Private Equity

Why Private Equity Firms Are Important

Private equity is ownership or interest in an entity that is not publicly listed or
traded. A source of investment capital, private equity comes from firms that
purchase stakes in private companies or acquire control of public companies
with plans to take them private and delist them from stock exchanges. Private
equity can also come from high-net-worth individuals (HNWI) who are eager
to see outsized returns.

The private equity industry is comprised of institutional investors, such as

pension funds, and large private equity firms funded by accredited investors.
Because private equity entails direct investment—often to gain influence or
control over a company's operations—a significant capital outlay is required,
which is why funds with deep pockets dominate the industry.

The minimum amount of capital required for accredited investors can vary
depending on the firm and fund. Some funds have a $250,000 minimum entry
requirement, while others can require millions more.

The underlying motivation for such commitments is the pursuit of achieving a

positive return on investment (ROI). Partners at PE firms raise funds and
manage the money to yield favorable returns for shareholders, typically with
an investment horizon of between four and seven years.

Types of PE Firms
Private equity firms have a range of investment preferences. Some are strict
financiers or passive investors wholly dependent on management to grow the
company and generate returns. Because sellers typically see this as
a commoditized approach, other PE firms consider themselves active
investors. That is, they provide operational support to management to help
build and grow a better company.

Active private equity firms may have an extensive contact list and C-
level relationships, such as CEOs and CFOs within a given industry, which
can help increase revenue. They might also be experts in realizing
operational efficiencies and synergies. If an investor can bring in something
special to a deal that will enhance the company's value over time, they are
more likely to be viewed favorably by sellers.
As private equity investments require millions of dollars, they are usually not
available to the average investor.

Investment banks compete with some private equity PE firms, also known
as private equity funds, to buy good companies and finance nascent ones.
Unsurprisingly, the largest investment-banking entities such as Goldman
Sachs (GS), JPMorgan Chase (JPM), and Citigroup (C) often facilitate the
largest deals.

In the case of PE firms, the funds they offer are only accessible to accredited
investors and may only allow a limited number of investors, while the fund's
founders will usually take a rather large stake in the firm as well.

That said, some of the largest and most prestigious private equity funds trade
their shares publicly. For instance, the Blackstone Group (BX), which has
been involved in the buyouts of companies such as Hilton Hotels and
MagicLab, trades on the New York Stock Exchange (NYSE) .45

How PE Firms Create Value

Private equity (PE) firms perform two critical functions:

 Deal origination and transaction execution

 Portfolio oversight

Deal Origination and Execution

Deal origination involves creating, maintaining, and developing relationships

with mergers and acquisitions (M&A) intermediaries, investment banks, and
similar transaction professionals. These relationships secure both high-
quantity and high-quality deal flow, referring prospective acquisition
candidates to private equity professionals for investment review. Some firms
hire internal staff to proactively identify and reach out to company owners to
generate transaction leads. In a competitive M&A landscape, sourcing
proprietary deals can help ensure that funds raised are successfully deployed
and invested.

Additionally, internal sourcing efforts can reduce transaction-related costs by

cutting out the investment banking middleman's fees. When financial
services professionals represent the seller, they usually run a full auction
process that can diminish the buyer's chances of successfully acquiring a
particular company. As such, deal origination professionals attempt to
establish a strong rapport with transaction professionals to get an early
introduction to a deal.

It is important to note that investment banks often raise their own funds, and
therefore may not only be a deal referral, but also a competing bidder. In
other words, some investment banks compete with private equity firms to buy
up good companies.

Transaction execution involves assessing management, the industry,

historical financials and forecasts, and conducting valuation analyses. After
the investment committee signs off to pursue a target acquisition candidate,
the deal professionals submit an offer to the seller.

If both parties decide to move forward, the deal professionals work with
various transaction advisors, including investment bankers, accountants,
lawyers, and consultants, to execute the due diligence phase. Due diligence
includes validating management's stated operational and financial figures.
This part of the process is critical, as consultants can uncover deal-killers,
such as significant and previously undisclosed liabilities and risks.

