Understanding Private Equity (PE)
December 30, 2020
You've probably heard of the term private equity (PE). Roughly $3.9 trillion in assets were held by private-equity (PE) firms as of 2019, and that was up 12.2 percent from the year before.
Investors seek out private equity (PE) funds to earn returns that are better than what can be achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity (PE), including how it creates value and some of its key strategies.
Private equity (PE) refers to capital investment made into companies that are not publicly traded.
Most PE firms are open to accredited investors or those who are deemed high-net-worth, and successful PE managers can earn millions of dollars a year.
Leveraged buyouts (LBOs) and venture capital (VC) investments are two key PE investment sub-fields.
What Is Private Equity (PE)?
Private equity (PE) is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity (PE) comes from high-net-worth individuals (HNWI) and firms that purchase stakes in private companies or acquire control of public companies with plans to take them private and delist them from stock exchanges. The private equity (PE) industry is comprised of institutional investors such as pension funds, and large private-equity (PE) firms funded by accredited investors. Because private equity (PE) entails direct investment—often to gain influence or control over a company's operations—a significant capital outlay is required, which is why funds with deep pockets dominate the industry. The minimum amount of capital required for accredited investors can vary depending on the firm and fund. Some funds have a $250,000 minimum entry requirement, while others can require millions more. The underlying motivation for such commitments is the pursuit of achieving a positive return on investment (ROI). Partners at private-equity (PE) firms raise funds and manage these monies to yield favorable returns for shareholders, typically with an investment horizon of between four and seven years.
The Private Equity (PE) Profession
The private equity (PE) business attracts the best and brightest in corporate America, including top performers from Fortune 500 companies and elite management consulting firms. Law firms can also be recruiting grounds for private equity (PE) hires, as accounting and legal skills are necessary to complete deals and transactions are highly sought after. The fee structure for private-equity (PE) firms varies but typically consists of a management and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale of the company is common, though incentive structures can differ considerably. Given that a private-equity (PE) firm with $1 billion of assets under management (AUM) might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees, it is easy to see why the industry attracts 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, while vice presidents can earn approximately half a million dollars. Principals, on the other hand, can earn more than $1 million in (realized and unrealized) compensation per year.
Types of Private-Equity (PE) Firms
Private-equity (PE) firms have a range of investment preferences. Some are strict financiers or passive investors wholly dependent on management to grow the company and generate returns. Because sellers typically see this as a commoditized approach, other private-equity (PE) firms consider themselves active investors. That is, they provide operational support to management to help build and grow a better company.
Active private-equity (PE) 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. They might also 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, they are more likely to be viewed favorably by sellers.
Investment banks compete with private-equity (PE) firms, also known as private equity funds, to buy good companies and to finance nascent ones. Unsurprisingly, 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 (PE) firms, the funds they offer are only accessible to accredited investors and may only allow a limited number of investors, while the fund's founders will usually take a rather large stake in the firm as well.
That said, some of the largest and most prestigious private equity (PE) funds trade their shares publicly. For instance, the Blackstone Group (BX), which has been involved in the buyouts of companies such as Hilton Hotels and MagicLab, trades on the New York Stock Exchange (NYSE)
How Private Equity (PE) Creates Value
Private-equity (PE) 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: prospective acquisition candidates referred to private-equity (PE) 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 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 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 (PE) 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, including 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.