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Private Equity

By Matthew Johnston

Private Equity

Private Equity (PE) is characterised by funds investing in private companies or buying out public companies. The particular structure and form of the transaction differs between the variations in PE funds that this article will outline later. By contrast to Hedge Funds, PE tends towards long term investment strategies. For example, Blackstone bought out Hilton in 2007 and still holds its investment today. Similarly, Hedge Funds trade more in securities and tend to have little control over the business. By contrast, PE funds actively restructure their purchases to maximise profit and retain the management of the company.

How are PE firms structured?

PE funds are led by General Partners and funded by Limited Partners. The Limited Partners generally consist of large institutions such as pension funds and insurance companies. These institutions are self-selected by the PE fund’s slow profit generation. General Partner compensation is commonly structured along the 2/20 lines similarly to Hedge Funds. (The 2 refers to a 2% fee on all assets under management. The 20 refers to a 20% cut of the profits of the fund.)

Leveraged Buyout (LBO)

The capital provided by the limited partners isn’t the only resource available to PE funds. LBO is where the fund borrows money to buy the target company. The target company also becomes collateral for the loans. That is to say, if the PE fund defaults then the lenders can make a claim on the target company’s assets and equity. The question is, why is this method of financing transactions so popular? The answer is twofold. Firstly, funds have a limited amount of equity, with which to invest. This means that an increased proportion of debt financing frees up capital for other investments. Secondly, there are tax benefits to leverage because the interest payments on the debt reduce the fund's corporation tax liability, which would not occur in the case of dividend payments directly to the fund.

Leverage has a multiplicative effect. It can increase profits if the business succeeds, but even temporary failures such as a loss of consumer base can lead to an inability to repay loans. The positive effects of leverage have resulted in the past to funds incurring a disproportionate amount of debt in the course of their buyout. This can lead to overleverage, where the company cash flows are not enough to service the debt. This occurred in the case of Toys ‘R Us. A consortium of PE funds Bain Capital, KKR and real estate firm Vornado leveraged their buyout of the toy company in 2005. Since then, Bloomberg found that 97% of Toys ‘R Us’ cash flow was being used to service their $5 billion debt. Over-leverage can, in the worst cases, lead to insolvency or the target company being passed over to the fund’s lenders.

What do PE funds look for in target companies?

In PE funds seeking to maximise profit from an investment will try to manage risk and find room to grow. In terms of managing risk, a target company would ideally have low fixed costs. These would have to be paid even if the revenue decreases and so would impose a financial burden on the PE fund. Similarly, a strong management team is helpful to a fund and can allow restructuring to proceed without resistance. PE funds prefer companies which are undervalued, and ideally could be improved easily to maximise the fund's returns.

There are additional factors when the company is undergoing an LBO, with risk playing a more substantial role. Stable cash flows are necessary to pay off the leverage debt. Any instability could lead to overleverage problems as outlined above. Similarly, a target company would require a low level of debt previous to the LBO, as otherwise, the cumulative liability could also lead to overleverage.

Problems with PE investments?

There are both hurdles and issues with PE investments. In terms of complications, a significant initial commitment of capital is required to become a Limited Partner. Similarly, Limited Partners are heavily restricted by the General Partners on how and when they can withdraw their investments. In terms of issues, PE fund investments are high risk and high reward. Certain types of fund are riskier than others, but there is always the potential that all investments can fail.

The advantages of PE investments are the problems reversed. Long-term capital holding institutions such as pension funds and insurance companies are in a perfect position to be able to invest for long periods, both meeting the high investment hurdle and preventing opportunity cost losses which would be incurred by short-term investment institutions.

Varieties of Private Equity?

There are several private equity variations which all hold the same core characteristics. A key area for variation is what sort of target company is preferred. Venture Capital (VC) involves PE investments specifically focusing on start-ups, and provide needed liquidity for future innovation and expansion. This type of PE has recently been less profitable than other varieties. An example of this type of fund is Sequoia Capital, a VC fund which had invested in Apple, Google and Oracle. VC differs from generic PE in that it is a necessarily risky area of investments. This is partially offset by the cheap cost of individual VC investments and the very high returns when things go well.

Another variety of PE is Growth Capital. These are characterised as minority investments into established companies who seek a new source of liquidity, be it for expansion or leverage reduction. Trading equity for capital can also allow the owner of the target company to remove some value and so lower their own financial risk. To maximise profits, funds will often want to make sure that the target company does have a capacity for future growth to achieve a return on the investment.

A final variety of PE is distressed investments. Funds which use this strategy choose their target companies based on current financial failings which they believe will rectify into the future. Just as VC seeks higher returns due to investing earlier in the company life cycle, distressed investments seek higher yields due to a current undervaluing of the market value due to a problem that they believe to be transient or solvable. There are two significant methods for achieving control in distressed investment scenarios. Firstly, a fund can attempt to buy up company debt in the hopes that the debt can later be converted into shares, i.e. the “Loan-to-Own” strategy. Secondly, the fund could directly offer debt or equity investments as a form of “rescue financing” supporting the company through a difficult time, in the hopes that it will recover and cause the investment to grow.

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