Understanding Private Equity – PE

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BY TROY SEGAL
 

 Updated May 15, 2019

TABLE OF CONTENTS

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 What Is Private Equity?

 The Private Equity Profession
 Types of Private-Equity Firms
 How Private Equity Creates Value
 Investment Strategies
 Oversight and Management
 Investing in Upside
 Investing in Private Equity
 The Bottom Line

What Is Private Equity?

The simplest definition of private equity (PE) is that it is equity – that is, shares representing
ownership of or an interest in an entity – that is not publicly listed or traded. A source of investment
capital, private equity actually derives from high net worth individuals and firms that purchase shares
of private companies or acquire control of public companies with plans to take them private,
eventually become delisting them from public stock exchanges. Most of the private equity industry is
made up of large institutional investors, such as pension funds, and large private equity firms funded
by a group of accredited investors.

Since the basis of private equity investment is a direct investment into a firm, often to gain a
significant level of influence over the firm's operations, quite a large capital outlay is required, which is
why larger funds with deep pockets dominate the industry. The minimum amount of capital required
for investors can vary depending on the firm and fund. Some funds have a $250,000 minimum
investment requirement; others can require millions of dollars.

The underlying motivation for such commitments is, of course, the pursuit of achieving a
positive return on investment. Partners at private-equity firms raise funds and manage these monies
to yield favorable returns for their shareholder clients, typically with an investment horizon between
four and seven years.

The Private Equity Profession

Private equity has successfully attracted the best and brightest in corporate America, including top
performers from Fortune 500 companies and elite strategy and management consulting firms. Top
performers at accounting and law firms can also be recruiting grounds, as accounting and legal skills
relate to transaction support work required to complete a deal and translate to advisory work for a
portfolio company's management.
The fee structure for private-equity firms varies, but it typically consists of a management fee and a
performance fee (in some cases, a yearly management fee of 2% of assets managed and 20%
of gross profits upon sale of the company). How firms are incentivized can vary considerably.

Given that a private-equity firm with $1 billion of assets under management might have no more than
two dozen investment professionals, and that 20% of gross profits can generate tens of millions of
dollars in fees for the firm, it is easy to see why the private-equity industry has attracted top talent. At
the middle market level ($50 million to $500 million in deal value), associates can earn low six figures
in salary and bonuses, vice presidents can earn approximately half a million dollars and principals can
earn more than $1 million in (realized and unrealized) compensation per year.

Types of Private-Equity Firms

A spectrum of investing preferences spans across the thousands of private-equity firms in existence.
Some are strict financiers – passive investors – who are wholly dependent on management to grow
the company (and its profitability) and supply their owners with appropriate returns. Because sellers
typically see this method as a commoditized approach, other private-equity firms consider themselves
active investors. That is, they provide operational support to management to help build and grow a
better company.

These types of 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, or they may 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, such an investor is more likely to be viewed
favorably by sellers. It is the seller who ultimately chooses whom they want to sell to or partner with.

Investment banks compete with private-equity firms (also known as private equity funds) in buying up
good companies and financing to nascent ones. It is no surprise that 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 private-equity firms, the funds they offer are only accessible to accredited investors and
may only have a limited number of investors, while the fund's founders will often take a rather large
stake in the firm as well. However, some of the largest and most prestigious private equity funds trade
their shares publicly. For instance, the Blackstone Group (BX) trades on the NYSE and has been
involved in the buyouts of companies such as Hilton Hotels and SunGard.

How Private Equity Creates Value

Private-equity firms perform two critical functions:

 deal origination/transaction execution
 portfolio oversight

Deal origination involves creating, maintaining and developing relationships with mergers and
acquisitions (M&A) intermediaries, investment banks and similar transaction professionals to secure
both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates
referred 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 the 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 (typically at the associate, vice
president, and director levels) 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 in buying 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 to include 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.

Private Equity Investment Strategies

When it comes to doing the deal, private equity investment strategies are numerous; two of the most
common are leveraged buyouts and venture capital investments.

Leveraged buyouts are exactly how they sound: a target firm is bought out by a private equity firm (or
as a part of a larger group of firms). The purchase is financed (or leveraged) through debt, which is
collateralized by the target firm'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 essence, in a leveraged buyout, acquiring PE firms are able to purchase companies with only
having to put up a fraction of the purchase price. By leveraging the investment, PE firms aim to
maximize their potential return, always of the utmost importance for firms in the industry.

Venture capital is a more general term, most often used in relation to taking an equity investment in a
young firm in a less mature industry (think internet firms in the early to mid-1990s). Quite often PE
firms will see that potential exists in the industry and more importantly the target firm itself, and often
due to the lack of revenues, cash flow and debt financing available to the target, 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 firm's often inexperienced management along
the way, private equity firms add value to the firm in a less quantifiable manner as well.

