Private equity (PE) refers to a financing approach where companies acquire funds from firms or accredited investors instead of stock markets. PE firms make a direct investment in these companies for an extended period as many of them are not publicly traded.
The ultimate goal of PE investments is to boost a company’s growth to the extent that it can go public or get acquired by a bigger entity. In exchange, investors earn fees and a substantial share of the improved profits. Many times, they also become the company’s shareholders.
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Source: Private Equity (wallstreetmojo.com)
- Private equity is a financing method that facilitates companies to acquire direct investments from PE firms for a long-term without adopting the traditional ways of fundraising such as public listing or business loans.
- The various methods adopted by the PE firms to invest in companies include buyout or leveraged buyout, merger, venture capital, growth capital, distress funding, fund of funds, etc.
- PE firms charge a management fee of typically 2% of AMU and a performance fee of 20% of the profits.
Private Equity Explained
A company acquires PE funding to revamp its business or to grow. End goals usually revolve around going public, mergers or being acquired by a successful firm. PE firms tend to help with these objectives in exchange for management and performance fees. The management fee is usually 2% of the asset under management (AUM).
While the performance fee is the share of net profit allocated to the General Partner, it is typically 20% of the profit. A general partner can earn it most of the time after the hurdle rate is achieved. Many times, limited or general partners also acquire some equities of the company.
Private Equity Investments
Raising PE capital from investors involves three crucial phases, i.e., pre-offering, offering and closing. Once convinced that the business holds potential, the PE firm invests in it through any of the following routes –
- Buyout or Leveraged Buyout: Here, the PE firm extends finance by buying the firm. Usually, more established companies raise funds through buyoutsBuyoutsA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued.read more with the investors exercising a controlling interest in the business. In many cases, once the business bounces back or shows enough potential, the firm sells it off to another company or makes it public.
- Venture Capital: Startups and other small emerging entities are often left behind due to lack of funds. When they exhibit high growth potential with visionary business plans, venture capitalists provide them funding.
- Growth Capital: When a mature company seeks finance for expanding its business operations through restructuring or penetration into new markets, PE firms extend growth capitalGrowth CapitalGrowth Capital, also called Expansion capital, is the amount of money offered to the fast-growing businesses requiring finances to expand their operations or new market ventures. All in all, it helps facilitate target firms for accelerating their growth rate.read more .
- Distress Funding: Hedge funds, investment firms and business development companies usually purchase a distressed company’s debt at a significant discount to make profits if the target company revives.
- Fund of Funds: PE firms pool investors’ money using mutual or hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more . It helps retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more in putting their money as otherwise they cannot invest such massive amounts.
- Real Estate Private Equity: Such funds are accessible to high-net-worth investors, providing them with an opportunity to invest a considerable sum in the real estate through ownership, acquisition or financing of the target company.
Examples of Private Equity
A renowned example of private equity funding is the ride-service company Lyft. As a startup, it had been raising funds privately that helped it grow into one of the largest cab companies in the US and a close rival of Uber.
In 2017, Lyft raised an additional $600 million Series G PE funding, valuing the firm at $7.5 billion, a steep increase from the $5.5 billion funding round of 2018. Finally, in 2019, Lyft went public with its first-day valuation at $22.2 billion. The image above shows its journey of fundraising.
A piece of more recent news about private equity funding is of Morrisons, which is Britain’s fourth-largest supermarket. In 2021, Morrisons agreed to the takeover proposal by a global investment company, Fortress Investment Group. The deal values Morrisons at $8.7 billion. The supermarket giant rejected another PE firm’s offer of 5.52 billion pounds before saying yes to Fortress.
Let us now take a look at some highly renowned private equity firms of the world.
Private Equity Deal Structuring
A PE deal is structured after the investor negotiates with the investee and lays down the final clauses in a term sheet. In addition, there is usually an anti-dilution provision. It protects an investor from stock dilution if the stock is later issued at a lower price than what the investor originally paid.
Thus, PE would fund a company in any of the following ways:
- Common Stock: The investor and the target company (investee) mutually decide a certain sum to be given as funds. In addition, they decide upon the percentage of stock the investor will receive.
- Preferred Stock: PE firms are always keen to use preferred Stock structures the most as it can be converted to common stock at the holder’s decision.
