Private Equity Primer

Private equity is the common term for equity investments into non-listed companies in order to help such companies develop and grow under stable conditions. Private equity investments entail not only access to capital but also to other resources like financial and industrial competence, networks and advisors.

Private equity funds span a company’s entire development cycle, from the first development phase where an idea, innovation or invention is nurtured into a company through the expansion phase and into a mature company. Private equity comprises a range of different forms of financing and participants which constitute a value chain where the links suit different investors and different phases in the development of a company.

Private equity is an asset class that is classified as alternative investments and has over the past few decades typically yielded better returns than investments in the public markets. There are however significant differences between different types of private equity, different geographical markets and different private equity funds. The returns also vary over different time periods and vintages.

Private equity companies raise funds from various types of investors such as pension funds, fund-of-funds, life insurance companies, foundations and endowments or banks. These funds are then invested in potentially high growth companies. Once a private equity firm has acquired a portfolio company, it applies its management expertise to drive the company’s corporate strategy forward, accelerating growth, either organically or through strategic acquisitions or restructuring, and improving efficiency and profitability.

When the private equity fund together with the management team has carried out the strategies and plans identified at the time of the investment, the private equity firm will look to exit from the investment via a number of alternative routes such as through a trade sale when the portfolio company is sold to an industrial buyer, a secondary sale in which the company is sold to another private equity fund which can continue to develop the company or through an IPO, in which the private equity firm often stays on as a substantial owner for a period of time.

Industry structure

Investors
The investors in private equity are essentially large international institutions. Most of the funds raised come from public or private pension funds, fund-of-funds, life insurance companies, foundations and endowments or banks. A new trend is that smaller investors and individuals can invest in private equity funds by way of listed vehicles or funds.

Other than seeking higher returns investors also invest in private equity in order to achieve portfolio diversification and to spread their risk. Even if private equity is cyclical the correlation to public markets is limited.

Private equity companies
In the early days private equity companies were often owned by different banks but today the majority of all private equity activity is undertaken by independent private equity firms owned by their management and leading professionals. These executives are expected to commit their own capital to the funds, investing in parallel with their investors, typically with between 1 and 3 percent of the total capital committed. This is a requirement from fund investors who thereby secure that their interests are aligned with the manager of the fund, the so called General Partner.

The funds have no permanent capital and instead investors commit to contributing capital up to a predetermined level as drawn by the investment manager to make investments into various portfolio companies and to cover the costs of the fund.

For larger international funds the most common structure is the English Limited Partnership, a structure well known to international investors since it has been in place since the industry emerged. This structure avoids double taxation of investors with different domiciles. Investors pay tax when the fund’s investments are divested in the same way as if they had owned the underlying companies directly. The investors enter into an agreement with the manager of the fund, the so called General Partner, concerning the management of the fund’s activity. The General Partner then selects and enters into agreements with an advisor, the so called Investment Advisor, who assist in the search for and analysis of various investment and exit opportunities. The investment or exit decisions are taken by the board of the General Partner.

A private equity fund as described above has normally no idle cash which has to be managed but only holdings in various portfolio companies. It is common that the fund’s ownership in the portfolio company is organised through a holding company. This structure does not affect the taxation of the underlying portfolio company’s revenues, its cost structure or regular taxation. The portfolio company pays the usual taxes in the countries where it has operations and where it is domiciled.

A fund is typically invested over a three to six year period. When the fund exits a portfolio company the proceeds are normally immediately returned to the investors, which means that every fund has a limited life span, typically between eight and 13 years. A new fund is therefore usually raised when the previous is fully invested, typically after three to five years. At every such fund-raising an extensive evaluation and due diligence is made of the private equity firm, its operations and track record. If investors are not satisfied with the result of such an evaluation they will not invest in the fund.

The private equity firms report back to their investors on a regular basis, usually quarterly, in accordance with established industry guidelines for reporting and valuation of portfolio companies. Regular communication in connection with new investments and/or divestments is also common as is an annual investor meeting.

A private equity investment in a company involves a transformational, value-added, active management strategy.

The private equity fund is seeking a high-quality management team and a strategic plan to grow and improve the business. Private equity investors usually own the business for a number of years and work with the company’s management to develop and improve performance, operations and strategic direction.

Over the past few decades, private equity has grown to represent a strong force in the economies of Western Europe and North America and today exerts substantial influence on the developed economies and many long-term portfolios held by institutional investors.

In general private equity works with three steps; the transaction or investment, the development of the portfolio company and then an exit, i.e. the sale of the company to a new owner.

The investment

A crucial part of the operations of a private equity fund is to secure a good supply of promising investment opportunities or companies with development potential – a deal flow.

The investment opportunities typically arise from family businesses seeking new owners, spin-outs from larger corporations or from private equity funds that operate at an earlier stage in the value chain and have developed and financed the company as far as they can. Privatisations and public to private transactions of listed companies are other sources.

Creating value in portfolio companies

When an investment has been done the work with developing the company starts. This process is pivotal in increasing the value of the portfolio company. Operating and industrial improvements in the portfolio companies are today absolutely necessary in order to achieve lasting value creation in the portfolio companies. The strategies deployed to reach these targets differ, but there are several basic strategies that are commonly used although every investment case has its unique merits.

The corporate governance model

Fundamental to the entire process of creating value in the portfolio companies is the corporate governance model applied by private equity. This means a very active ownership which primarily is done via the portfolio company board of directors but also through informal contacts directly between the owners and company management. This results in swift decision-making and small, flexible and empowered boards willing to take risks in a way that is otherwise rarely seen. Since management is expected to invest in the company on the same terms as the other owners there is also a strong alignment of interest between owners, board and management.

Buy-and-build
This implies expanding the company quickly by acquiring competitors or companies with similar or complementary products, technologies or market presence. It is often a question of increasing market share to achieve economies of scale and drive internal efficiencies. For more mature business it is often a way of participating in or even leading an ongoing consolidation of a fragmented industry.

Expansion
There is often great potential in opening new markets for the portfolio company’s products. For the growth company it may imply market entry for the first time which means getting the commercialisation of an invention of new technology going. New markets may mean new geographies but also new customer groups previously not targeted. This requires capital for market investments but also experience and knowledge about this kind of expansion and what it means for the company.

With private equity a broadening of the product offering is often on the agenda and that may mean new products in existing categories or applying a technology to new product categories or uses.

Better margins and efficiency
With private equity ownership a process starts by aiming at increasing efficiency and profitability. The process concerns all levels in the company with bench-marking and best-practice often used methods. The ambition is typically to become “best-in-class” in categories such as production, customer relations and service.

The cost structure can also be overhauled and could entail shifting simpler production to low-cost countries or making necessary investments in order to improve productivity at home.

Investments
One way to boost growth and add value to a company is through investment. It may relate to new production facilities, marketing investments or product development. Private equity ownership is often sought when the companies cannot muster these investments on their own.

Exit
When the private equity fund together with the management in the portfolio company has carried out the strategies and plans identified at the time of the investment it may be time to start planning for the exit, which means letting a new owner take over and continue developing the company. Private equity funds normally own portfolio companies for periods of between three and 10 years. At an exit a structured process is common which often involves an auction process.

A trade sale is when the portfolio company is sold to an industrial buyer. A secondary sale occurs when the company is sold to another private equity fund which can continue to develop the company. Today it is not unusual for one private equity fund to sell to another private equity fund which may have a different geographical scope and larger financial resources necessary to help the company through its next development phase. In this manner a company can be financed by private equity for an extended period of time. With an IPO, the private equity firm often stays on as a substantial owner for a period of time.

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Private Equity Primer

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