Private Equity is an obscure investment vehicle in the retail universe. I find this unusual because most companies are privately owned and investing in them can be very profitable.
My previous research established that Private Equity lagged in comparison to the S&P 500 over the past 5 years. However, things have changed, we’ve got the coronavirus, M&A activity is on the up and private capital is available. Is the next decade going to be different?
I decided to have a more in-depth look into Private Equity and its opportunities for individuals. I’ll start by explaining how a fund works because it is a bit different than an ETF.
What is a Private Equity fund
Private Equity gained traction in the the last decades of the 20th century. It started off with the notion that all firms we invest in were private at some point. This presents the opportunity to acquire a portfolio of companies and create shareholder value.
These funds can bring substantial return and expand an investor’s choice of assets. The industry standard target return is 20 – 40% per annum, however, the bulk of it is realised upon closure of the fund.
The most popular fund structure is a limited partnership consisting of the General Partners (GPs) and the Limited Partners (LPs).
GPs are responsible for the management of the fund. They are the ones who pick and later grow the investments. GPs commit capital to the fund to verify that their interests are aligned with those of the LPs. Moreover, additional legal documents ensure that everyone’s goals are in sync.
A GPs work has an opportunistic bias because a lot of the transactions are opaque and time dependent. The same investment can be a success or a failure if made only 2 years apart.
LPs consist of angel investors, endowment funds, pension funds, corporations, sovereign wealth funds and intermediaries. These investors are referred to as limited because they don’t hold any legal responsibility should any of the fund’s companies be subjected to a lawsuit. The LPs often choose the GPs they want based on track record and personal qualities.
A lot of funds use the well known 2/20 fee structure. There is a 2% management fee and a 20% cut of the realised profits.
One of the important specifics is that a fund usually has a lifespan of 10 years. It is dissolved at the end of the period and all capital gains are realised and distributed among the GPs and the LPs.
Choice of Private Equity assets
I suppose we can split it like stock: value and growth companies.
Growth funds invest in young and unestablished companies which struggle to secure lending through a bank. These investments can be lucrative but have a higher failure rate. Start-ups are backed by Venture Capital which will be covered in a separate article.
The value firms are acquired via leveraged buy-outs. Such transactions are completed by using high levels of debt and aim to increase the enterprise value by economies and operational improvements.
The drawback of leveraged buy-outs is that a high debt level can put a lot of pressure on a company and ultimately lead to its demise.
The biggest leveraged buy-out of all time was KKR’s purchase of RJR Nabisco.
Industry specific issues
The assets are not liquid, Private Equity is a long term thing. You buy a company and like it or not you’re stuck there for years, the median holding time is in fact 9 years.
Purchasing and selling companies is a slow and difficult process. There is an inherent informational asymmetry in the private sector which makes choosing assets difficult.
More importantly, the methods used to grow the business don’t always deliver equal outcomes. You can manage two similar companies the same way and end up with one success and one bankruptcy. It is possible to dissect the failure but changing the approach won’t necessarily prevent future losses.
It’s all about relationships. GPs attend board meetings, participate in strategy formation or fill in for company managers. LPs can help them by introducing customers or suppliers to the fund’s firms. If you trade shares you’re never in communication with the company’s CEO.
Active effort is required to source deals. We’re talking about smaller companies so you can’t do research by checking news articles. You have to roll up your sleeves and go out there to find opportunities.
These are some of the reasons why LPs have to choose GPs carefully.
Private Equity deal sourcing
The fund is formed, all of the GPs and LPs interests are in check, the money’s there and the governance structure is established. Now the question is what does it invest in?
There are many privately funded companies so the opportunity is out there. However, the fund has to find the lucrative ones. Some funds actively seek deals while others are popular and attract deals. Normally the fund will be in touch with friends, commercial and investment banks, stockbrokers, service providers and even company managers.
Successful deal sourcing requires a lot of work because the fund has to develop a deep understanding of the industry, the company, specific risks and to determine if it can improve future outcomes. There is also the issue with the fit of the investment in the overall portfolio.
All of this is in the job description of the fund’s GPs and investment managers.
Should the fund specialise in an industry
This is similar to a stock portfolio. Are you a value or a growth investor? Do you just focus on a single industry or buy broad market ETFs?