Oversight and Management

Which leads us to the second important function of private-equity professionals: oversight and support
of the firm's various portfolio companies and their management teams. 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, which increases 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, PE firms remove the constant public
scrutiny of quarterly earnings and reporting requirements, which then allows the PE firm and the
acquired firm's management to take a longer-term approach in bettering the fortunes of the company.

Also, management compensation is 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 (hopefully) eventually lead to the acquired
firm's valuation increasing substantially in value from the time it was purchased, creating a
profitable exit strategy for the PE firm – whether that be resale, an IPO or another option.

Investing in Upside
One popular exit strategy for private equity involves growing and improving a middle-market company
and selling it to a large corporation (within a related industry) for a hefty profit. The big investment
banking professionals cited above typically focus their efforts on deals with enterprise values worth
billions of dollars. However, the vast majority of transactions reside in the middle market ($50 million
to $500 million deals) and lower-middle market ($10 million to $50 million deals). Because the best
gravitate toward the larger deals, the middle market is a significantly underserved market: That is,
there are significantly more sellers than there are highly seasoned and positioned finance
professionals with the extensive buyer networks and resources to manage a deal (for middle-market
company owners). 

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 might significantly grow by
cultivating international sales channels. Or a highly fragmented industry can undergo consolidation
(with the private-equity firm buying up and combining these entities) 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 (typically between four
and seven years). A good portfolio company can typically increase its EBITDA both organically
(internal growth) and by acquisitions.

It is critical for private-equity investors to 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 (and appropriate
compensation structuring) is typically required before a deal gets done.

Investing in Private Equity

For investors who are not in a position to put forth millions of dollars, private equity is often ruled out
of a portfolio – but it shouldn't be. Though most private equity investment opportunities require steep
initial investments, there are still some ways for smaller fry to play.

There are several private equity investment firms, aka called business development companies, who
offer publicly traded stock, giving average investors the opportunity to own a slice of the private equity
pie. Along with the Blackstone Group (mentioned above), examples of these stocks are Apollo Global
Management LLC (APO), Carlyle Group (CG) and Kohlberg Kravis Roberts/ KKR & Co. (KKR), best
known for its massive leveraged buyout of RJR Nabisco in 1989.

(Learn more about this infamous deal in Corporate Kleptocracy At RJR Nabisco.) 

Mutual funds have restrictions in terms of buying private equity due to the SEC's rules
regarding illiquid securities holdings, but they can invest indirectly by buying these publicly listed
private equity companies, too; these mutual funds are typically referred to as funds of funds.
Additionally, average investors can purchase shares of an exchange-traded fund (ETF) that holds
shares of private equity companies, such as ProShares Global Listed Private Equity ETF (PEX).

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 strong deal flow.

What Is the Structure of a 

Private Equity Fund?
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BY JAMES GARRETT BALDWIN

 
 Updated Jul 9, 2019
TABLE OF CONTENTS

 Private Equity Fund Basics

 Fees
 Partners and Responsibilities
 Limited Partnership Agreement
 Investment and Payout Structure
 Other Considerations
 The Bottom Line

Although the history of modern private equity investments goes back to the beginning of the last
century, they didn't really gain prominence until the 1970s. That's around the time when technology in
the United States got a much-needed boost from venture capital. Many fledgling and struggling
companies were able to raise funds from private sources rather than going to the public market. Some
of the big names we know today—Apple, for example—were able to put their names on the map
because of the funds they received from private equity.

Even though these funds promise investors big returns, they may not be readily available for the
average investor. Firms generally require a minimum investment of $200,000 or more, which means
private equity is geared toward institutional investors or those who have a lot of money at their
disposal.

If that happens to be you and you're able to make that initial minimum requirement, you've cleared the
first hurdle. But before you make that investment in a private equity fund, you should have a good
grasp of these funds' typical structures.

KEY TAKEAWAYS
 Private equity funds are closed-end funds that are not listed on public exchanges.
 Their fees include both management and performance fees.
 Private equity fund partners are called general partners, and investors or limited partners.
  The limited partnership agreement outlines the amount of risk each party takes along with the
duration of the fund.
 Limited partners are liable up to the full amount of money they invest, while general partners
are fully liable to the market.
Private Equity Fund Basics
Private equity funds are closed-end funds that are considered an alternative investment class.
Because they are private, their capital is not listed on a public exchange. These funds allow high-net-
worth individuals and a variety of institutions to directly invest in and acquire equity ownership in
companies.

Funds may consider purchasing stakes in private firms or public companies with the intention of de-
listing the latter from public stock exchanges to take them private. After a certain period of time, the
private equity fund generally divests its holdings through a number of options, including initial public
offerings (IPOs) or sales to other private equity firms.