Portfolio Oversight and Management

Oversight and management make up the second important function of private

equity professionals. Among other support work, they can walk a young
company's executive staff through best practices in strategic planning
and financial management. Additionally, they can help institutionalize new
accounting, procurement, and IT systems to increase the value of their
investment.

When it comes to more established companies, PE firms believe they have

the ability and expertise to take underperforming businesses and turn them
into stronger ones by increasing operational efficiencies, and with it earnings.
This is the primary source of value creation in private equity, though PE firms
also create value by aiming to align the interests of company management
with those of the firm and its investors.

By taking public companies private, private equity firms remove the constant
public scrutiny of quarterly earnings and reporting requirements, which then
allows them and the acquired firm's management to take a longer-term
approach to improve the fortunes of the company.
Management compensation is also frequently tied more closely to the firm's
performance, thus adding accountability and incentive to management's
efforts. This, along with other mechanisms popular in the private equity
industry, eventually lead to the acquired company's valuation increasing
substantially in value from the time it was purchased, creating a profitable exit
strategy for the private equity firm—whether that's a resale, an initial public
offering (IPO), or an alternative option.

Private Equity Investment Strategies

There are plenty of private equity investment strategies. Two of the most
common are leveraged buyouts (LBOs) and venture capital (VC)
investments.

Leveraged Buyouts (LBOs)

LBOs are exactly how they sound. A company is bought out by a private
equity firm, and the purchase is financed through debt, which is collateralized
by the target’s operations and assets.

The acquirer (the PE firm) seeks to purchase the target with funds acquired
through the use of the target as a sort of collateral. In an LBO, acquiring
private equity firms are able to assume control of companies while only
putting up a fraction of the purchase price. By leveraging the investment, PE
firms aim to maximize their potential return.

Venture Capital (VC)

VC is a more general term , frequently used in relation to taking an equity

investment in a young company in a less mature industry—think Internet
companies in the early- to mid-1990s. Private equity firms will often see that
potential exists in the industry, and more importantly in the target firm itself,
noting that it’s being held back, say, by a lack of revenues, cash flow, and
debt financing.

PE firms are able to take significant stakes in such companies in the hopes
that the target will evolve into a powerhouse in its growing industry.
Additionally, by guiding the target’s often inexperienced management along
the way, PE firms add value to the company in a less quantifiable manner as
well.
How PE Firms Exit a Deal
One popular exit strategy for private equity firms involves growing and
improving a middle-market company and selling it to a large corporation for a
hefty profit. The big investment banking professionals cited above typically
focus their efforts on deals with enterprise values (EVs) worth billions of
dollars; the average deal size in 2023 was $964 billion.6

Because the best gravitate toward the larger deals, the middle market is a
significantly underserved market. There are more sellers than there are highly
seasoned and well-positioned finance professionals with extensive buyer
networks and resources to manage a deal.

The returns of private equity are typically seen after a few years. It is
considered a longer-term investment.

Flying below the radar of large multinational corporations, many of these

small companies often provide higher-quality customer service and/or niche
products and services that are not being offered by the
large conglomerates. Such upsides attract the interest of private equity firms,
as they possess the insights and savvy to exploit such opportunities and take
the company to the next level.

For instance, a small company selling products within a particular region may
grow significantly by cultivating international sales channels. Alternatively, a
highly fragmented industry can undergo consolidation to create fewer, larger
players—larger companies typically command higher valuations than smaller
companies.

An important company metric for these investors is earnings before interest,

taxes, depreciation, and amortization (EBITDA) . When a private equity firm
acquires a company, they work together with management to significantly
increase EBITDA during its investment horizon. A good portfolio company
can typically increase its EBITDA both organically and by acquisitions.

Private equity investors must have reliable, capable, and dependable

management in place. Most managers at portfolio companies are given
equity and bonus compensation structures that reward them for hitting their
financial targets. Such alignment of goals is typically required before a deal
gets done.
How to Invest in Private Equity
Private equity opportunities are often out of reach for people who can't invest
millions of dollars, but they shouldn't be. Though most PE investment
opportunities require steep initial investments, there are still some ways for
smaller, less wealthy players to get in on the action.

