1. What is private equity?
Private equity is an investment in a firm that acquires and runs businesses based on the goal of selling them later. Private equity firms invest money raised from both institutional and accredited investors. They may buy private or publicly traded companies outright or invest in them along with an acquisition team. In general, they do not own shares of firms whose shares remain traded in the stock exchange. Private equity is often regarded as an alternative investment by venture capital and hedge funds. Only a select few high-net-worth individuals and institutions can invest in such investments since they demand massive amounts of capital over long periods of time.
2. Private Equity firms business model
Private-equity firms purchase, restructure, and exit a company at a higher price. Private-equity funds also use third-party capital through leveraged finance for the acquisition of their targets since most private equity funds are leveraged. In general, private-equity investments are in more favor during the periods of peak of equity values and low interest rates. On the one hand, private equity can enhance a business to make it more competitive, but the same initiative could also sink the business under irrecoverable debt in a poor strategy or incompetence.
3. Types of private equity investments
Like venture capital, private equity generally invests in going concerns and not start-ups. Private equity firms want to increase the value of these portfolio companies before they can exit after several years. Such strong returns from private equity since 2000 propelled the industry’s growth. Private equity buyouts hit $654 billion in 2022-one of its strongest years ever. If stocks are strong and interest rates are low, private equity gets very attractive.
4. Private Equity Industry Growth
Since the growth of the private equity industry depends strongly on the market conditions, it has grown exponentially over the years, especially during good market conditions. Some of the strong returns and increase in investment interest have driven this kind of growth. In fact, the industry received its second-best performance last year, 2022, when it hit a record $654 billion in buyouts because of the good stock market performance and low interest rates. However, in this scenario, private equity investments lose their appeal as the available number of investors, who can invest high-value capital over a longer duration, decreases.
5. Features of private equity funds
Private equity firms commit their clients’ capital to structured private equity funds. There, they are general partners, or GPs, collecting management fees as well as a share of profits-known there as “carried interest.” The term of these funds is finite: 10 to 12 years-and no capital may be withdrawn from them. Over several years, private equity funds begin to distribute profits to investors. In 2023, the weighted average holding period for portfolio companies held by private equity firms was estimated to be 5.6 years.
6. Private equity investment strategies
There exist various types of investments where some private equity firms venture in specific niches, while others cut across a wide scope of transactions. While private equity majorly targets mature companies, the reverse happens with venture capital, as it majorly targets startups. Other private equity niches are comprised of: Distressed investing engages firms that are in critical financial distress. Growth Equity : Investment in companies beyond the startup. Sector specialists: They specialize in particular sectors, such as technology or energy. Private equity can also engage in secondary buyouts- that is, buyouts of a firm from one private equity firm by another, or in carve-outs that is, the purchase of a subsidiary of a larger company.
7. Classes of Private equity transaction
Private equity deals vary by situation but in a category. The most general type of private equity deal is one where a firm outright purchases an entire company-in either the public or private arena. Private equity firms acquire distressed public companies with the intent of restructuring and streamlining operations. Carve-out is another type of transaction where private equity firms purchase a subsidiary or unit of the bigger firm. These transactions are generally more complex in nature and involve more risk; however, they are highly lucrative for strategic growth. Examples include Carlyle buying Tyco Fire & Security Services Korea in 2014 and Francisco Partners buying corporate training platform Litmos from SAP in 2022.
8. The way Private Equity
creates value In general, as soon as a private equity firm acquires a company, they generally have in place a well-defined plan that is intended to enhance the value of the company. It often includes the kinds of cost-cutting measures or strategic restructuring that the previous management may have been unwilling or unable to carry out. The private equity firm can also bring in some niche expertise, such as technological innovation or even geographical expansion, to add value to the company. The company can either retain the existing management team to finish these projects or introduce new leaders to drive its vision.
9. Leverage in private equity
The most critical feature of private equity is that it relies heavily on leverage; or in simpler terms, debt to finance acquisitions. Debt financing enables firms to increase returns on equity investments although operating improvements have become the source of value creation for private equity more so than ever before because the use of leverage has decreased as a source of value since equity investors begin to provide firms with higher capital inflows. Increased equity funding has minimized debt usage, but the servicing of that debt still increases expected returns on investments by a significant margin.
10. What has private equity been criticized for?
Private equity firms have often been criticized for participating in the “underhanded” practice of “asset stripping,” which is selling the assets of a company to realize an easy profit. Private equity firms counter this image by touting their experience as managers and touting the successful turnarounds of portfolio companies. Highly ironic, private equity firms often focus on long-term growth and value creation in the companies they acquire despite their sometimes ruthless reputation. Instead, however, the layoffs or restructurings that can come about as a result of private equity firms’ actions are seen as negative.
11. How Management of Private Equity
Funds Works Typically, a private equity fund is managed by the GP or general partner, which in this case is the firm that came up with the fund. A general partner is in charge of all decisions pertaining to fund management and commits around 1% to 3% of the capital amount in a fund. In return, the general partner enjoys a management fee set at about 2% of the assets held under its management and receives a carried interest share of the profits obtained above a threshold. General and Limited Partners are institutional investors or high-net-worth persons providing capital to the fund in exchange for a small share of the profits. They are the clients of the private equity firms.
12. General and Limited
Partners in Private Equity A general partner is essentially a manager of the private equity fund, which is responsible for investment and operation decisions. A general partner usually invests just a small percentage of the total capital of the fund but earns great management fees and profit participation. LPs, which provide the majority of capital, have virtually no control over the operation of the fund. They can be pension funds, endowments, and other rich individuals. They invest into this fund while expecting high yields. However, they also know that they cannot withdraw the money until the specified term for the fund is over.