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Private market investments are being touted by UK government officials as a way for savers to earn higher returns on their retirement money, but the data makes it clear that isn’t always the case. As a whole new class of investors potentially put money to work in private markets, they can look to the long history of private equity investment trusts for clues on returns and how these strategies can fit into a portfolio………Continue reading….
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Source: Global Morning Star
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Critics:
Private-equity capital is invested into a target company either by an investment management company (private equity firm), a venture capital fund, or an angel investor; each category of investor has specific financial goals, management preferences, and investment strategies for profiting from their investments.
Private equity can provide working capital to finance a target company’s expansion, including the development of new products and services, operational restructuring, management changes, and shifts in ownership and control. As a financial product, a private-equity fund is private capital for financing a long-term investment strategy in an illiquid business enterprise.
Private equity fund investing has been described by the financial press as the superficial rebranding of investment management companies who specialized in the leveraged buyout of financially weak companies. Evaluations of the returns of private equity are mixed: some find that it outperforms public equity, but others find otherwise. Some key features of private equity investment include:
An investment manager (the private equity investor) raises money from institutional investors (e.g., hedge funds, pension funds, university endowments, and ultra-high-net-worth individuals) to pursue a particular investment strategy.
The fund’s raised proceeds are placed into an investment fund, of which the investment manager acts as a general partner (GP) and the institutional investors act as limited partners (LPs).
The investment manager then purchases equity ownership stakes in companies by using a combination of equity and debt financing, with the goal of generating returns on the equity invested, including any subsequent equity investments into the target companies, over a target horizon based on the particular investment fund and strategy (typically 4–7 years).
From a financial modeling perspective, the primary levers available to private equity investors to drive returns are:Revenue growth ,Margin expansion (typically an EBITDA margin), Free cash flow generation / debt paydown, Valuation multiple expansion (typically an Enterprise Value / EBITDA multiple), Value creation strategies can vary widely by private equity fund.
For example, some investors may target increasing sales in new or existing markets (driving revenue growth), and others may look to reduce costs through headcount reduction (expanding margins). Many strategies incorporate some amount of corporate governance restructuring, for example, setting up a board of directors or updating the target’s managerial reporting structure.
The use of debt financing in acquiring companies increases an investment’s return on equity by reducing the amount of initial equity required to purchase the target. Moreover, the interest payments are tax-deductible, so the debt financing reduces corporate taxes and thus increases total after-tax cash flows generated by the business.
Following a series of high-profile bankruptcies, aggressive leverage usage by private equity funds has declined in recent decades. In 2005, approximately 70% of the average private equity acquisition represented debt, but it was closer to 50% in 2020.
Firms that assume large operational risks (e.g., “turnarounds”) will usually apply far lower leverage levels to acquired companies in order to provide management with more financial flexibility; firms taking fewer operational risks will often try to maximize available leverage and focus on investments that generate strong, stable cash flows needed to service the higher debt balances.
Over time, “private equity” has come to refer to many different investment strategies, including leveraged buyout, distressed securities, venture capital, growth capital, and mezzanine capital. One of the most noteworthy differences between leveraged buyouts and the other strategies is that buyouts are generally “control equity positions”, as buyout funds usually purchase majority ownership stakes in their target companies, while other investment strategies typically purchase minority (“non-control”) ownership stakes, reducing their ability to effect transformational changes across target companies.
For large deals, private-equity investors often invest together in a syndicate, in order to jointly benefit from exposure diversification, complementary investor information and skills, and heightened connectivity for future investments. A private-equity fund, ABC Capital II, borrows $9bn from a bank (or other lender). To this, it adds $2bn of equity – money from its own partners and from limited partners.
With this $11bn, it buys all the shares of an underperforming company, XYZ Industrial (after due diligence, i.e. checking the books). It replaces the senior management in XYZ Industrial, with others who set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the valuation of the company for an early sale.
