What is Private Equity?
Private Equity refers to pools of capital, typically organized as limited partnerships, that make long-term equity and subordinated debt investments in both private and public companies. The partnerships typically have a life of 10 years, and the General Partners who manage them seek investments with a horizon of 5 to 7 years.
Private Equity investors normally have either a control position in their portfolio companies or significant influence, carefully defined by the provisions of a Shareholders’ Agreement.
There are 5 principal types of Private Equity: Venture, Buyout, Expansion, Mezzanine and Other. Other, not surprisingly, is a catch-all for strategies such as distressed, special situations, PIPEs (private investment in public equity) and secondaries. The Other category represents approximately 10 % of Private Equity.
Buyouts are by far the largest category. These strategies include LBOs (leveraged buyouts) and MBOs (Management Buyouts). It is in this sector that most of the high profile, headline making transactions occur. One of the most notorious is the LBO of Nabisco, described in Barbarians at the Gate. The buyout category is often assumed to include Growth or Expansion capital. Buyouts and Growth together represent approximately 60 % of all Private Equity.
Venture Capital is the next largest category, at around a fifth of all private equity. Venture capital focuses on start-up or early stage businesses. Portfolio companies are often in the areas of technology, communications and Life Sciences. This is the Stephen Jobs starting Apple in his garage sector. Investment amounts are usually smaller, and spread across a larger number of investments, in recognition that some of the start-up companies will fail.
Mezzanine funds utilize high-yielding subordinated debt to invest in established companies that have earnings and positive cash flow, but require additional risk capital. Mezzanine debt often includes warrants, preferred shares or other equity conversion rights. It is used for expansion, acquisitions, re-capitalization and MBOs and LBOs.
Why Does It Work?
The essence of private equity investing is insider information. Banned in public equity investing, the informational advantage that private equity managers get is crucial to their success. Private equity investors conduct exhaustive due diligence before selecting their portfolio companies. They will have detailed knowledge about the company, its management, products and markets, as well as the industry and the competition. Long before a deal closes, the GP will have a business plan and strategy agreed with management, a binding Shareholders’ Agreement and employment and incentive contracts in place with management.
From the time the deal closes, the GP will have seats on the portfolio company’s Board of Directors. The GP brings not just capital but strategic and operational management skills, specific industry knowledge and financial engineering expertise.
Private equity investors take a very long view, typically holding investments for anywhere from 5 to 7 years, patiently adding value before the final exit. The illiquidity discount that private equity investors readily accept as the investments are made normally narrows in as the portfolio companies approach a liquidity event, whether it be a sale to a strategic buyer, and IPO or an income trust conversion.
