Good to know: The Basics of Private Equity

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By Hg

‘Fewer than 15% of companies with revenue over $100 million are publicly held, giving public investors narrow exposure to the broader economy‘ (1)

What are the benefits of investing in private markets? Private markets refer to the trading of securities, assets, and other investment types that are not publicly traded on a formal exchange. These markets allow for direct transactions between institutional investors and include investments like private equity, venture capital, private debt, and real estate. But what is private equity exactly? 

Private equity is an investment strategy that involves direct investments into private companies.  Private equity fund managers seek to generate profit by increasing the value of the companies through strategic management, operational improvements, and value creation. Investing in private equity offers potential for high returns that may outperform traditional investment strategies, making it an attractive option for individuals aiming to broaden their investment portfolio and increase their wealth.  Investing in private markets via alternative investments such as private equity can offer several potential benefits for individual investors. 

Here are some of them:  

  1. Higher potential returns: One of the main reasons investors turn to private equity is the potential for higher returns. Private companies may offer significant growth potential, especially in the early stages, 

  2. Portfolio Diversification: Private equity can provide a level of diversification beyond what traditional investment in public equity and debt securities can offer. This can help to spread risk and potentially increase returns. 

  3. Access to Unique Opportunities: Private equity gives individual investors access to investment opportunities that they would not otherwise have. This includes the ability to invest in start-ups, growth companies, or turnaround situations that are not available in public markets. 

  4. Lower Correlation with Public Markets: The performance of private equity investments is often less correlated with public markets. This can provide a buffer against market volatility and could enhance the risk-return profile of an investment portfolio. 

  5. Influence Over Management: In some cases, private equity investors may be able to exert influence over the management of the companies they invest in, potentially leading to better decision making and potentially higher returns. 

  6. Long-Term Capital Appreciation: Private equity investments are usually long-term in nature, often held for several years. This can lead to significant capital appreciation as companies grow and develop. 

7. Tax Benefits: Depending on the jurisdiction and the specific structure of the investment, there may be tax benefits associated with investing in private equity. 

 What is buy-out PE? 

Buyout private equity strategies are one of the most common forms of private equity investment. The basic idea is that a private equity firm acquires a controlling interest in an established company, with the goal of improving its operations and financial performance to eventually sell it for a profit.   Here's how it typically works:  

  1. Identification of Target Company: The private equity firm identifies a company that has potential for improved performance. This company may be underperforming, undervalued, or in need of strategic changes. 

  2. Acquisition: The private equity firm acquires a controlling stake in the company. This is often done through a leveraged buyout, where the acquisition is financed by a combination of equity (from the private equity firm) and debt. 

  3. Operational Improvements: Once in control, the private equity firm works to improve the company's operations and financial performance. This could involve a variety of strategies, such as cost cutting, revenue growth initiatives, strategic acquisitions, or restructuring. 

  4. Exit: After several years, when the company's performance has improved, the private equity firm sells its stake in the company. This could be done through a sale to another company, an initial public offering (IPO), or a recapitalization. The goal is to sell at a higher price than the acquisition cost, generating a return on investment. Buyout private equity strategies can be complex and carry risks, but they also have the potential for significant returns if executed effectively. 

 Basic terminologies used in private equity and client reports: 

  • Private Equity (PE): Direct investments into private companies with the aim of increasing their value through strategic management and operational improvements. 

  • Leveraged Buyout (LBO): A strategy where a company is acquired using a significant amount of borrowed money to meet the cost of acquisition. 

  • Exit Strategy: The way a private equity firm plans to sell its investment for a profit. This could be through a sale to another company, an initial public offering (IPO), or a recapitalization. 

  • Portfolio Company: A company that a private equity firm has invested in and holds in its portfolio. 

  • Carried Interest: The share of profits that the private equity fund manager takes as compensation. 

  • Limited Partners (LPs): Investors in a private equity fund. 

  • General Partners (GPs): The private equity firm that manages the fund. 

  • Capital Commitment: The amount of money an investor agrees to invest in a private equity fund. 

  • Capital Call/Distribution: A capital call is when a private equity fund calls on its investors to contribute a portion of their capital commitment to a new investment. A distribution is when profits from an investment are returned to the investors. 

  • Internal Rate of Return (IRR): A metric used in capital budgeting to estimate the profitability of potential investments. It is the annual return earned on an investment, adjusted for time value of money. 

  • Net Asset Value (NAV): The net value of an entity and is calculated as total assets minus intangible assets (patents, goodwill) and liabilities. 

  • Vintage Year: The year in which the first influx of investment capital is delivered to a project or investment. 

  • Due Diligence: A comprehensive appraisal of a business or investment opportunity to establish its assets and liabilities and evaluate its commercial potential. 

  • EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization): A measure of a company's operating performance. Essentially, it's a way to evaluate a company's performance without having to factor in financing decisions, accounting decisions, or tax environments. 

  • Management Fee: A fee paid by the limited partners to the general partners to pay for the fund’s ongoing operations. It’s typically around 1-2% of the committed capital. 

(1)Source: Bain Global Private Equity Report 2024. Analysis based on S&P Capital IQ data as of December 2022; most recent data from Statistics of US Businesses (2017) used to triangulate S&P Capital IQ estimates for privately held company counts by revenue band 

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