The stock market is experiencing a bull market, and XYZ Industrial is sold two years after the buy-out for $13bn, yielding a profit of $2bn. The original loan can now be paid off with interest of, say, $0.5bn. The remaining profit of $1.5bn is shared among the partners. Taxation of such gains is at the capital gains tax rates, which in the United States are lower than ordinary income tax rates.
Note that part of that profit results from turning the company around, and part results from the general increase in share prices in a buoyant stock market, the latter often being the greater component. The lenders (the people who put up the $9bn in the example) can insure against default by syndicating the loan to spread the risk, or by buying credit default swaps (CDSs) or selling collateralised debt obligations (CDOs) from/to other institutions.
Often the loan/equity ($11bn in the example) is not paid off after the sale, but left on the books of the company (XYZ Industrial) for it to pay off over time. This can be advantageous since the interest is largely off-settable against the profits of the company, thus reducing, or even eliminating, tax. Most buyout deals are much smaller; the global average purchase in 2013 was $89m, for example.
The target company (XYZ Industrials here) does not have to be floated on the stock market; most buyout exits after 2000 are not IPOs. Buy-out operations can go wrong and in such cases, the loss is increased by leverage, just as the profit is if all goes well. Growth capital refers to equity investments, most often minority investments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.
Companies that seek growth capital will often do so in order to finance a transformational event in their life cycle. These companies are likely to be more mature than venture capital-funded companies, able to generate revenue and operating profits, but unable to generate sufficient cash to fund major expansions, acquisitions or other investments.
Because of this lack of scale, these companies generally can find few alternative conduits to secure capital for growth, so access to growth equity can be critical to pursue necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product development.
The primary owner of the company may not be willing to take the financial risk alone. By selling part of the company to private equity, the owner can take out some value and share the risk of growth with partners. Capital can also be used to effect a restructuring of a company’s balance sheet, particularly to reduce the amount of leverage (or debt) the company has on its balance sheet.
A private investment in public equity (PIPE), refer to a form of growth capital investment made into a publicly traded company. PIPE investments are typically made in the form of a convertible or preferred security that is unregistered for a certain period of time. The Registered Direct (RD) is another common financing vehicle used for growth capital. A registered direct is similar to a PIPE, but is instead sold as a registered security.
Venture capital (VC) is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch of a seed or startup company, early-stage development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that do not have a proven track record or stable revenue streams.
Venture capital is often sub-divided by the stage of development of the company ranging from early-stage capital used for the launch of startup companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth. Entrepreneurs often develop products and ideas that require substantial capital during the formative stages of their companies’ life cycles.
Many entrepreneurs do not have sufficient funds to finance projects themselves, and they must, therefore, seek outside financing. The venture capitalist’s need to deliver high returns to compensate for the risk of these investments makes venture funding an expensive capital source for companies. Being able to secure financing is critical to any business, whether it is a startup seeking venture capital or a mid-sized firm that needs more cash to grow.
Venture capital is most suitable for businesses with large up-front capital requirements which cannot be financed by cheaper alternatives such as debt. Although venture capital is often most closely associated with fast-growing technology, healthcare and biotechnology fields, venture funding has been used for other more traditional businesses. Investors generally commit to venture capital funds as part of a wider diversified private-equity portfolio, but also to pursue the larger returns the strategy has the potential to offer.
However, venture capital funds have produced lower returns for investors over recent years compared to other private-equity fund types, particularly buyout. Secondary investments refer to investments made in existing private-equity assets. These transactions can involve the sale of private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors.
By its nature, the private-equity asset class is illiquid, intended to be a long-term investment for buy and hold investors. Secondary investments allow institutional investors, particularly those new to the asset class, to invest in private equity from older vintages than would otherwise be available to them. Secondaries also typically experience a different cash flow profile, diminishing the j-curve effect of investing in new private-equity funds.
Often investments in secondaries are made through third-party fund vehicle, structured similar to a fund of funds although many large institutional investors have purchased private-equity fund interests through secondary transactions. Sellers of private-equity fund investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds.
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