Private Equity

In the field of finance, the term private equity (PE) refers to investment funds, usually limited partnerships (LP), which buy and restructure financially weak companies that produce goods and provide services. A private-equity fund is both a type of ownership of assets ( financial equity) and is a class of assets (debt securities and equity securities), which function as modes of financial management for operating private companies that are not publicly traded in a stock exchange.

Private-equity capital is invested into a target company either by an investment management company (private equity firm), or by a venture capital fund, or by an angel investor; each category of investor has specific financial goals, management preferences, and investment strategies for profiting from their investments. Each category of investor provides working capital to the target company to finance the expansion of the company with the development of new products and services, the restructuring of operations, management, and formal control and ownership of the company.

As a financial product, the private-equity fund is a type of ''private capital'' for financing a long-term investment strategy in an illiquid business enterprise. Since the 1980s, the financial press describe "private equity fund" investment as the superficial rebranding of investment management companies who specialized in the leveraged buyout of financially weak companies.

Key features

The features of private-equity investment operations:

* An investment manager applies the money of investors to fund acquisitions for hedge funds, pension funds, university endowments, and rich people.
* Restructuring the target company to sell it for a higher price than paid, and so yield a greater profit for the equity invested, usually by cutting costs for short-term high profits.
* Use debt financing (leverage) to buy a target company; thus, a small increase in the value of the target company — a 20% increase in the price of the company-as-asset — might yield a 100% return on equity invested, if the private equity used to buy the target company was a 20% down-payment and 80% financed debt. Moreover, because debt financing reduces corporate taxes, the interest payments are tax-deductible, and thus increase profits for the investors.
* Start-up companies usually produce innovations in products and services, and private-equity firms invest working capital into start-up companies, and create value by reducing costs and aligning the financial interests of the corporate managers with the financial interests of the private-equity shareholders. A greater share of the income of the target company is distributed to the shareholders, and a lesser share of the income is reinvested to the company, i.e. the workers and the manufacturing equipment. Usually, when a private equity firm buys a start-up company, the investors might act like venture capitalists and develop the products and services of the target company in order to achieve a greater share of the market. Moreover, when a private-equity firm buy a large target company, the new corporate management (the private equity investors) might lower morale among the workers, which then results in lower-quality products.
* Private-equity investors combine their investment transactions with other investors in a syndicate, in order to jointly benefit from the diversification of investments among the different types of financial risk; the combination of complementary investor information and financial skill sets; and greater social connections for future investments.
* The investment strategies common to private-equity financing include the leveraged buyout, distressed securities, venture capital, growth capital, and mezzanine capital. In a typical leveraged-buyout transaction, a private-equity firm buys sufficient stock (shares of ownership) to grant them majority control of a mature company, which is unlike venture capital and growth capital investments, wherein the investors provide working capital to a start-up company, without majority control of the company.

Strategies

The strategies private-equity firms may use are as follows, leveraged buyout being the most common.

Leveraged buyout

Leveraged buyout, LBO, or Buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit, or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically mature and generate operating cash flows.

Private-equity firms view target companies as either Platform companies, which have sufficient scale and a successful business model to act as a stand-alone entity, or as add-on / tuck-in / bolt-on acquisitions, which would include companies with insufficient scale or other deficits.

Leveraged buyouts involve a financial sponsor agreeing to an acquisition without itself committing all the capital required for the acquisition. To do this, the financial sponsor will raise acquisition debt, which looks to the cash flows of the acquisition target to make interest and principal payments. Acquisition debt in an LBO is often non-recourse to the financial sponsor and has no claim on other investments managed by the financial sponsor. Therefore, an LBO transaction's financial structure is particularly attractive to a fund's limited partners, allowing them the benefits of leverage, but limiting the degree of recourse of that leverage. This kind of financing structure leverage benefits an LBO's financial sponsor in two ways: (1) the investor only needs to provide a fraction of the capital for the acquisition, and (2) the returns to the investor will be enhanced, as long as the return on assets exceeds the cost of the debt.

As a percentage of the purchase price for a leverage buyout target, the amount of debt used to finance a transaction varies according to the financial condition and history of the acquisition target, market conditions, the willingness of lenders to extend credit (both to the LBO's financial sponsors and the company to be acquired) as well as the interest costs and the ability of the company to cover those costs. Historically the debt portion of a LBO will range from 60%–90% of the purchase price. Between 2000–2005 debt averaged between 59.4% and 67.9% of total purchase price for LBOs in the United States.

Simple example of leveraged buyout

A private-equity fund, ABC Capital II, borrows $9bn from a bank (or other lender). To this, it adds $2bn of ''equity'' – money from its own partners and from ''limited partners''. With this $11bn, it buys all the shares of an underperforming company, XYZ Industrial (after '' due diligence'', i.e. checking the books). It replaces the senior management in XYZ Industrial, with others who set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the valuation of the company for an early sale.

