June 2017 – Volume 1, Issue 4
An Introduction to Private Equity
What is Private Equity?
Private equity has been misunderstood in some essential ways. The modern-day, eager-to-bank student has exhausted investment banking guides ubiquitously with limited knowledge about private equity. Where investment banking as an analyst or associate is execution heavy, client-facing, and cyclical in nature; private equity looks at fewer companies and delves into independent business models through rational judgement and thinking. Whereas an investment banker would begin analysis at the revenue line, a private equity analyst would investigate into asking “How much money do you have to spend to acquire one customer,” or “How much can you grow a price point to the next level?”
Private equity firms are not traditional retail investors that invest in public companies; they raise funds from wealthy investors and institutions to purchase companies using large amounts of debt (hence the word “leverage”), leaving little of their own equity at risk. In a buyout, these specialists revamp business models, divest unprofitable operations and ‘do things differently’ to hopefully sell it back to investors or the public markets through an initial public offering (IPO). Private equity creates economic wealth – as companies become more productive, they pay taxes, employ more people and ‘do a good thing for the economy’.
A private equity firm consists of partnerships between general partners (GPs), where the private equity fund is a result of investment by limited partners (LPs). Consider the execution of a buy-and-sell scenario:
- “Private Equity Fund #1” has a target capital of $100 million, where it is able to secure $125 million through investment by LPs. The fund is now over-subscribed by $25 million.
- In the investment period, the capital collected is invested into company X, Y, and Z.
- In the exit period, the investments are harvested and company X is sold to another corporation for a profit, company Y has been sold to the public through an IPO.
- Company Z went bankrupt, the investment was a bust; this is the exit outcome private equity companies do not want.
- Fund profits are largely realized by capital gains on the sale of portfolio businesses. Gains are shared with GPs through carried interest, usually 20% of the fund’s profits.
Financing buyout acquisitions with high levels of debt improves returns on investment, and covers the private equity firm’s management fees. Ideal characteristics of candidates for investment include stable cash flows, limited capital investment requirements, and the opportunity to enhance performance in the short-to-medium term.
Trends in Private Equity
Private equity has evolved from a time where the largest investors were public pension funds, with stakeholders paying equal fees regardless of when they committed to the fund. Today, sovereign wealth funds are the largest investors, where bigger LPs pay lower fees. Private equity firms have adapted into a period of specialization, regulation, institutionalization and globalization. Where P/E firms started as generalists, have specialized into differentiated industries and geographies to distinguish themselves. Due to favorable returns, firms are facing the repercussions of greater scrutiny from regulators. As firms grow and manage greater capital, they must face investors with valuable resources to provide better experiences and foster relationships. In doing so, firms help portfolio companies further through globalization and establishment in emerging markets.
After the financial crisis of 2008, private equity firms were adept to several buy-out acquisitions due to discounted valuations allowing investors to buy in at favorable prices. Having access to cheap capital due to reduced customer spending and borrowing, firms could pay high premiums for portfolio businesses they invested in. Today, it is argued that increased company valuations have made it difficult to purchase companies without applying too much leverage and exposing large amounts of equity. Stagnant global GDP has slowed economic growth and companies have engaged in improving margins by cost cutting, eliminating potential buyout candidates for private equity firms to invest in. As competition increases, massive returns that GPs could earn on once-common undervalued assets are harder to find today.
Despite this downward trend, private equity buyout firms delivered returns that outperformed public markets by a sizable margin in 2016. Using an apples-to-apples metric developed by investment advisory firm Cambridge Associates, U.S. P/E funds delivered a 6% internal rate of return (IRR) versus the S&P 500’s 4% IRR for the 12 months ended June 2016.
- Private equity workers have received backlash as they pay a capital gains tax-rate, due to the 20% carried-interest earned from their investment. If their profits were treated as ordinary income, they would be required to pay a much higher comprehensive tax rate.
- In June 2017, private equity firm CVC Capital Partners raised a record $18B fund for investments in Europe and North America. The seventh fundraising is the largest by an European P/E firm.
Looking to explore a future in Private Equity? Check out QFAC’s recruitment guide here to learn about opportunities available to get involved throughout the academic year. Apply to QFAC 2017 as a delegate and get valuable networking experience with private equity professionals across North America!