- Debt Financing with anEquity kicker : It can be used by investees who are already operational and profitable or have reached Break-even. The number of shares and percentages is based on the size of the loan and the company’s value.
- Convertible Debt: Here, the investor can convert the holding at will into common stocks of the company. Most often, investors with the motive to earn high returns, make use of their conversion rights.
- Reverse Mergers: When an ongoing private company amalgamates with an existing public company with a trading symbol, it is termed as a reverse mergerReverse MergerReverse merger refers to a type of merger in which private companies acquire a public company by exchanging the majority of its shares with a public company, thereby effectively becoming a subsidiary of a publicly-traded company. It is also known as reverse IPO or Reverse Take Over (RTO)read more . Such a public company is referred to as a shell company.
- Participating Preferred Stock: It is a combination of preferred and common stocks. It can be converted to equity without the participating features when the company makes an initial public offeringInitial Public OfferingInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes.read more (IPO). Participation can either be equal or based on the seniority of rounds.
- Multiple Liquidation Preference: Here, preferred stockholders of a specific round of financing get the right to receive a multiple of their original investment when the company is sold or liquidated. This multiple can be 2x, 3x, or even 6x. Multiple liquidation preferences permit the investor to convert to common stock if the company performs well.
- Warrants: Warranties are derivative securities that give the holder the right to purchase shares of a company. Purchased at a pre-determined price, usually, they are issued to make stocks or bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more more attractive to potential investors.
- Options: Options gives the investor a right to purchase/sell shares of stock at a specific price, within a period. Stock purchase options are most common option.
- Full Ratchets: Full Ratchets is a mechanism of protecting investors from future down rounds. If the full ratchet provision states that if a company in future issues stock which is at a lower price per share than existing preferred stock. Then, the conversion price of the existing preferred stock would be adjusted downward to the new, lower price which increases the number of shares of previous investors. Term sheet in Private Equity will give more clarity on these mechanisms.
Since successful PE deals can rake in billions, private equity jobs are quite popular as many companies pay handsome salaries. As per Glassdoor, the annual national average salary of a private equity associate in the US is $1,16,366. However, it is not easy to measure illiquid investments like PE investments compared to measuring the performance of the traditional asset classes. As such, the Internal Rate of Return (IRR) and investments multiples are the two measures used to assess Private Equity investments’ performance.
The table below provides us with the types of PE investments along with their IRR return expectations.
Private Equity Trends
The industry saw tremendous growth post-1970s. In 2017, the total asset Total Asset Total Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity read more under the management of all PE funds together was reported to be USD 2.5 trillion. This growth has been due to the consistent and robust fundraised over the years by them.
Over the years, this industry has undergone consolidation, and hence the number of funds has fallen. Apart from traditional investors such as family offices and university endowments, PE fund has also attracted non-traditional investors such as sovereign wealth funds.
As per a report, the first quarter of 2020 witnessed a sharp decline in the PE investments by 25% in the US and 33% in Europe. In contrast, Asia recorded a 25% increase in the second quarter. The firms are now focusing on digitization of the investment cycle to facilitate easy access to the investors. Many investors are showing inclinations towards PE firms focusing on environmental, social and governance (ESG) factors.
Private equity is a type of investment provided to companies with high growth potential (typically those not listed on any exchange) for a medium to long term period, in exchange for fees and profit.
Private equity is a risky affair for investors since its failure results in massive losses. But if the company succeeds using the funds so acquired, investors could pocket heavy profits depending on the extent of success.
PE adds value for the startups and other companies as it helps finance companies. Money comes through fees, shareholding and profits from sales/mergers or enhanced business.
This article has been a guide to What is Private Equity. Here we discuss the structure of Private Equity Firms, Deal structuring, Fees, and Performance Measures. You may have a look at the following articles to learn more about Private Equity –
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The private equity opportunity
CapMan’s private equity strategies combine extensive industrial experience, strong analytical skills and sound business judgement to identify and develop the most attractive investment opportunities in the Nordic region.
We are long-term, operational, and hands-on with a strong ambition to develop Nordic market leaders.
We have strong experience in development and implementation of growth strategy, building international organisations, execution of acquisitions and arranging finance.
What is private equity?
Private equity is an asset class and refers to funds organised as limited partnerships that make direct investments in unlisted companies. A characteristic of private equity investors is that they are active owners that develop the businesses. Ownership stakes can be majority, minority or consist of a combination of equity and debt instruments.