 
Unlike public funds, the capital of private equity funds is not available on a public stock exchange.
Although minimum investments vary for each fund, the structure of private equity funds historically
follows a similar framework that includes classes of fund partners, management fees, investment
horizons, and other key factors laid out in a limited partnership agreement (LPA).

For the most part, private equity funds have been regulated much less than other assets in the
market. That's because high-net worth investors are considered to be better equipped to sustain
losses than average investors. But following the financial crisis, the government has looked at private
equity with far more scrutiny than ever before.

Fees
If you're familiar with the fee structure of a hedge fund, you'll notice it's very similar to that of the
private equity fund. It charges both a management and a performance fee.

The management fee is about 2% of the capital committed to invest in the fund. So a fund with assets
under management (AUM) of $1 billion charges a management fee of $20 million. This fee covers the
fund's operational and administrative fees such as salaries, deal fees—basically anything needed to
run the fund. As with any fund, the management fee is charged even if it doesn't generate a positive
return.

The performance fee, on the other hand, is a percentage of the profits generated by the fund that are
passed on to the general partner (GP). These fees, which can be as high as 20%, are normally
contingent on the fund providing a positive return. The rationale behind performance fees is that they
help bring the interests of both investors and the fund manager in line. If the fund manager is able to
do that successfully, he is able to justify his performance fee.

Partners and Responsibilities

Private equity funds can engage in leveraged buyouts (LBOs), mezzanine debt, private
placement loans, distressed debt, or serve in the portfolio of a fund of funds. While many different
opportunities exist for investors, these funds are most commonly designed as limited partnerships.

Those who want to better understand the structure of a private equity fund should recognize two
classifications of fund participation. First, the private equity fund’s partners are known as general
partners. Under the structure of each fund, GPs are given the right to manage the private equity fund
and to pick which investments they will include in its portfolios. GPs are also responsible for attaining
capital commitments from investors known as limited partners (LPs). This class of investors typically
includes institutions—pension funds, university endowments, insurance companies—and high-net-
worth individuals.
Limited partners have no influence over investment decisions. At the time that capital is raised, the
exact investments included in the fund are unknown. However, LPs can decide to provide no
additional investment to the fund if they become dissatisfied with the fund or the portfolio manager.

Limited Partnership Agreement

When a fund raises money, institutional and individual investors agree to specific investment terms
presented in a limited partnership agreement. What separates each classification of partners in this
agreement is the risk to each. LPs are liable up to the full amount of money they invest in the fund.
However, GPs are fully liable to the market, meaning if the fund loses everything and its account turns
negative, GPs are responsible for any debts or obligations the fund owes.

The LPA also outlines an important life cycle metric known as the “Duration of the Fund.” PE funds
traditionally have a finite length of 10 years, consisting of five different stages:

 The organization and formation.

 The fund-raising period. This period typically lasts two years.
 The three-year period of deal-sourcing and investing.
 The period of portfolio management.
 The up to seven years of exiting from existing investments through IPOs, secondary markets,
or trade sales.

Private equity funds typically exit each deal within a finite time-period due to the incentive structure
and a GP's possible desire to raise a new fund. However, that time-frame can be affected by negative
market conditions, such as periods when various exit options, such as IPOs, may not attract the
desired capital to sell a company.

Notable private equity exits include Blackstone Group's (BX) 2013 IPO of Hilton Worldwide Holdings
(HLT) that provided the deal's architects a paper profit of $12 billion.

Investment and Payout Structure

Perhaps the most important components of any fund’s LPA are obvious: The return on
investment and the costs of doing business with the fund. In addition to the decision rights, the GPs
receive a management fee and a “carry.”

The LPA traditionally outlines management fees for general partners of the fund. It's common for
private equity funds to require an annual fee of 2% of capital invested to pay for firm salaries, deal
sourcing and legal services, data and research costs, marketing, and additional fixed and variable
costs. For example, if a private equity firm raised a $500 million fund, it would collect $10 million each
year to pay expenses. Over the duration of the 10-year fund cycle, the PE firm collects $100 million
in fees, meaning $400 million is actually invested during that decade.

Private equity companies also receive a carry, which is a performance fee that is traditionally 20% of
excess gross profits for the fund. Investors are usually willing to pay these fees due to the fund's
ability to help manage and mitigate corporate governance and management issues that might
negatively affect a public company.

Other Considerations
The LPA also includes restrictions imposed on GPs regarding the types of investment they may be
able to consider. These restrictions can include industry type, company
size, diversification requirements, and the location of potential acquisition targets. In addition, GPs are
only allowed to allocate a specific amount of money from the fund into each deal it finances. Under
these terms, the fund must borrow the rest of its capital from banks that may lend at different multiples
of a cash flow, which can test the profitability of potential deals.

The ability to limit potential funding to a specific deal is important to limited partners because several
investments bundled together improves the incentive structure for the GPs. Investing in multiple
 companies provides risk to the GPs and could reduce the potential carry, should a past or future
deal underperform or turn negative.

