Private Equity (PE) is a form of alternative investment where capital is invested away from the public markets. PE investors either directly invest in private companies or buy out public companies, resulting in de-listing from the public markets i.e. taken private. The valuation of a private company is not determined by market forces.
By definition, Private Equity is making investments in companies that are not publicly traded. In reality, Private Equity provides more than just capital investments. Its a key driver of economic growth, supports employment for millions of people around the world and provides a steady source of income for its investors (pension funds, university endowments, sovereign wealth funds etc).
PE investors can take a majority or minority ownership stake in a company. Returns on these investments will not be correlated to the public market indices. And since the investments are private, they are not as liquid as public investments and would require the PE investors to hold their capital invested for long periods of time before they are able to realize any returns. Depending on the fund size, investment strategy and the industry/sector invested in, a private equity firm may look to exit its investments after achieving a Money On Invested Capital (MOIC) and Internal Rate of Return (IRR) target. A typical life cycle of a private equity fund is the following:
PE Funds have a Limited Partner (LP), who own majority of the shares in the fund (typically 99%) and have limited liability, and General Partners (GP), who own 1% of the shares and have full liability. The GP is responsible for executing and operating the investments made by the PE fund. The LP provides the capital, so they comprise of institutional investors, government pension funds, corporate pension funds, sovereign wealth funds, high net worth individuals etc.
Dealings in the Private Equity Industry
There are a lot of private equity funds across the world. There are large investment banking private equity groups as well, but they are placed on the other side of the chinese wall given the private nature of the transactions. As of Dec 2019, the following are the top 5 private equity funds in terms of the amount of capital raised to fund private investments over the past 5 years:
The Blackstone Group ($83bn)
The Carlyle Group ($64bn)
Kohlberg Kravis Roberts & Co. (KKR) ($50bn)
CVC Capital Partners ($47bn)
Warburg Pincus ($36bn)
Bain Capital ($35bn)
EQT Partners ($30bn)
Thoma Bravo ($30bn)
Apollo Global Managemenet ($29bn)
Neuberger Berman ($29bn)
Number of these firms were part of the investment banking private equity group before going independent. KKR was part of Bear Stearns until 1976. Blackstone was part of Lehman Brothers until 1985. CVC Capital Partners was part of Citigroup until 1996. Among the major investment banks, only a handful like - Goldman Sachs Capital Partners, JP Morgan's One Equity Partners and Macquire's Infrastructure & Real Assets Group - remain within their respective banking consolidations. Here is a list of Private Equity firms captured in the Wiki.
Prior to the 2008 crisis, the private equity industry did not have a great reputation. Many prominent PE deals in the past were considered displays of massive greed. KKR's acquisition of RJR Nabisco was covered extensively in a series of articles written for the Wall Street Journal and was later published as a book called 'Barbarians at the Gate'. KKR used a popular strategy in the private equity world, called 'Leveraged Buy Out' (LBO) to acquire RJR. LBO is the acquisition of a company using significant amount of borrowed money (i.e. debt) to meet the cost of acquisition. The assets of the company being bought are used as collateral for the loans, along with the assets of the acquiring company. KKR funded majority of the $31bn acquisition with debt, which then created the unfortunate side effect of being unable to meet the interest payments on the large amount of debt and therefore, causing a liquidity related event of default. This acquisition was a massive failure for KKR's investors.
Large amounts of debt based LBO deals are still prevalent in the private equity industry. Leading up to the financial crisis in 2008 saw some of the biggest LBO deals in the US. Some examples include Toys “R” Us ($7bn), Hertz Corporation ($15bn), Energy Future Holdings ($44bn), Harrah’s Entertainment ($27bn), and Hilton Hotels ($26bn). These were some of the largest LBO deals ever in size, but similar to RJR Nabisco acquisition by KKR, none of these deals produced strong returns for their investors and even worse, some even went gone concern.
Post 2008 crisis, access to credit and debt reduced significantly. Investment Banks had massive balance sheet problems, making underwriting difficult. Until 2012 the US was in a prolonged recession. And during the period from 2008 to 2012 the number of private equity deals fell massively. According to a report, 2005 to 2007 saw 7,590 deals in the US worth $1.1 trillion, and for the period between 2008 to 2012 saw 5,056 deals worth $400bn, showing nearly a 65% reduction in capital employed through private equity channels post the crisis.
Overall, it is estimated that Private Equity firms manage over $2 trillion in assets worldwide today, with close to $1 trillion in committed capital still available to make new Private Equity investments in the coming years and decades. This committed capital is both a boon and a curse. Its a boon because funds have access to capital when they see an opportunity, but its a curse because investors feel an overhang when the capital is not deployed quickly and efficiently to generate returns. Therefore, Private Equity firms are constantly on the look out for new opportunities to put capital to work.
An area that is significantly benefiting from the availability of committed capital is 'Infrastructure' which is now an asset class in its own right within the private equity investment space. Many of the LPs who provide capital to the GPs are pension funds and sovereign wealth funds. They are looking for safe assets with good downside protection with stable income generation profiles to meet their return requirements. This matches the offerings of private infrastructure companies who are seeking capital to build physical infrastructure (example: hyperloop transportation, fibre optics communication, 5G towers, battery manufacturing plants, etc) and these infrastructure assets will generate recurring revenues over long periods of time and will be materially less impacted by changes to macroeconomic environments as consumers (people and companies) will require these infrastructure services forever. The only downside here is infrastructure takes time to build. Just like Rome was not built in a day, some of the real value add infrastructure assets may take many years to build before seeing recurring revenues, break even points and beyond. This requires Private Equity firms to be patient and invest for longer duration in expectation for future returns.
Although there are still some private equity funds in the industry with an objective to make a quick buck and work towards short sighted returns, which is generally considered value destroying in the long run, overall, the PE industry has come a long way since the Barbarians at the Gate. They are now more socially acceptable as they seem to be visibly investing financial resources into many value add initiatives. They tend to partner with private companies to create sustainable economic growth, build companies and as an effect, increase employment levels.
Who invests in Private Equity?
Given the size of the industry, its private nature, illiquid nature of the investments and the long term periods for which capital remains blocked, who has the appetite for private equity investments? The big Investors (LPs) in PE funds are pension funds (government and corporate), insurance companies, endowment funds, banks and sovereign wealth funds. See below a split of the $1.6 trillion Private Equity industry by investor type.
As you can tell, these investors are managing people's money. Therefore, when they invest in Private Equity funds they are generally looking for a strategy where value is created through building strong and competitive companies in industries and sectors that are well protected from downside risks with creation of assets that will continue to hold value in the long term. The investors expect the Private Equity Fund (i.e. GP) to provide financial and operational support to the companies they invest in to succeed in executing their business strategy and to guide their investments to a profitable exit through an IPO or a trade sale.
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