Private Equity - The Basics
What is private equity (PE) as a business and who are the players?
PE involves raising capital from investors to acquire and take an ownership stake in a privately-held business and utilize their controlling stake to make changes and improve the business. This, then, typically involves holding the business for a period of years and selling it for a profit.
The PE firm, known as the General Partner (GP) in a deal, find investors, known as Limited Partners (LPs). The GP is then responsible for managing the portfolio companies, the companies the acquire. There is also a management company that is a separate legal entity, but still controlled by the same individuals from the GP. The fund pays the management company a management fee - historically 2% of committed capital - to cover operating expenses.
What is the internal structure of the GP/Management Company?
The groupings of roles are as follows: Partner/Managing Director (MD), Principal/Director, Vice President (VP), and Associate/Analyst.
The Partner/MD group sets the firm strategy, leads fundraising, makes final investment decisions, manages LP relationships, and oversees the firm's direction.
The Principal/Director group sources new deals, leads negotiations, guides deal teams, and oversees portfolio companies.
VPs manage day-to-day execution of deals, oversee due diligence, lead communication with external advisors, and mentor junior staff.
Finally, the Associate/Analyst group performs financial modeling (Leveraged Buyouts [LBOs]), conducts market research, prepares investment memos, and performs initial due diligence.
What are the main strategies utilized by PE firms?
LBOs involve acquiring a mature, stable company using debt (leverage) to finance the purchase. The PE firm (GP) takes a majority or controlling stake and aims to increase value by improving operations and paying down debt with the company's cash flow.
Venture Capital (VC) is focused on early-stage startups with high growth potential but unproven business models or products. The firm will take a minority stake and primarily provide capital for rapid scaling.
Growth equity targets established, high-growth companies that need capital to scale operations, expand market, or fund an acquisition. Firm typically take a significant minority stake without using heavy leverage, partnering with existing management.
How is value created?
By actively owning and operating the company, PE firms fundamentally change the value of the business. They utilize operational improvements like installing stronger management, streamlining supply chains, cutting costs, and optimizing sales strategies to increase profitability. They use leverage to finance acquisitions, magnifying the return on equity if the company performs well. They also use growth to new markets or acquisitions to get larger.
PE funds typically have a 10-12 year life where the LP's committed capital is called upon (capital calls) as the GP finds investments. The investment is then locked up until the portfolio company is sold, either by sale to another company or initial public offering (IPO).
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Private equity is a long-term, illiquid investment class defined by funds that utilize various strategies, most notably LBOs, to acquire private companies. Returns are created through operational enhancements, capital restructuring, and eventually an exit.