Industry Overview

Overview

Private equity is the investment in the equity of companies not traded in the public markets (NYSE, NASDAQ etc.). Private equity firms generally aim to take a majority stake (>50% ownership) or a significant minority stake (40-50% ownership) in these companies to generate a return. These are very illiquid investments and have a timeline ranging from 5-7 years.

According to the 2016 Preqin Global Private Equity & Venture Capital Reports, there are more than 5,200 private equity firms around the world that manage approximately $4.2 trillion. In 2015, 1,062 private equity funds raised approximately $551bn in new money.

Like any investment manager, private equity firms invest money from outside investors. There are many different types of firms that invest in private equity funds including:

  • Asset managers
  • Insurance companies
  • Pension Plans
  • Endowments
  • Foundations
  • High net worth individuals

At the end of the day, the private equity firms try to offer better return to their investors than what the investors could earn in the public market.

History

Private equity has unofficially been around for over 100 years. If you are looking to get into the space, it is helpful to know just how the industry got started and how it has evolved over time. Below is brief timeline highlighting major events in the growth of the private equity industry.

1901 – J.P. Morgan made the first unofficial private equity investment when purchasing Carnegie Steel Company in 1901 using a large amounts of leverage to fund the purchase.

1946 – Private equity took root when American Research and Development Corporation and J.H. Whitney & Company opened up official private equity funds. These funds were not the type of private equity firms you think of today. The purpose of these firms was to support soldiers who had come home from WWII by making investments in their private sector businesses.

1989 – KKR closed the $31.1bn takeover of RJR Nabisco which was the largest LBO in history at the time. This famous hostile takeover was not approved by the management of RJR Nabisco and put private equity in the public eye for the first time. Though the deal ultimately counted as a $700mm loss for KKR, it was vastly important for the growth of the industry. This classic LBO should be understood by anyone trying to enter the business and is detailed in the book Barbarians at the Gate: The Fall of RJR Nabiscoby Bryan Burrough and John Helyar.

2007 – Energy Future Holdings was bought out by KKR, TPG and Goldman Sachs Capital Partners for $45bn in the largest LBO in history. Energy Future Holdings ultimately filed for bankruptcy in 2014. This deal highlighted the large and sometimes reckless amount of leverage that companies were taking on from 2003 – 2007. This time between the tech bubble crash and the financial crisis in 2008 – 2009 was considered a golden age for private equity.

Today –The financial crisis heavily influenced the private equity industry. Global private equity volume and deal size are not what they were in 2007, but the industry is healthy and growing again. Some of the earliest firms such as KKR, Apax Partners, and Thomas H. Lee are still investing heavily. However, in the recent years, there have been a big surge in the number of new private equity firms that are focusing on middle market deals in specific industries (given the team’s expertise).

Making a Private Equity Investment

So how does a private equity firm actually go about making an investment? In short, a private equity firm buying a company is not much different from you buying a house. Let’s look at a brief example.

 

Individual Buys a House

In order to buy a house, you would take out a mortgage to buy the house, then use a combination of money from that mortgage and money from your savings account for the final purchase price of the house. Similarly, a private equity firm takes out a loan from an investment bank, then uses a combination of loan money and money from investors to buy an individual company.

 

Private Equity Firm Buys a Company

 

The private equity firm takes a loan from an investment bank, and money from investors (called “limited partners”) to buy a company. The private equity firm then manages that company, and uses the cash the company generates to pay back the loan from the investment bank. When the private equity firm sells that company in a few years, it hopefully provides a profit to its investors.

 

Different PE Strategies

Different private equity firms take different strategies in the life cycle of a private company. Some invest when a company is at an early growth stage and some invest when a company is distressed or doing poorly. More specific details can be found in the Private Equity Strategies section of the website, but here is a general overview:

  • Angel/Seed Capital– These type of private equity firms usually bet on promising teams that are trying to test their ideas / hypotheses. Often times, the team doesn’t have a product yet and needs some capital to start building a prototype and prove it works.
    • Many seed investments are made by individual investors such as former successful entrepreneurs
  • Venture Capital– Venture capital firms provide minority equity investments in companies that have high growth potential in the future. These companies are usually just beyond the startup phase where they have proven that there is a potential large demand for their product or service.
    • Andreessen Howotitz is a famous venture capital firm

(https://a16z.com/)

  • Growth Capital– Growth equity can be thought of the intersection between private equity controlled buyouts and venture capital minority investing. Private equity firms that make growth capital investments take a large interest in the company’s operations to help the company achieve its growth potential.
    • Sequoia is a well-known growth capital investor

(https://www.sequoiacap.com/)

  • Mezzanine Investing– Mezzanine investing is a hybrid investment between debt and equity that gives the lender ownership rights to a company in the case of default. Mezzanine investments are generally minority investments.
  • Leveraged Buyouts– This is the most well-known form of private equity investing that is highlighted above. Leveraged buyouts focus on mature companies that are leaders in their markets and have stable and predictable cash flows.
  • Distressed Buyouts– This is similar to a leveraged buyout, except the private equity firm buys a company that is under financial distress through financial leverage or operational volatility.

Conclusion

A general rule for any investor is to buy low and sell high. Private equity investors try to do the same thing. Whether making early stage minority investments, or late stage distressed investments, private equity firms aim to generate return to their investors. Due to the high level of success in the past, private equity is seen as a highly attractive asset class that can generate returns upward of 20%, which is much higher than historical public market returns of ~10%.

Note: When we refer to private equity in the rest of our articles, we are referring to Leveraged Buyout private equity. This is just one stage of private equity, but we feel it is the most popular form of private equity.