Private equity is ideally suited when, in order to realise specific medium-term value-creation opportunities, buyers must take outright ownership and execute decision-making power.
Want to grow your business rapidly and with strategic know-how?
Are you looking to scale up activities but require specific expertise and financial backing? Or is your business facing an operational turnaround? These are just some examples where private equity may prove a suitable ownership model. Learn more about CapMan’s private equity investment strategies below.
Private equity strategies at CapMan
We make majority investments in Nordic niche market leaders.
Unlisted growing companies with strong cash flow and winning cultures
Nordic mid-market buyouts
A Nordic team based in Helsinki and Stockholm, 30+ years of experience and solid networks
We make significant minority investments in growing businesses seeking international growth.
Entrepreneur-driven growth companies
Minority investments in small and mid-cap companies as an alternative to selling a majority stake
Active minority partner with an excellent track record of developing successful companies
CapMan Special Situations
We invest in in turnarounds and restructurings that help businesses return to the path of prosperity.
Underperforming or non-core businesses that are facing a turnaround situation
Flexible use of both equity and debt instruments, majority and minority positions, and a strong platform and operational expertise to execute demanding operational transformations
Liquidity, financing, and operational expertise to support throughout the financial restructuring and operational turnaround process
A selection of current and former success stories
Private equity investment process
Private equity companies manage funds, which typically invest in unlisted companies. The private equity investment process starts from collecting capital for a fund and ends with returning committed capital and realised returns to fund investors.
1. Establishing a fund
Private equity fund managers raise capital from institutional investors to establish private equity funds. Typically, investors include both private and state pension funds, funds of funds, life insurance companies, foundations and other institutions. Often the fund manager also commits capital to the newly established fund. Private equity funds are typically organized as limited partnerships with a life cycle of approx. ten years. Capital is called from investors when investments are made into portfolio companies and returned after exits. The fund manager acts as an advisor to the fund making the investment and exit proposals and developing the investment targets during the ownership period.
2. Making an investment
The private equity fund manager maps potential investment targets for the fund. Generally, the targets need to fulfil certain criteria in terms of size, industry and life cycle phase in accordance with the fund’s strategy. In addition, the fund manager evaluates the attractiveness of each potential target based on its value creation and exit potential. Investment targets are usually sourced either through proprietary networks or by participating in auction processes. Efficient deal sourcing therefore calls for strong business networks across the fund’s target geography.
After an investment target is identified, a more detailed analysis on the business is performed. This due diligence analysis usually involves going through the company’s financial and legal documents in more detail, as well as evaluating its commercial attractiveness. Negotiations with banks to arrange financing are also initiated at this stage. Provided that bank financing is available and due diligence findings support the investment, final negotiations regarding the transaction are initiated.
Once the investment is made, the private equity fund manager starts developing the company based on a detailed value creation plan. In addition to financial capital, the manager supports the target company by providing sector knowledge, operational experience and access to a wider business/industry network. This usually involves taking a seat on the target company’s board.
Private equity investors are temporary owners. Consequently, a portfolio company is usually held between 4 to 6 years, during which the value creation plan is being implemented in co-operation with the management team. There are several alternatives available for the private equity fund to exit the investment. Most commonly exits take place via:
- Trade sale to an industrial buyer
- Secondary sale to another private equity fund
- Listing through initial public offering (IPO)
- Sale to the management group
Once the exit is finalised, the initial capital and proceeds from the investment are returned to the fund investors.
Learn more about private equity
Private equity enables the growth and development of unlisted businesses. The private equity industry started to evolve in the Nordic region in the late 1980s, when several private equity houses, including CapMan, were established.
Private equity investing consists of funds making equity investments in non-listed companies. Private equity investors are active owners. Besides capital, the investors provide the companies with strategic and managerial support. Value creation in private equity is primarily based on achieving increased growth and operational efficiency.
Private equity investments are usually categorised based on life cycle phase of the target company:
Seed/early stage investments
Financing for development and commercialization of a business concept.
Minority/majority investments in early stage or expansion ventures.
Typically minority investments in companies with major growth potential.
Acquisition of a controlling interest in a company together with the operative management or an outside management group.
Investments in distressed companies or companies operating in an industry with major changes.
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