If you have thought about working in finance, the chances are that you have come across the term ‘Private Equity’. In many ways it is like Investment Banking to those who are outside the industry. It is prestigious, it pays incredibly well and it seems to be the thing to do if you are interested in working in finance. And much like Investment Banking, a lot of people don’t actually understand what the Private Equity is, how it works and how they make their money.
This post will try and answer some of those questions and give you an overview of the Private Equity industry.
What are private equity firms?
At their most basic level Private Equity firms are fund managers. However instead of investing the shares of a listed business as equity fund managers do, they invest in and purchase whole companies. They buy these companies either on market (if the company is listed) or they may buy it from the private owners of the company who are looking for a way to exit their businesses.
How do private equity firms get their capital?
Private equity firms typically raise capital through unlisted closed ended funds. These funds usually have a defined term (which are normally 5 but can stretch out to 7 years) and the cash in these funds are typically locked up for this whole period. At the end of the term, the fund is then wrapped up, the businesses within the fund are sold and the investors in the fund receive their return (less the fees they owe the Private Equity firm)
Who are the investors that invest in the Private Equity funds?
Private Equity firm typically raise cash from large pools of capital that are looking for a home for an extended period of time. The typical investors in Private Equity funds include Pension Funds, Sovereign Wealth Funds and Superannuation Funds.
These pension funds invest in almost every class of asset that you can imagine – listed equities, debt, infrastructure, property and through Private Equity they are getting exposure to unlisted businesses.
What sort of fees to Private Equity firms charge?
Given their private nature and the fact that there is no set ‘norm’ it is hard to make a comment which generalises about the fee structure of Private Equity firms. Generally speaking they will charge a success fee (whenever they add assets to the portfolio), a management fee and an incentive fee above a certain benchmark rate of return.
They are actually incredibly high fee vehicles, however investors do expect a high rate of return on their invested capital.
How do Private Equity funds generate returns?
Although the structuring of individual cases can get incredibly complex, the ‘normal’ Private Equity buyout (or leveraged buyout) is actually reasonably simple. It is basically made up of 5 steps
- Buy a stable business (either listed or unlisted) with stable free cash flows
- Finance the acquisition with a significant amount of debt
- Cut all unnecessary expenditure and make the business as efficient as possible
- Use every dollar of available cash to pay down debt
- Sell the business for the same (or greater) multiple of earnings as when they bought it
Obviously each of these steps is incredibly complex and significant returns are gained by having an intimate knowledge of the smallest issues such as the way that the entity is structured for tax reasons.
A worked example
I know it is always much easier to see an example to see what I mean so below is a simple example to illustrate how they operate their business
- Banker’s Pitch Private Equity acquires Company A for $100m which represents a 10x free cash flow multiple
- One of the most important characteristics is the consistency of these earnings
- In this case Company A is earning $10m consistently per annum
- They finance the acquisition with $20m of equity and $80m of debt
- Assume a cost of debt of 8% p.a. (i.e. they are paying $6.4m in interest per year)
- They cut all unnecessary expenditure and make the business as efficient as possible
- Most businesses have some fat in them which can be cut – whether it relates to the R&D spend or the amount that the company pays for its annual holidays
- Assume that Banker’s Pitch Private Equity is able to extract $1.0m more in earnings out of the business by cutting costs brutally
- Assume that the business also had land valued at $10m which they then sell and lease back for $0.5m per annum
- The pre-interest free cash flow of the business ($10.5m p.a.) is therefore slightly higher than when they bought the business
- They use every available dollar to pay down debt
- As soon as they sell the land they pay down the debt balance from $80m to $70m
- They then progressively pay down the principal on the loan from the consistent earnings (which accelerates the rate at which the loan is paid down)
- The loan looks like this:
- Start of year 1: $80m – $10m land sale = $70m
- End of year 1 (post principal and interest payments) = $65.1m
- End of year 2 = $59.8m
- End of year 3 = $54.1m
- End of year 4 = $47.9m
- End of year 5 = $41.3m
- They then sell the business for the same multiple (or greater if they can achieve it)
- Getting a multiple expansion on a purchase is every Private Equity firm’s dream which is why they market their sales so heavily when it comes time to sell the business
- Assume Banker’s Pitch Private Equity can only sell company A for the same multiple that they bought it for (i.e. 10x FCF)
- The business is therefore worth $10.5m (the new FCF) x 10 = $105m
- This may not seem great but look at the return that Banker’s Pitch Private Equity Firm generated
- They sell the business for $105m
- The pay back the remaining debt of $41.3m
- The equity check they receive is therefore $105 – $41.3 = $63.7m
- Don’t forget that they only put in $20m of equity
- The return on the capital they actually invested is (63.7/20)^(1/5)-1=26% p.a.
This is a per annum rate of return and is in line with what Private Equity firms typically aim for (it used to be much higher but a lot of the higher returns have been competed away).
Note that there are plenty of risks with this type of strategy: perhaps the business doesn’t consistently generate the cash you need to pay the interest bill or perhaps you can’t sell the business for the same price you paid for it or extract the savings that you thought you could. Things can quite easily go wrong which is why private equity firms demand that their investments generate these levels of return.
There is plenty more to talk about on this topic including how to get a job in Private Equity, what type of people does private equity employ and how do they actually go about achieving some of the steps I have mentioned above so keep an eye out for these posts.