IFT Notes for Level I CFA® Program
R50 Introduction to Alternative Investments
4. Private Equity
Private equity means investing in private companies or public companies with the intent to take them private. The sponsors (or investment managers) raise capital over a period of time to invest money in multiple companies in a specific sector or geographic region. For instance, you may have a health care PE fund or a real estate PE fund. They call for a specific amount of investment from investors (to be paid over a certain period of time in specific amounts) who are looking for opportunities to earn a high rate of return.
There are four main categories of private equity:
- Leveraged Buyouts: Borrowed funds are used to buy an established company.
- Venture Capital: This refers to investments in companies that have not been established yet.
- Development Capital: It refers to minority equity investments in mature companies that require funds for growth or expansion, restructuring, entering a new territory, an acquisition, etc.
- Distressed Investing: It involves buying the debt (such as corporate bond, bank debt, etc.) of companies going through financial troubles. The company may be in bankruptcy proceedings, or likely to default on debt. The distressed securities are available at a bargain. Institutional investors such as hedge funds or private equity firms buy these distressed securities after carefully evaluating because they believe the company may not be in as bad a position as the market believes it to be and the cash flow problems may be temporary. They accept risk, expect the debt to increase in value and make a profit in the end.
This reading focuses on leveraged buyouts and venture capital. For development capital and distressed investing, it is sufficient to know the brief descriptions given above.
4.1. Private Equity Structure and Fees
Private equity structure is very similar to what we saw in hedge funds.
- Structured as limited partnerships with investors. They are not structured as corporations to avoid double taxation. Corporations pay dividends to investors who then have to pay taxes. The partnership structure avoids double taxation.
- The private equity firm is the general partner (GP). Firm and GP are used interchangeably. A GP commits a certain amount of capital to the fund. The decision-making authority lies with the general partner.
- Investors are limited partners (LP). They are passive investors who have committed the capital but do not have any authority in what companies to invest in and when, or when to divest.
- The investment manager makes all the investment-related decisions such as what companies to invest in, to divest, calling for capital, etc.
- Committed capital: It is the amount that limited partners have agreed to provide the fund. PE funds raise committed capital and then draw those funds over a period of 3-5 years when specific investment opportunities arise. The GP decides when to call for committed capital from the LPs.
- Management fee is 1-3% of committed capital: This is an important distinction from hedge funds where management fees are based on the assets under management.
- The GP typically receives 20 percent of the total profit of the private equity fund as an incentive. GPs usually do not receive any incentive fee until the LPs have received their initial investment back. This is covered in detail in Level II.
4.2. Private Equity Strategies
Leveraged buyout is an acquisition of an established public or private company with borrowed funds. If the target company is a public company then after the acquisition, the company becomes private, i.e., the target company’s equity is no longer publicly traded.
The acquisition is significantly financed through debt, hence the name leveraged buyout. LBOs capital structure consists of equity, bank debt, and high-yield bonds. The firm (GP) puts in some money of its own, raises a certain amount from LPs, and a substantial amount of money is borrowed in the form of debt to invest in companies.
For example, assume the GP invests in a target company that requires an investment of $100 million. In this, the GP invests $20 million of its money (equity), $70 million from bank debt, and the remaining $10 million is raised by issuing high-yield bonds.
There are three changes that happen to a company as a result of a leveraged buyout:
- An increase in financial leverage.
- Change in management or the way the company is run.
- If the target company is previously public, after the LBO it becomes private.
- To improve the company’s operations; to add value and eventually increase cash flows and profits.
- Leverage will enhance potential returns once the restructuring/growth strategy is complete and the company turns profitable. Debt is central to an LBO structure. Buyouts are rarely done entirely using equity.
There are two types of LBOs:
- Management buyouts (MBO): Current management team purchases and runs the company.
- Management buy-ins (MBI): Current management team is replaced and the acquirer team runs the company.
Target companies for LBOs are as follows:
- Undervalued stock price: PE firms buy companies which are out of favor currently.
- Willing management.
- Inefficient companies: To generate attractive returns by acquiring inefficiently managed companies and turning them around.
- Low leverage: Companies that do not have a large portion of debt currently. This way, PE firms can use debt to fund their purchase.
