Private equity Investing. To many, private equity firms have a reputation as predators, swooping in to buy solid companies at rock bottom prices, only to break them apart and sell the pieces for profit. To others, private equity companies have virtually saved jobs and communities by salvaging decaying enterprises and making them profitable.
For many institutions and well-heeled investors, private equity funds are an alternative, long-term investment opportunity bearing significant returns. The typical minimum investment is $250,000.
Private equity is the active management of capital strategically invested in tapping the fullest potential of targeted companies. Private equity strategies may involve leveraged buyouts of publicly traded enterprises. In other instances, funds may be invested in promising ventures or technologies that lack proper management and funding. Alternatively, investments may include purchasing underachieving companies with perceived untapped possibilities.
A private equity group becomes the manager of invested funds and may implement a broad range of strategies like venture capital, leveraged buyouts, and growth capital to create wealth. An appointed manager or “general partner” takes control of the company with the objective to add real value to the enterprise. The added value eventually represents gains for the investors or “limited partners” during the life of their investment.
How Does a Private Equity Firm Make Money?
Value creation is the essence of the private equity strategy. Whether the approach is a leveraged buyout of an underperforming public company or the outright acquisition of a startup with high potential, private equity investors assume the role of active management. By executing growth strategies, the general partner might employ aggressive restructuring to align the new company with new objectives. The realignment can mean a substantial personnel change or an entirely new marketing approach.
Eliminating excess or nonessential functions is normal, and the result is usually a leaner, less bureaucratic organization. In many cases, the private equity manager may place greater emphasis on certain underdeveloped assets than the previous management did.
Besides growth capital, venture capital, or LBOs, other opportunities for a private equity operation may include mezzanine financing or distressed buyouts.
How Does a Private Equity Company Perform an LBO?
Leveraged buyouts (LBOs) are a strategy for many private equity funds. Populated by a staff of professional, well-compensated analysts, private equity groups detail every aspect of a potential target public company’s finances and potential. Before any investment is approved, analysts examine every financial element of the target company’s balance sheet, P&L, sales history and trends, forecasts, and company structure.
Viewing the business through this virtual microscope, financial experts at the private equity firm determine where hidden value may lie. Could the company or parts be profitable (and sellable) with the right management? Could the company be split in such a way that the sum of the parts becomes greater than the whole?
Sometimes large public companies stagnate after an extended period of growth and acquisitions, and certain aspects of the business begin to struggle. Current management may not have the appetite for severing traditional or legacy portions of the company whereas a new manager will see the organization more objectively.
Once a target is established, the private equity group begins to accumulate stock in the corporation. With substantial collateral and massive borrowing, the fund eventually achieves a majority or acquires the total shares of the company stock. The private equity group will then choose to delist the corporation and take the company private, opening the door for new management.
Growth of Private Equity
From the 1980s to 2008, when lending and investment regulations were liberal or relatively nonexistent, private equity investing increased rapidly. Many private equity deals were highly profitable. According to the Harvard Business Review, private equity buyouts that had exceeded $1 billion grew on average from $28 billion in value to $502 billion from 2000 to 2006, an incredible return for the fund investors.
During the recession of 2008, funds struggled, and some private equity firms disappeared. However, since the recession has waned, private equity is rebounding in the United States and Canada and are once again becoming robust, even in the face of stiffer regulations and lending practices.
How is a Private Equity Different from Other Investment Classes?
Private equity funds are substantially different from conventional mutual funds or EFTs. Mutual funds work with predetermined strategies and limit investments to specific categories of stocks, bonds, or both. Also, stock fund mandates may restrict managers to either value or growth equities.
Hedge funds are similar to private equity funds in several aspects but assume no active business management role. Hedge funds operate as Limited Liability Partnerships (LLP) and attract high-level investors looking for diversity and a broaden the range of investment opportunities. Hedge fund investment strategies may involve currency positions, commodities, interest rates, indexes, and more. Hedge fund managers regularly scrutinize the landscape for potential market, political, or specific company activities to find upcoming market advantages upon which to capitalize.
Private equity funds, on the other hand, invest in or lend to real businesses. Their process is to study opportunities in detail to uncover important, unrealized potential. If such opportunities are apparent, the private equity company may acquire the business, make targeted changes, sell and then capitalize on the underlying value. Through this process, investors can reap substantial gains from their investment.
Fees and Profits
Private equity fees vary. A typical payment schedule requires a 2% management fee and 20% of the profits gained.
Consistent with their lean management philosophy, private equity firms tend to employ only a handful of highly qualified professionals to make the decisions, handle the evaluations, and manage the investments.
Private equity fund managers are incentivized by substantial compensation. Success is determined by favorable borrowing and tax advantages created, positive cash flow, and eventual profitability.
What is the Time Commitment for a Private Equity Investment?
Private equity fund strategies require an extended holding time for investments because most business turnarounds, resales, or IPOs do not happen overnight, and often take years to materialize. Waiting for a retooled company to recover or a new venture to attain an IPO or a sale can be a substantial effort. Moreover, maintaining stability in the funding is necessary to sustain momentum. The average minimum holding time of the investment varies, but 5.5 years is the average holding period required to achieve a targeted internal rate of return which may be 20% to 30%.
Private equity activity tends to be subject to the same market conditions as other investments. However, leveraged buyouts and acquisitions tend to provide a quicker return when the markets are in a growth phase and when interest rates are low.
Status of Private Equity in Canada
According to the MacMillan Private Equity Booklet, Canada has been a favorable market for private equity transactions by both foreign and Canadian concerns. Typical transactions have ranged from $15 million to $50 million. Conditions in Canada support ongoing private equity investment with solid economic performance and legislative oversight similar to the United States.
Some of the largest Private Equity firms in Canada include CPP Investment Board, ONEX Corporation, The Caisse de dépôt et placement du Québec, and many others.
We hope you found this article insightful. If you have any questions about alternative investing or hedge fund investing, we invite you to contact our Montreal Hedge Fund. It will be our pleasure to answer your questions.