What is private equity?

Private equity (PE) has gained a great amount of influence in today's financial marketplace, but few people actually understand the ins and outs of the industry. This article breaks down the topic, discussing the types of private-equity firms and what they do, the methods behind private equity transactions, how returns are generated and how investors can gain access to private-equity investments.

The simplest definition of private equity 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 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.

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.

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 (NYSE:GS), JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE: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 (NYSE:BX) trades on the NYSE and has been involves in the buyouts of companies such as Hilton Hotels and SunGard.

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.

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.

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.

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.

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 (NASDAQ: CG) and Kohlberg Kravis Roberts/ KKR & Co. (NYSE: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 (see "Can mutual funds invest in private equity?"). 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).

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.