Publicly Traded Stock

There are several private equity investment firms—also called business

development companies (BDCs)—that offer publicly traded stock, giving
average investors the opportunity to own a slice of the PE pie. Along with the
Blackstone Group, there is Apollo Global Management (APO), Carlyle Group
(CG), and Kohlberg Kravis Roberts (KKR), best known for its massive
leveraged buyout of RJR Nabisco in 1989.7

Funds of Funds

Mutual funds have restrictions in terms of buying private equity due

to Securities and Exchange Commission (SEC) rules
regarding illiquid securities holdings, but they can invest indirectly by buying
these publicly-listed private equity companies. These mutual funds are
typically referred to as funds of funds.

Exchange-Traded Funds

Average investors can also purchase units in an exchange-traded fund (ETF)

that holds shares of private equity firms, such as ProShares Global Listed
Private Equity ETF (PEX).8

Crowdfunding

Private equity crowdfunding allows companies or entrepreneurs to obtain

financing. The investor is offered debt or equity in exchange for partial
ownership of the business. Oftentimes, private equity crowdfunding is
shortened to the term equity crowdfunding.

Crowdfunding can be used by companies to raise money, similar to how

individuals can raise money for causes via GoFundMe. Examples of online
platforms for equity crowdfunding include Wefunder, AngelList, Crowdfunder,
SeedInvest, and CircleUp. With private equity crowdfunding, however,
entrepreneurs and businesses generally have to give up equity to get the
investment.

The Securities and Exchange Commission (SEC) has created regulations to

allow companies to access capital. There are regulations, such as limits on
the aggregate amount of money and on the number of non-accredited
investors.9

Working at a Private Equity Firm

The private equity business attracts some of the best and brightest in
corporate America, including top performers from Fortune 500 companies
and elite management consulting firms. Law firms can also be recruiting
grounds for private equity hires, as accounting and legal skills are necessary
to complete deals, and transactions are highly sought after.

The fee structure for PE firms varies but typically consists of a management
and performance fee. A yearly management fee of 2% of assets and 20%
of gross profits upon sale of the company is common, though incentive
structures can differ considerably.10

Given that a PE firm with $1 billion of assets under management (AUM) might
have no more than two dozen investment professionals, and that 20% of
gross profits can generate tens of millions of dollars in fees, it is easy to see
why the industry attracts top talent.

Compensation for PE jobs will vary depending on the company, title, and
location. In North America, associates can make an average total
compensation of $234,000; vice presidents, $392,000; principals, $608,000;
and managing directors/partners, $1.1 million.2

How Do Private Equity Owners Make Money?

Private equity owners make money by buying companies they believe have
value and can be improved. They improve the company, which generates
more profits. They also make money when they eventually sell the improved
company for more than they bought it for.

Why Is Private Equity So Hard to Get Into?

Finding a job in private equity is hard because private equity jobs are very
competitive and there are, comparatively, not that many private equity jobs
available. Because private equity is competitive, firms seek out the best
candidates. Coming into private equity without prior related work experience
is impossible. Internships or jobs in investment banking beforehand are the
typical gateway into private equity jobs. Those jobs themselves are very
competitive.

What Is the Disadvantage of Private Equity?

Private equity comes with a few disadvantages. These include increased risk
in the types of transactions, the difficulty to acquire a business, the difficulty
to grow a business, and the difficulty to sell a business. Another disadvantage
is the lack of liquidity; once in a private equity transaction, it is not easy to get
out of or sell. There is a lack of flexibility. Private equity also comes with high
fees.

The Bottom Line

With funds under management already in the trillions, private equity firms
have become attractive investment vehicles for wealthy individuals and
institutions. Understanding what private equity exactly entails and how its
value is created in such investments are the first steps in entering an asset
class that is gradually becoming more accessible to individual investors.

As the industry attracts the best and brightest in corporate America, the
professionals at private equity firms are usually successful in deploying
investment capital and in increasing the values of their portfolio companies;
however, there is also fierce competition in the M&A marketplace for good
companies to buy. As such, it is imperative that these firms develop strong
relationships with transaction and services professionals to secure a strong
deal flow.

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