Private equity explained

And they do it all with other people’s money (actually with your money because the vast majority of it comes from pension funds).

In fact, although that first sentence is (at least with very, very rare exceptions) not true, there is more than a grain of truth in the quip about the exit. That’s because private equity is, fundamentally, about enabling a business to transition from its present state to one with significantly higher value. 

This transition can take one of two broad forms. The first is when private equity buys an entire company, either from its parent, from the state in the case of a privatisation, or from its stock market shareholders. 

The company’s operating management team, provided that they are up for the challenge, will be motivated by being able to purchase, (at a fairly nominal cost) a meaningful percentage of the equity.

These transactions are referred to as management buyouts because the management team, in the best of all scenarios, works in close partnership with their new co-shareholders to deliver a mutually agreed and developed business plan.

The second is where an established private company, which might be owned by its founder entrepreneur, a group of private shareholders, or indeed a family, needs additional finance in order to effect a major strategic advance.

If, for whatever reason, they are unable to raise this finance through borrowing they may raise equity finance, selling new shares in the company at an agreed valuation to a private equity investor. These deals are referred to as Growth Capital or Minority Stakes investments.

There are other categories, such as Venture Capital (broadly speaking, investing in companies that have not yet proved they can generate profits), Replacement Capital (funding to buy out a minority shareholder) or turnaround investments, but Buyouts and Growth Capital are the most common by far. 

What unites them is what the investor wants to see, which is a degree of value creation that allows them to achieve their target return (typically 25-40 per cent per annum) and their co-shareholders to achieve greater financial rewards than they would have done without private equity involvement. 

This only works if there is a close partnership, built on mutual understanding and shared, totally transparent objectives, between PE and operating management co-shareholders. In most cases it will entail not only consistent growth in profits but also a strategic positioning of the company to further enhance its value. Hence the focus on the exit.

This exit imperative can be something of a bete noire for many entrepreneurs and managers, who view with distaste the prospect of the company they built being sold off to the highest bidder in order to make the PE guys rich. And it is certainly true that PE has to achieve exits at the highest possible value in order to offset their inevitable losses and still provide attractive returns to their investors (that’s your pension funds, remember). 

But, especially given PE’s reliance in most cases on the company’s management team to deliver both growth and, often, the exit, it can be more subtle than this implies.
Certainly, a buyout company will be sold in its entirety. But this may be to another private equity fund (a ‘Secondary Buyout’) which allows the management team to continue running it (and partially owning it). 

Or it may be through an IPO which does the same (though PE usually avoids IPO’s because they tend to be messy, uncertain and often don’t deliver best value for the company). Even when the sale is to a larger company which is buying for strategic reasons, management will in most cases still play a key role in the process and have a big hand in shaping its outcome.

But of course you can’t have an exit until you get there, and that entails a few years of running the company in partnership with the PE investor. Management teams get nervous about that prospect too, especially when they see a raft of covenants, events of default, undertakings, warranties, investor consent requirements and the rest of it in the first draft of an investment agreement.

But it is above all the management team that the investor is backing, they want you to succeed. They have two drivers while they are invested. The first is to protect the value of their investment. This they do via reporting requirements and the undertakings from you, basically designed to ensure that you stick with the plan they bought into unless you persuade them otherwise.

The second is to do what they can to add value – a good investor will bring a different perspective and a variety of ideas, contacts and introductions that can often help increase efficiency or accelerate growth.

It is, when it works properly, a true and open partnership where everybody gains more than they would have otherwise, which is the essential point about private equity.

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