng]

What Is Private Equity?
March 03 2009 | Filed Under » Banking, Careers, Venture Capital

Private equity is a source of investment capital from high net worth individuals and institutions for the purpose of investing and acquiring equity ownership in companies. Partners at private equity firms raise funds and manage these monies for the purpose of yielding favorable returns for their shareholder clients, typically with an investment horizon between four and seven years.

These funds can be used in the purchase of shares of private companies, or in public companies that eventually become delisted from public stock exchanges under go-private deals. The minimum amount of capital required for investors can vary depending on the firm and fund raised. Some funds have a $250,000 minimum investment requirement; others can require millions of dollars. Let's delve a little deeper into private equity firms. (Smaller investors have found ways to get closer to the private equity action; see Private Equity Opens Up For The Little Investor.)

Introduction to Private Equity
Private equity has successfully attracted the best and brightest in corporate America, including top performers from Fortune 500 companies and elite strategy and management consulting firms. Top performers at accounting and law firms can also be recruiting grounds, as accounting and legal skills relate to transaction support work required to complete a deal and translate to advisory work for a portfolio company's management.

The fee structure for private equity firms varies, but it typically consists of a management fee and a performance fee (in some cases, a yearly management fee of 2% of assets managed and 20% of gross profits upon sale of the company). How firms are incentivized can vary considerably.

Given that a private equity firm with $1 billion of assets under management might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees for the firm, it is easy to see why the private equity industry has attracted top talent. At the middle market level ($50 million to $500 million in deal value), associates can earn low six figures in salary and bonuses, vice presidents can earn approximately half a million dollars and principals can earn more than $1 million in (realized and unrealized) compensation per year.

Transaction Support and Portfolio Oversight
There are two critical functions within private equity firms:

deal origination/transaction execution
portfolio oversight

Deal origination involves creating, maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks and similar transaction professionals in an attempt to secure both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates referred to private equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners in an effort to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that the funds raised are successfully deployed and invested.

Additionally, internal sourcing efforts can reduce costs related to a transaction by cutting out the investment banking middleman's fees. When financial services professionals represent the seller, they usually run a full auction process that can diminish the buyer's chances of successfully acquiring a particular company. As such, deal origination professionals (typically at the associate, vice president and director levels) attempt to establish a strong rapport with transaction professionals in order to get an early introduction to a deal. It is important to note that investment banks often raise their own funds and therefore may not only be a deal referral but also a competing bidder. In other words, some investment banks compete with private equity firms in buying up good companies. (Get a closer look at the players in stiff competition for companies in M&A Competition Is Cutthroat For Acquirers.)

Transaction execution involves assessing management, the industry, historical financials and forecasts, and conducting valuation analyses. After the investment committee signs off to pursue a target acquisition candidate, the deal professionals submit an offer to the seller. If both parties decide to move forward, the deal professionals work with various transaction advisors to include investment bankers, accountants, lawyers and consultants to execute the due diligence phase. Due diligence includes validating management's stated operational and financial figures. This part of the process is critical, as consultants can uncover deal killers, such as significant and previously undisclosed liabilities and risks.

The second important function of private equity professionals involves oversight and support of the firm's various portfolio companies and their management team. Among other support work, they can walk management through best practices in strategic planning and financial management. Additionally, they can help institutionalize new accounting, procurement and IT systems in order to increase the value of their investment.

Types of Private Equity Firms
There is a spectrum of investing preferences across the thousands of private equity firms in existence. Some are strict financiers - passive investors - who are wholly dependent on management to grow the company (and its profitability) and supply their owners with appropriate returns. Because sellers typically see this method as a commoditized approach, other private equity firms consider themselves active investors. That is, they provide operational support to management in order to help them build and grow a better company.

These types of firms may have an extensive contact list and "C-level" relationships, such as CEOs and CFOs within a given industry, which can help increase revenue, or they may be experts in realizing operational efficiencies and synergies. If an investor can bring in something special to a deal that will enhance the value of the company over time, such an investor is more likely to be viewed favorably by sellers. It is the seller who ultimately makes the choice of whom they want to sell to, or partner with.

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It is no surprise that the largest investment-banking entities, such as Goldman Sachs (NYSE:GS) , JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C) facilitate the largest deals. These banks typically focus their efforts on deals with enterprise values worth billions of dollars. However, the vast majority of transactions reside in the middle market ($50 million-$500 million deals) and lower-middle market ($10 million-$50 million deals).

Because the best investment banking professionals gravitate toward the larger deals, the middle market is a significantly underserved market. That is, there are significantly more sellers than there are highly seasoned and positioned finance professionals that have the extensive buyer networks and resources to manage a deal (for middle-market company owners).

Investing in Upside
Middle-market companies can offer significant financial upside to their private equity owners. Many of these small companies fly below the radar of large multinational corporations and often provide higher quality customer service. These companies provide niche products and services that are not being offered by the large conglomerates.

Such upsides attract the interest of private equity firms, as they possess the insights and savvy to exploit such opportunities and take the company to the next level. For instance, a small company selling niche products within a particular region might significantly grow by cultivating international sales channels. Or a highly fragmented industry can undergo consolidation (with the private equity firm buying up and combining these entities) to create fewer, larger players. Larger companies typically command higher valuations than smaller companies.

An important company metric for these investors is earnings before interest, taxes, depreciation and amortization (EBITDA). When a private equity firm acquires a company, they work together with management in order to significantly increase EBITDA during its investment horizon (typically between four and seven years). A good portfolio company can typically increase its EBITDA both organically (internal growth) and by acquisitions.

A popular exit strategy for private equity involves growing and improving a middle-market company and selling it to a large corporation (within a related industry) for a hefty profit. It is critical for private equity investors to have reliable, capable and dependable management in place. Most managers at portfolio companies are given equity and bonus compensation structures that reward them for hitting their financial targets. Such alignment of goals (and appropriate compensation structuring) is typically a requirement prior to a deal getting done. (See how private equity plays in different parts of a company's life cycle at Private Equity A Trendsetter For Stocks.)

Conclusion
Private equity firms have become attractive investment vehicles for wealthy individuals and institutions. As the industry attracts the best and brightest in corporate America, the professionals at these firms are usually successful in deploying investment capital and in increasing the values of their portfolio companies. However, there is also fierce competition in the M&A marketplace for good companies to buy. As such, it is imperative that these firms develop strong relationships with transaction and services professionals in order to secure strong deal flow.

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