- Strong and stable cash flow: In an LBO transaction, the acquiring company finances the purchase with a large portion of the debt. If there is a stable cash flow, it makes interest payments easier.
- Lots of physical assets.
Venture capital firms invest in private companies (portfolio companies) with significant growth potential. The time horizon is typically long-term. The distinction between VC and LBO is that the latter invests in mature companies, whereas VC invests in growing companies with a good business plan and strong prospects for future growth. Other important points related to VCs are given below:
- The company being invested in is often called the portfolio company as it will become a part of the VC’s portfolio of investments.
- Venture capitalists are actively involved in the companies they invest in.
- The rate of return expected depends on the stage the company is in when the investment happens.
- VC investing can take place at various stages
Formative stage: Company is still being formed.
- Angel investing: Financing provided at the idea stage.
- Seed stage financing: Financing provided for product development and market research.
- Early stage: Financing for companies moving towards operation, but before commercial production and sales. Fund to initiate commercial production and sales.
Later stage financing: For expansion after commercial production and sales but before IPO.
Mezzanine stage: Preparing to go public.
The goal of private equity is to improve new or underperforming businesses and exit them at high valuations. Typically, investments (target companies) are held for an average of 5 years. The holding period may be longer or shorter. Common exit strategies are:
- Trade sale: Selling the company to a competitor or any strategic buyer. It can be done through auction or private negotiation. For instance, if a PE firm (GP) invested in a small generic pharma company, it may sell it to large pharma firm after a few years.
- IPO: Company goes public, i.e., it sells all or some of its shares to public investors.
- Recapitalization: Increases leverage or introduces it to the company and pays itself a dividend. Not a true exit strategy, but introduces leverage or re-leverages.
- Secondary sale: Assume you are a VC firm that focuses on early stage companies. You may sell the portfolio company later to another private equity firm that focuses on later stage companies.
- Write off/liquidation: This is a worst-case scenario when the investment has not gone as planned. The company’s prospects do not look promising, so the VC firm sells the assets or writes it off to focus on other projects.
4.3. Private Equity: Diversification Benefits, Performance, and Risk
Private equity may provide higher return opportunities relative to traditional investments. Some of its benefits include the following:
- Access to private companies.
- Ability to actively manage and improve portfolio companies.
- Diversify the portfolio because of lower correlation with stocks and bonds.
- Easy to use leverage.
Investors should identify and invest in the best performing private equity funds.
4.4. Portfolio Company Valuation
Three approaches to value a portfolio company are listed below:
- Market or comparables: Values a company or its equity using multiples of different financial measures. Example: EBITDA multiple used to value large, mature private companies.
- Discounted cash flow: Values a company as the present value of the expected future cash flows. Free cash flow to the firm and weighted average cost of capital are used to estimate the value of a company.
- Asset based: Values a company based on the values of its underlying assets less the value of any related liabilities.
A private equity fund is considering purchasing a media company that had an EBITDA of $100 million. In the past year, three media companies were sold for 6x EBITDA, 8x EBITDA, and 7x EBITDA. What is the maximum value the private equity fund is most likely to assign to the media company?
The maximum value the private equity fund is most likely to assign is that using the highest multiple (8 × 100 million = 800 million).
4.5. Private Equity: Investment Considerations and Due Diligence
Due diligence is important before making private equity investments. Here are some factors to consider:
- Current and anticipated economic conditions, including interest rates and capital availability, must be considered before making an investment.
- Another factor to consider is refinancing risk as lack of refinancing options can lead to default.
- Long-term commitment: Private equity investments are illiquid and are best suited for investors with a long-term horizon. The period between investing in a portfolio company and exiting is long, and in between there are limited liquidity options.
- Carefully select GP
- One of the critical factors behind the success of a private equity fund is its GP as the GP along with the investment manager makes the decision where to invest, how much to invest (how much of committed capital must be drawn), and when to invest. So evaluating the GP’s knowledge and experience is critical.
- Relevant questions to ask would be: Is the valuation methodology right? Are the GP’s interests aligned with that of LPs?
- Many other due diligence questions are similar to what we saw with hedge funds.