Private equity is gaining ever more prominence in today’s investment environment. During 2018, private equity investment in European companies hit a new record volume of €80.6 billion. In addition, a number of prominent deals made headlines recently, such as private equity firm KKR’s plans to buy a minority share in German media giant Springer, or Liberty London, one of the world’s most iconic department stores, being sold for £300 million to US private equity firm Glendower Capital. As an alternative form of investment, private equity offers unique key benefits to investors. In what follows, we provide a brief introduction on what private equity is, how it works, and why individual investors should consider it as an investment strategy.
What is private equity?
Simply put, private equity describes the purchase of equity stakes in companies that are usually not listed on a public stock exchange. Sometimes, however, private equity investments are made into publicly listed companies with the aim of taking them private. Typically, businesses targeted by private equity funds have high growth potential and clear competitive advantages. Investments are made through a a limited partnership fund structures that pool capital on behalf of investors, or “limited partners”.
Private equity represents then a means that companies can use to raise equity without having to get listed on a public exchange. Funds raised by private equity firms are managed and run by some of the most successful investment professionals. These professionals are responsible for sourcing deals, analysing companies in terms of them being a potential investment target, and closing on the most attractive opportunities. The management firm is then responsible for carrying out the operational improvement plan or strategic repositioning for each portfolio company, which is held for an average of three to five years, as well as managing the risk at the portfolio level. At the end of each deal cycle, the private equity firm executes on an “exit” via a sale to a strategic acquirer, an IPO, or a resale via another buyout.
How was private equity developed?
The term ‘private equity’ has only really entered public consciousness in the last three decades. However, the pooling of funds in order to purchase stakes in companies and the investment methods used in the private equity industry are – as the Wall Street Journal puts it – “as old as capitalism itself”.
Private equity firms, in the form we know them today, can be traced back to the American Research and Development Corporation, founded in 1946. The industry grew rapidly in the USA during the 1970s and 1980s, when the country underwent a technological revolution and new businesses, such as Apple and Intel, were looking for alternative financing. Throughout the 1990s and beyond, private equity deals continued to gain in importance, and according to
Pitchbook’s 2018 Annual Private Fund Strategies Report, North American and European private firms raised in excess of $2 trillion and 3,000 funds during the last ten years.
Figure 1: North American and European private equity fundraising by year
How are private equity firms organized?
Private equity firms are organized for the purpose of aggregating investors’ capital in order to invest in privately held companies. While the terms ‘private equity firm’ and ‘private equity fund’ are often used interchangeably in this context, it is worthwhile getting technical for a moment and explaining the relationship between the two.
Private equity firms are run by “general partners”, sometimes also called sponsors. The general partner invests on behalf of limited partners who have committed their money together in a fund with an expected lifetime of circa ten years. The distinction between these form of partners lies on the level of the management of the fund and the accompanying liability. General partners are responsible for the operations and daily decision-making of a limited partnership, and hence face unlimited liability regarding the financial dealings of the partnership. Limited partners, on the hand, by not being involved directly and daily in the partnership face limited liability, that is limited to the amount of their participation in the partneship.
Under this framework, we can understand how private equity firms are general partner to the various private equity funds they manage and earn money by charging management and performance fees. A typical fee structure, and we are simplifying here a lot as these structures differ throughout the industry and are defined very precisely each time, is a 1.5% to 2% management fee and a 20% performance fee on any returns above 8% per year.
How do private equity firms invest?
Private equity investments follow an array of different investment strategies. In general, private equity is associated with injecting capital into mature companies that require an equity boost and strategic refocus to grow and expand their business or to turnaround a loss making enterprising to a profit-generating one. Either way, the aim is to increase that company’s enterprise value.
Private equity firms might buy a family-owned business outright or, in other cases, such as the Liberty London deal, existing investors (for example other private equity firms) are the ones being bought out. In the most typical private equity case, investments come in the form of equity capital for business expansion, while credit strategies, that are often lumped under the broad term “private equity”, use credit instruments to recapitalise companies in need of financing. Nonetheless,the most popular type of private equity investment is the so-called leveraged buyout (LBO). In this case, the private equity fund’s investment in a company involves the use of leverage, i.e. borrowing money to finance an acquisition with the aim of maximizing the return on equity. The term “buyout” refers to the investment taking the form of a controlling stake in a company with the cooperation of the company’s existing management, in contrast to a “buy-in” that refers to an investment that involves replacing the existing management team.
What are the advantages of investing in private equity?
Private equity has proven to be one of the most rewarding asset classes. Returns delivered by private equity investments have been consistently in excess of public equities, even during the financial crisis.
Figure 2: Private equity index returns against the S&P 500
It is no coincidence that professional investors, such as sovereign wealth funds, have on average more than 25% of their portfolio invested in private markets.
Figure 3: Sovereign Wealth Funds’ Average Asset Allocation
As an actively managed investment directed by shrewd financial and operational know-how, private equity is able to generate substantial value for the underlying company. Private equity managers get involved in strategic initiatives and decisions for the companies they invest in often enabling the company to focus on its highest margin opportunities. In addition to their experience and know-how in investing in operating companies, private equity firms have a legitimate informational advantage. These firms have extensive networks and decades of industry specific experience that enable them to identify private companies whose business model and profit potential constitute an opportunity that is quite rarely present in public markets.
Last but not least, private equity not only enables investors to directly back entrepreneurs and become part of business ventures in verticals that better complement their investment portfolios, it also exposes investors to a wider set of investment opportunities and risk premia – be it companies that are too small to be listed on the stock market or certain industry sectors and geographic regions (emerging markets) that are underrepresented on public stock exchanges. Indicatively, as of 2016 and in reference to the US market, the number of companies with over 500 employees that not listed on any stock exchange is circa 3.5 times larger compared to the number of publicly listed companies.
Figure 4: The Opportunity Set for Private Equity
How can I invest in private equity?
The asset class has typically been accessible for banks, insurance companies, pension funds and other institutional investors with considerable funds at their disposal. The reason is simple. Minimum amounts are normally in excess of €5m-€10m. This has quite naturally made private equity unattainable for many private investors. Moonfare is addressing that issue by lowering the investment threshold to €100,000, thereby opening the market to a wider range of investors.