Curated Texan
When Edward J. Barton, Rory R. Leibhart and Emily L. Sander set out to write a book about private equity, On-Ramp To Exit, they wanted to take readers inside the finance world and share their knowledge. Which they have. Here’s an excerpt in this guest post that we hope you’ll find helpful in your own endeavors.
The first private equity firms cropped up in the middle of the last century, just after World War II. The first two firms were American Research and Development Corporation (ARDC) and J.H. Whitney & Company, founded in 1946. By the late 1970s and early 1980s, private equity was booming, with the number of firms estimated to be about 500 globally.
PRIVATE EQUITY TODAY
Private equity has become a foundation part of the world economy. It provides businesses with consistent access to financing, even during recessionary times. It drives business outcomes by emphasizing growth, efficiently managed operations, and financial engineering.
There are now about 4,000 private equity firms in the United States alone. Globally, the market has surpassed $4.74 trillion in assets under management (AUM), which is larger than the GDP of Japan. In size and structure, private equity firms run the gamut: large, medium, small, and boutique, with areas of specialization in specific industries or markets.
WHAT PRIVATE EQUITY IS NOT
Private equity differs from other sources of financing.
Private equity ownership is not:
- A bank loan: Unless you default on a loan, the bank doesn’t own your business. The private equity team will be much more involved than your banker because they own your business, or at least a portion of it.
- Public company ownership: Private equity transactions are not IPOs. Private equity-backed companies face less regulation and disclosure requirements than companies that go public. Shares in privately held companies are less liquid than trading in shares on the various stock exchanges.
- Angel investment: Private equity is best suited for growth-stage businesses and mature cash-flowing businesses, not startups.
- Venture capital: Private equity focuses on sustainable business models that are reasonably assured to generate ROI. By nature, private equity firms are more risk-tolerant than banks and other lenders but more conservative than venture capital firms.
HOW IS A PRIVATE EQUITY FIRMED STRUCTURED?
Private equity firms typically represent two things to the market: Professional investors and professional asset managers. As professional investors, they find opportunities to acquire other peoples’ assets (businesses). As professional asset managers, they use other peoples’ money to fund those investments and manage portfolios.
To achieve these goals, they recruit the best and brightest professionals to identify companies to buy and raise capital. They maximize their ability to make money by growing their assets under management and sharing in the profits of the companies they’ve invested in.
Private equity firms are typically a series of closed-end funds with a defined lifecycle. Investors in these funds are called limited partners (LPs): pension funds, sovereign wealth funds, endowments, insurance companies, family office investment companies, and accredited high-net worth individuals. Some of the largest LPs in private equity funds include California Public Employees’ Retirement System (CalPers), Canada Pension Plan Investment Board (CPPIB), Abu Dhabi Investment Authority (ADIA), Government Pension Investment Fund (GPIF) of Japan, and Teacher Retirement Systems of Texas (TRS). Collectively, these five LPs themselves manage over $3.7 trillion.
The jobs of some executives at private equity funds involve building and developing long-term relationships with these limited partners, ultimately seeking to continually raise capital funds the investments made by the other side of the private equity house, the deal team.
On the deal side, managing directors (MDs) and their teams are always looking for companies and investments to add to the firm’s portfolio, increasing the portfolio size and offering more opportunities to deliver returns on LP investment, sharing profits. They’re often tapped into specific markets or industries where they have proven track records and experience and look out for strategic opportunities to position their portfolio better. As a founder, you’ll likely get a call from someone on the firm’s deal team. Depending on the market for companies like yours, you may be called by dozens of such firms.
Outside of the private equity firm, the investment bank is another key player on the stage. Like private equity firms, investment banks vary in size, industry expertise, and geographic focus. The investment bank may be part of a much larger financial institution. Chase Bank and Goldman Sachs are examples of firms with an investment banking division amidst many other lines of business.
Fundamentally, investment banks are advisors that facilitate the purchase and sale of businesses, earning fees for closing deals between parties. The investment bank is essential to the private equity world, and can be considered the “middleman” between private equity firms and founders or operators.
PRIVATE EQUITY INVESTMENT TIMELINE
Private equity funds are typically closed-end, meaning they have a finite lifecycle. A typical private equity fund has a 3-7 year timeline from open to close. This includes an investment period of 2-3 years, with the remaining period devoted to “harvesting” profits on the investments made. Some private equity funds have extended time frames that allow for follow-on funding rounds, depending on the fund’s performance and other market factors during the fund’s lifecycle.
HOW DOES A PRIVATE EQUITY FIRM MAKE MONEY?
It can be helpful to think of private equity firms as “flipping” businesses, much like real estate investors “flip” properties.
The key concepts in any private equity strategy are:
- Invest capital
- Improve the businesses acquired
- Exit the business at a profit
At a high level, it’s that simple.
The private equity model requires a lot of investment capital. The primary source of money comes from the firm’s LPs. The model also utilizes debt borrowed from the banks and other financial institutions. With capital raised, the private equity fund buys businesses. The financial structure of a particular company is known as its “capital stack.”
There are essentially three ways that private equity firms make money:
- Earning fees through managing the money from their LPs and putting it to work by making investments
- Earning a “promote” or return on the investment profit itself by ensuring that the investments generate as much profit for investors as possible (see discussion on Carried Interested below)
- Charging the portfolio companies a management fee for their oversight of the investment
A portion of the compensation received by private equity firms comes as a percentage of the assets under management. Typically, private equity firms charge their LPs 1-2% of assets under management. That may seem small, but as private equity firms grow their assets to hundreds of billions of dollars, those fees represent significant cash compensation.
The bulk of the PE firm’s compensation comes from the performance (profitability) of the investments (businesses) they manage. This fee is known as “carried interest.” This aligns the private equity firm’s motives with those of their LPs. Often, the PE firm earns 20% or more of profits – above a specific minimum internal rate of return. This minimum threshold, called preferred return, or “pref” for short, is paid out to LPs before the PE firm shares in the profits.
- To listen into the Private Equity Podcast, visit:
Audio: https://privateequityexperience.buzzsprout.com
Video: https://www.youtube.com/@PrivateEquityExperience/videos
- Contact the authors at: Ed Barton: https://www.linkedin.com/in/edwardjbarton/
Rory Liebhart: https://www.linkedin.com/in/private-equity-cfo/
Emily Sander: https://www.linkedin.com/in/emilysander/
To visit the Private Equity Experience website visit: https://privateequityexperience.com
Disclaimer: The information provided in this blog post is for educational and informational purposes only. It should not be considered as financial advice. Readers should consult with a professional financial advisor before making any investment decisions, especially in private equity or other alternative investments. Investing in private equity involves significant risks, including the potential loss of principal. Past performance is not indicative of future results. The author does not guarantee the accuracy, completeness, or reliability of the information provided. All opinions expressed in this blog post are solely those of the author and do not reflect the opinions of any affiliated organizations. The author may hold positions in the investments discussed. Readers are encouraged to conduct their own research and due diligence before investing in any financial instruments.