If you’re focused you will gain domain expertise but you may be exposed to specific risks. And if you diversify you’ll bring down the return.
It is a difficult question and answers vary in the same way as they do when it comes to stock.
Private Equity investment evaluation
You probably already use an investment evaluation process which may involve reports, financial statements and news. However, Private Equity funds have other problems to consider.
The top management team
The first one is what do they support, the founders or the business. One of the first things to look at is the quality of the top management team. Do the founders have skin in the game? Are these people knowledgeable? Are they a good team, what are their strengths and weaknesses? What does the company need now? Will they fit with the future needs of the company?
These are some of the questions a Private Equity fund may think of. Sometimes an idea isn’t enough. It may be a great business but you need the right people to bring it to life. Ultimately, the purpose of the fund is to beat the stock market so performance matters.
Some funds choose to lean towards the idea rather than the people. As usual there are no right or wrong choices as long as the GPs believe that the investment will be profitable.
Either way the fund and the management team are partners so this is the first element of due diligence.
It’s not that different to a stock market investment. However, a small private company or a start-up won’t have established accounting and forecasting practices.
You have to evaluate the validity of the accounting and the financial projections. It’s good to explore new ideas but you have to ensure that the methodology is consistent.
This brings us back to specialisation and domain knowledge. A growth fund will have more tacit knowledge about small companies than a mega fund.
The financials can be confusing even when we’re talking about a leveraged buy-out of an established company. It gets even worse if the fund is buying a single division because the new company will need a new management structure.
We also have to think about the industry alongside the size of the firm. Industries which profit from network effects and intangible assets make valuations harder.
This part of the research greatly benefits from domain specific knowledge.
You can’t compare a new firm’s product with one of the listed competitors. The GPs need industry specific expertise or a consultant to understand the firm’s value proposition and the environment.
Even if the product is good it can still fail due to poor execution. This brings us back to the firm as a whole and the quality of the top management team.
Any product development has to be in line with industry standards to prevent an alienation of the customers. It’s not just the case of I have money, I’ll buy a good company and make a profit.
Private Equity valuation methods
Here you’ll find the usual suspects: comparables and net present value (NPV) or discounted cash flow (DCF) depending on the fund’s requirements. We can argue all day which is better so funds use all of these.
Leveraged buy-outs are easier to value because you’ll approach it as a listed company. The only difference is that the private firm is opaque and you are expected to overpay for full control.
Growth companies bring another issue called pre-money valuation and post-money valuation. These account for the change in the company’s value after the investment.
The easiest way to explain this is if you buy a house for 100k and renovate it for another 50k. Your pre-money valuation is 100k and the post-money one is 150k.
The comparables method is quick and easy to use. You just need a few similar competitors’ balance sheet, income statement, earnings per share, number of outstanding shares, P/E ratio and sales data.
It is important to compare like for like so you can’t use a listed company to value a growth asset. Once you’ve got all the data you calculate the P/E ratio, market value to book value of equity, enterprise value to EBITDA and enterprise value to revenue. That’s it!
I think that the main problem will be to account for illiquidity if you are using listed companies or to collect enough data if using private ones.
NPV and DCF methods
Both are theoretically sound and the DCF is know to be very comprehensive. You start with a forecast, calculate the net present value (NPV) and determine if the project is viable.
Once you have the NPV you can play around and continue with a DCF to determine the potential exit valuation. Finally, you complete a sensitivity analysis, assign some probabilities to each scenario and come up with a number.
It sounds easy but it’s not, at least not in terms of predicting future outcomes. Even so, if the math doesn’t make any sense there would be no point in proceeding with qualitative analysis.
I prefer to use two methods because they are built on the same data. I think that a DCF model gives a bit more space for creativity. However, the best case scenario is when the two valuations match. The output of a Private Equity valuation can look a bit like this:
Whatever the case, the model only gives you an approximation of future returns. The math behind it is sound but the output is dependent on the assumptions the author made.
Therefore, the more scenarios, the merrier. You can even run a Monte Carlo simulation.
Finally, a valuation is just someone’s opinion on the future fabric of reality. It always pays to experiment a bit and see if you can come up with something better.
What does the Private Equity fund own?