The stock market is experiencing a bull market, and XYZ Industrial is sold two years after the buy-out for $13bn, yielding a profit of $2bn. The original loan can now be paid off with interest of, say, $0.5bn. The remaining profit of $1.5bn is shared among the partners. Taxation of such gains is at the capital gains tax rates, which in the United States are lower than ordinary income tax rates.

Note that part of that profit results from turning the company around, and part results from the general increase in share prices in a buoyant stock market, the latter often being the greater component.

Notes:
* The lenders (the people who put up the $9bn in the example) can insure against default by syndicating the loan to spread the risk, or by buying credit default swaps (CDSs) or selling collateralised debt obligations (CDOs) from/to other institutions.
* Often the loan/equity ($11bn in the example) is not paid off after the sale, but left on the books of the company (XYZ Industrial) for it to pay off over time. This can be advantageous since the interest is largely off-settable against the profits of the company, thus reducing, or even eliminating, tax.
* Most buyout deals are much smaller; the global average purchase in 2013 was $89m, for example.
* The target company (XYZ Industrials here) does not have to be floated on the stock market; most buyout exits after 2000 are not IPOs.
* Buy-out operations can go wrong and in such cases, the loss is increased by leverage, just as the profit is if all goes well.

Growth capital

Growth capital refers to equity investments, most often minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.

Companies that seek growth capital will often do so in order to finance a transformational event in their life cycle. These companies are likely to be more mature than venture capital-funded companies, able to generate revenue and operating profits, but unable to generate sufficient cash to fund major expansions, acquisitions or other investments. Because of this lack of scale, these companies generally can find few alternative conduits to secure capital for growth, so access to growth equity can be critical to pursue necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product development.

The primary owner of the company may not be willing to take the financial risk alone. By selling part of the company to private equity, the owner can take out some value and share the risk of growth with partners. Capital can also be used to effect a restructuring of a company's balance sheet, particularly to reduce the amount of leverage (or debt) the company has on its balance sheet.

A private investment in public equity (PIPE), refer to a form of growth capital investment made into a publicly traded company. PIPE investments are typically made in the form of a convertible or preferred security that is unregistered for a certain period of time.

The Registered Direct, or RD, is another common financing vehicle used for growth capital. A registered direct is similar to a PIPE, but is instead sold as a registered security.

Mezzanine capital

Mezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure that is senior to the company's common equity. This form of financing is often used by private-equity investors to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. Mezzanine capital, which is often used by smaller companies that are unable to access the high yield market, allows such companies to borrow additional capital beyond the levels that traditional lenders are willing to provide through bank loans. In compensation for the increased risk, mezzanine debt holders require a higher return for their investment than secured or other more senior lenders. Mezzanine securities are often structured with a current income coupon.

Venture capital

Venture capital or VC is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch of a seed or startup company, early-stage development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that do not have a proven track record or stable revenue streams.Joseph W. Bartlett
"What Is Venture Capital?"
The Encyclopedia of Private Equity. Accessed 20 February 2009

Venture capital is often sub-divided by the stage of development of the company ranging from early-stage capital used for the launch of startup companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth.

Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies' life cycles. Many entrepreneurs do not have sufficient funds to finance projects themselves, and they must, therefore, seek outside financing. The venture capitalist's need to deliver high returns to compensate for the risk of these investments makes venture funding an expensive capital source for companies. Being able to secure financing is critical to any business, whether it is a startup seeking venture capital or a mid-sized firm that needs more cash to grow. Venture capital is most suitable for businesses with large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. Although venture capital is often most closely associated with fast-growing technology, healthcare and biotechnology fields, venture funding has been used for other more traditional businesses.

Investors generally commit to venture capital funds as part of a wider diversified private-equity portfolio, but also to pursue the larger returns the strategy has the potential to offer. However, venture capital funds have produced lower returns for investors over recent years compared to other private-equity fund types, particularly buyout.

Distressed securities

The category of Distressed securities comprises financial strategies for the profitable investment of working capital into the corporate equity and the securities of financially weak companies. The investment of private-equity capital into distressed securities is realised with two financial strategies:
# "Distressed-to-Control" ("Loan-to-Own") investment whereby the investor buys debt securities in hope of acquiring ownership and control of the company's equity after financing the corporate restructuring of the target company;
# "Special Situations" ("Turnaround") investment wherein the investor buys debt securities and equity investments, to be used as ''rescue financing'' that will restore the profitability of the financially-weak target company.