Meanwhile, LPs are not provided with veto rights over individual investments. This is important
because LPs, which outnumber GPs in the fund, would commonly object to certain investments due to
governance concerns, particularly in the early stages of identifying and funding companies. Multiple
vetoes of companies may educe the positive incentives created by the commingling of fund
investments.

The Bottom Line

Private-equity firms offer unique investment opportunities to high-net-worth and institutional investors.
But anyone who wants to invest in a PE fund must first understand their structure so he or she is
aware of the amount of time they will be required to invest, all associated management and
performance fees, and the liabilities associated.

Typically, PE funds have a 10-year duration, require 2% annual management fees and 20%
performance fees, and require LPs to assume liability for their individual investment, while GPs
maintain complete liability.

Private Equity vs. Venture Capital: What's the

Difference?
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 Updated Apr 15, 2019
Private Equity vs. Venture Capital: An Overview
Private equity is sometimes confused with venture capital because they both refer to firms that invest
in companies and exit through selling their investments in equity financing, such as initial public
offerings (IPOs). However, there are major differences in the way firms involved in the two types of
funding conduct business.

Private equity and venture capital buy different types and sizes of companies, invest different amounts
of money, and claim different percentages of equity in the companies in which they invest.

Private Equity
Private equity, at its most basic, is equity—shares representing ownership of, or an interest in, an
entity—that is not publicly listed or traded. Private equity is a source of investment capital that comes
from high net worth individuals and firms. These investors buy shares of private companies—or gain
control of public companies with the intention of taking them private and ultimately delisting them from
public stock exchanges. Large institutional investors dominate the private equity world, including
pension funds and large private equity firms funded by a group of accredited investors.

 
Because the goal is the direct investment in a company, a lot of capital is needed, which is why high
net worth individuals and firms with deep pockets are involved.
Venture Capital
Venture Capital is financing given to startup companies and small businesses that are seen as having
the potential to break out. The funding for this financing usually comes from wealthy investors,
investment banks, and any other financial institutions. The investment doesn't have to be just
financial, but can also be offered via technical or managerial expertise.

Investors providing funds are taking a risk that the newer company delivers, and doesn't deteriorate.
However, the tradeoff is potentially above-average returns if the company delivers on its potential. For
newer companies or those that have a short operating history—two years or less—venture capital
funding is both popular and sometimes necessary for raising capital, particularly if they don't have
access to capital markets, bank loans, or other debt instruments. The one downside for the fledgling
company is that the investors often get equity in the company and, therefore, a voice in company
decisions.

Key Differences
Private equity firms mostly buy mature companies that are already established. The companies may
be deteriorating or not making the profits they should be due to inefficiency. Private equity firms buy
these companies and streamline operations to increase revenues. Venture capital firms, on the other
hand, mostly invest in startups with high growth potential.

Private equity firms mostly buy 100% ownership of the companies in which they invest. As a result,
the companies are in total control of the firm after the buyout. Venture capital firms invest in 50% or
less of the equity of the companies. Most venture capital firms prefer to spread out their risk and
invest in many different companies. If one startup fails, the entire fund in the venture capital firm is not
affected substantially.

Private equity firms invest $100 million and up in a single company. These firms prefer to concentrate
all their effort into a single company since they invest in already established and mature companies.
The chances of absolute losses from such an investment are minimal. Venture capitalists spend $10
million or less in each company since they mostly deal with startups with unpredictable chances of
failure or success.

Special Considerations
Private equity firms can buy companies from any industry, while venture capital firms are limited to
startups in technology, biotechnology, and clean technology. Private equity firms also use both cash
and debt in their investment, but venture capital firms deal with equity only.

These observations are common cases. However, there are exceptions to every rule; sometimes one
firm type does things out of the norm for its kind.

KEY TAKEAWAYS
 Private equity is investment capital in a company or other entity that is not publicly listed or
traded.
 Venture Capital is funding given to startups or other young businesses that show potential for
long-term growth.
 Private equity and venture capital buy different types of companies, invest different amounts
of money, and claim different amounts of equity in the companies in which they invest.
ADVISOR INSIGHT
Rebecca Dawson
Silber Bennett Financial, Los Angeles, CA

With private equity, multiple investors’ assets are combined, and these pooled resources are used to
acquire parts of a company, or even an entire company. Private equity firms do not maintain
ownership for the long term, but rather prepare an exit strategy after several years. Basically, they
seek to improve upon an acquired business and then sell it for a profit.

Whereas, a venture capital firm invests in a company during its earliest stages of operation. It takes
on the risk of providing new businesses with funding so that they can begin producing and earning
profits. It is often the startup money provided by venture capitalists that gives new businesses the
means to become attractive to private equity buyers or eligible for investment banking services.