We already talked about buying the whole company. It’s easy and simple, you own 100% of the outstanding shares.
For example, company A is listed and completed a deal with a Private Equity fund. The offer is $96 per share for all 10,000,000 outstanding shares. The fund pays $960 million and has a new asset.
Not really, we still have the debt to deal with. It may interact with the equity in a variety of ways depending on the type of financing used by the fund.
Nevertheless, it is easier than a partial stake or a turnaround. Both of these often require some form of restructuring, dilution of existing shareholders or purchase of preferred stock.
In any case you have to look into the existing equity, debt, option pool, etc, and calculate what would be the best way to invest.
All Private Equity transactions involve the use of debt and since we’re talking about large amounts we have to split it in tranches.
Ideally you want to structure it in a way which will allow you to squeeze the maximum profit out of the firm. Therefore, you’ll have a few tranches, for example Senior A, B, C, D, E, with different maturities and interest.
The purpose of this is to combine cheap and more expensive debt and repay the latter when you have bigger cash flows.
There can be restrictive covenants which allow the lender to exert control over the management of the firm. This is understandable, especially if they funded a large portion of the acquisition.
Consequently, the Private Equity fund may be unable to do everything the GPs want.
After the acquisition
Unlike stock, the fund can’t just buy the company and wait for the management team to do their thing.
Private Equity houses are always involved in the governance process because the purpose of the investment is to create value. This is achieved by collection of information via KPIs, audits, strategy review, etc, and subsequent actions.
The fund also has expertise in financial engineering aimed at an increase in the net profit. This could happen either via the financing structure or by altering the free cash flows’ size and timing.
All good things come to an end and the profits have to be realised at some point. Unfortunately, Private Equity investors can’t just send a limit order to the stock exchange.
The liquidity event can difficult to organise or the fund may be forced to sell a company because it is due to be dissolved soon.
In an ideal situation you’ll have a couple of years to organise the transaction. Usually a liquidity event will be planned at the time of purchase and the GPs would have discussed the possible exits.
An IPO is the gold standard for exit. It is profitable and increases the visibility of the company. The listing can create interest in the firm and the fund can realise substantial profits. Furthermore, it is both a testament and an advertisement of the ability of the GPs.
The drawback of the IPO is that the share price will change until the expiration of the lock-up period and the fund may realise lower profit. You also have the uncertainty of the floatation process as some IPOs fail.
While not the gold standard, acquisitions account for 75% of all Private Equity exits. They have the advantage of an agreed upon price and a consistent process.
There are other exits such as a partial sale or loss reduction approaches. Private Equity assets can fail as any other investment. The average failure rate varies between 10 – 30%.
Investment options for individuals
There is no doubt that neither you nor I will become LPs or GPs so we can’t be a part of a fund. We’ll need to look at more realistic options.
It’s always easy to buy stock in the big Private Equity firms, for example Blackstone, KKR and Carlyle. Another option, which avoids single stock risk, is to buy a Private Equity ETF.
The question is how much money are you going to make? The Private Equity index underperformed compared to the S&P 500.
There are platforms which offer access to private company shares, SharesPost, EquityZen and Forge for example. You’ll face problems like low volume and lack of liquidity so we’re getting closer to the Private Equity world.
These are not formal marketplaces in the sense of a stock exchange. Still, you can get in companies like Airbnb and Evernote.
Purchasing private shares has the same drawback as listed stock. You won’t be able to control the company in the way a GP can.
Private Equity is an interesting asset class, albeit investing in it is a bit different and more complicated than stock. Nevertheless, the appeal is there because of the high profit potential.
The fact that the industry is backed by endowment funds and sovereign wealth funds should give confidence to the retail investor. However, we have to remember that these institutions participate as LPs and have the opportunity to choose the GPs they want.
I can see a parallel with the choice of an IFA or a wealth manager by an individual. It has to be someone you trust.
The involvement of the GPs in the acquired firms is the main difference between an active ETF and Private Equity. We already discussed the importance of a firm’s top management team and I believe that GPs should be treated the same way.
Overall, Private Equity remains very risky for the individual investor. It is possible to purchase shares of private companies. However, such an endeavour will require more research than stock and should include some modelling. The listed companies and ETFs are easy to buy, however, your investment may underperform.