Moreover, the private-equity investment strategies of hedge funds also include actively trading the loans held and the bonds issued by the financially-weak target companies.

Secondaries

Secondary investments refer to investments made in existing private-equity assets. These transactions can involve the sale of private-equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors.The Private Equity Secondaries Market, A complete guide to its structure, operation and performance
The Private Equity Secondaries Market, 2008 By its nature, the private-equity asset class is illiquid, intended to be a long-term investment for buy and hold investors. Secondary investments allow institutional investors, particularly those new to the asset class, to invest in private equity from older vintages than would otherwise be available to them. Secondaries also typically experience a different cash flow profile, diminishing the j-curve effect of investing in new private-equity funds. Often investments in secondaries are made through third-party fund vehicle, structured similar to a fund of funds although many large institutional investors have purchased private-equity fund interests through secondary transactions. Sellers of private-equity fund investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds.

Other strategies

Other strategies that can be considered private equity or a close adjacent market include:
* Real estate: in the context of private equity this will typically refer to the riskier end of the investment spectrum including "value-added" and opportunity funds where the investments often more closely resemble leveraged buyouts than traditional real estate investments. Certain investors in private equity consider real estate to be a separate asset class.
* Infrastructure: investments in various public works (e.g., bridges, tunnels, toll roads, airports, public transportation, and other public works) that are made typically as part of a privatization initiative on the part of a government entity.
* Energy and Power: investments in a wide variety of companies (rather than assets) engaged in the production and sale of energy, including fuel extraction, manufacturing, refining and distribution (Energy) or companies engaged in the production or transmission of electrical power (Power).
* Merchant banking: negotiated private-equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.
* Fund of funds: investments made in a fund whose primary activity is investing in other private-equity funds. The fund of funds model is used by investors looking for:
:* Diversification but have insufficient capital to diversify their portfolio by themselves
:* Access to top-performing funds that are otherwise oversubscribed
:* Experience in a particular fund type or strategy before investing directly in funds in that niche
:* Exposure to difficult-to-reach and/or emerging markets
:* Superior fund selection by high-talent fund of fund managers/teams
* Search fund: A search fund is an investment vehicle through which an entrepreneur (called a "searcher") raises funds from investors in order to acquire an existing small business. After an acquisition is made, the entrepreneur takes an operating role in the acquired company, such as CEO and President.
* Royalty fund: an investment that purchases a consistent revenue stream deriving from the payment of royalties. One growing subset of this category is the healthcare royalty fund, in which a private-equity fund manager purchases a royalty stream paid by a pharmaceutical company to a drug patent holder. The drug patent holder can be another company, an individual inventor, or some sort of institution, such as a research university.

As well as this to compensate for private equities not being traded on the public market, a private equity secondary market has formed, where private equity investors purchase securities and assets from other private equity investors.

History and development

Early history and the development of venture capital

The seeds of the US private-equity industry were planted in 1946 with the founding of two venture capital firms: American Research and Development Corporation (ARDC) and J.H. Whitney & Company. Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. In 1901 J.P. Morgan arguably managed the first leveraged buyout of the Carnegie Steel Company using private equity. Modern era private equity, however, is credited to Georges Doriot, the "father of venture capitalism" with the founding of ARDC and founder of INSEAD, with capital raised from institutional investors, to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (a return of over 5,000 times its investment and an annualized rate of return of 101%). It is commonly noted that the first venture-backed startup is Fairchild Semiconductor, which produced the first commercially practicable integrated circuit, funded in 1959 by what would later become Venrock Associates.

Origins of the leveraged buyout

The first leveraged buyout may have been the purchase by McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955 Under the terms of that transaction, McLean borrowed $42 million and raised an additional $7 million through an issue of preferred stock. When the deal closed, $20 million of Waterman cash and assets were used to retire $20 million of the loan debt. Lewis Cullman's acquisition of Orkin Exterminating Company in 1964 is often cited as the first leveraged buyout. Similar to the approach employed in the McLean transaction, the use of publicly traded holding companies as investment vehicles to acquire portfolios of investments in corporate assets was a relatively new trend in the 1960s popularized by the likes of Warren Buffett (Berkshire Hathaway) and Victor Posner ( DWG Corporation) and later adopted by Nelson Peltz (Triarc), Saul Steinberg (Reliance Insurance) and Gerry Schwartz ( Onex Corporation). These investment vehicles would utilize a number of the same tactics and target the same type of companies as more traditional leveraged buyouts and in many ways could be considered a forerunner of the later private-equity firms. Posner is often credited with coining the term "leveraged buyout" or "LBO".

The leveraged buyout boom of the 1980s was conceived by a number of corporate financiers, most notably Jerome Kohlberg Jr. and later his protégé Henry Kravis

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