How do you understand the concept of private equity? If you think that it stands somewhere next to private property, this article is for you. Let’s make it clear and simple. Private equity is a particular type of investment capital that is not noted on a stock exchange. It is composed of investors and funds that invest in private companies or participate in public companies’ buyouts, delisting the public equity.
By acquiring equity ownership in different companies, private equity partners raise funds and manage them to get good returns with an investment horizon from 4 to 7 years.
The minimum capital, required for investors, can differ according to the particular company and the funds raised.
Private equity is attractive, isn’t it?
The private-equity industry attracts top professionals from various consulting firms and even Fortune 500 companies. And it is no wonder why. The fee structure of these firms may vary, but usually it includes a management and a performance fee. For example, it may consist of a 2% fee from the managed asset and a 20% fee from the company’s gross profit.
Let’s say that a private-equity firm operates assets of $1 billion. Having no more than two dozen investors, their 20% fee from the gross profit could bring them millions of dollars. If the associates of such firms usually earn a salary of six figures, the executives may earn more than a million. Sounds tempting, doesn’t it?
How does it work?
Private-equity firms have two major functions: deal origination and portfolio oversight.
Deal origination includes launching and developing relations with M&A (mergers and acquisitions) intermediaries and investment banks to ensure a stable, high-quality deal flow. Deal originators, usually associates or directors, try to build good relationships with transaction professionals in order to be introduced early to deals.
Executing transactions includes careful assessing of the industry, historical data, financial forecasts and performing valuation analyses. After the decision to proceed with the chosen acquisition candidate is taken, deal specialists transfer their offers to sellers. In the case that all the parties agree to go further, deal professionals continue negotiations with investment bankers and consultants to perform the due diligence stage. This stage is highly important and presupposes the investigation of the financial records and other significant aspects that may even kill the deal.
The second but not less important function of private-equity specialists is to oversee portfolio companies. They support the management teams, showing them the best practices of strategic planning.
Do private-equity firms differ?
For sure, they do. There are many types of private-equity firms happily existing. Some of them can be called passive investors, who just put in their money and totally depend on the company’s management decisions on how to grow profitability and gain good returns for their owners. Others are considered active investors. These investors are those who provide management help and support on how to improve the company’s performance.
Active investment firms often possess a vast list of C-level contacts within a particular industry, which may help to gain additional revenue. When the investor contributes something special in a deal that may further potentially increase the company’s value, sellers consider them very favourable.
Waiting for an upside
Great and famous investment banks, including JPMorgan, Goldman Sachs and Citigroup, participate in the largest deals usually worth billions of dollars. Still, the overall majority of deals refer to the middle and lower middle market, covering transactions from 10 to 500 million dollars.
Middle companies can offer substantial financial upside to their private equity investors. These, usually small, companies do not attract the attention of huge corporations but provide outstanding customer service and unique products that are popular among customers. Private-equity firms may become interested in such benefits, because they can use them to promote the company to the next level.
In buying a company, a private-equity firm works hard together with the company’s management to increase EBITDA (e.g. earnings before interest, taxes, depreciation and amortisation) metric. It can be increased by means of the company’s internal growth and acquisitions. Growing a middle market company, a private-equity firm sells it to a big corporation and receives significant profit.