The formulas, tricks and trade secrets of Private Equity
What Is Private Equity
The formal definition of private equity is vaguely:
… The ownership of equity securities in a business not publicly traded.
As simple and concise as this definition is, it doesn’t differentiate between passive and active investors. This is an important distinction because the private equity offering contains much more strategic value than the offering of most other private investors. In this sense, a private equity investment more closely resembles an investment made by a management team.
What is Private Equity?
The primary difference being that the private equity professionals do not constitute staff and hence, they represent an extension of management that isn’t completely engrossed in the daily operations of the business. This allows them some independence and a refreshingly different view of the business from the outside world. Therefore, my expanded definition of private equity is:
… the ownership by a value-add investor of equity securities in a business not publicly traded.
What is Private Equity? There two primary uses of private equity in a business: 1) to replace existing capital, and 2) to invest new capital. So, this begs the question, what drives investments that swap capital and inject capital?
Swapping Capital (What is Private Equity?)
Transition – many private equity transactions occur because, for whatever reason, there’s a transition of ownership and/or management. We know these transactions as MBOs, MBIs and, of course, BIMBOs (we’ve actually done one of these transactions). The drivers for transition can be anything from an outrageous offer to the current owner simply calling it a day.
Succession – this is a form of transition, but more specifically involves an owner reaching pension age and passing the business on to family members or new owners. In either case, a private equity firm can sponsor the buyer to purchase the business from the seller. This often works well because the prospective buyer has an entrenched understanding of the business, but doesn’t have the funds to help pay the seller a hefty one-off pension payment.
Privatisation – we hear about many private equiteers that exit investments via the public markets (i.e. IPOs). But sometimes, if a listed business is undervalued or the private equiteer has lost his/her mind, we also see them enter via public markets. We know these transactions as public-to-private deals. However, they’re not as common as other transaction types because the process can be painful. Apart from needing to convince thousands of stockholders to sell, you often need to pay a premium to convince them to sell.
Consolidation – sometimes it can be a pain in the backside to have a fragmented stockholder base, even if there are only 5 or 10 investors. In this case, a private equiteer will sponsor a more enthusiastic stockholder to buy-out the less enthusiastic stockholders, giving him/her more control to drive growth. This may also be the result of a succession or expansion transaction.
Equitisation – this involves changing the balance of debt and equity in a business. Often a private equiteer will invest to de-leverage a business by paying down some of the debt. This may be a turnaround situation or as a way for a business to bring in a private equiteer (for their skill, contacts, etc.) without burdening the company with new equity it doesn’t yet need.
Injecting Capital (What is Private Equity?)
Expansion – this is the typical venture capital scenario, but also a private equity scenario, when a business needs more money to expand. The money may fund plant & equipment, working capital, staff, professional services, marketing, or any number of other needs. In this case, the investment requires the issuance of new stock, often with preferred status. This isn’t as common as one may think (in private equity) because typical private equity candidates already produce significant cash flows to fund growth or at least the interest payments on debt (which we know is much cheaper than private equity). It’s more common in businesses with unstable cash flows, already high gearing, a lack of financial sophistication, or a specific need for a private equity investor.
Acquisition – this is simply a specific example of expansion funding, but it differs because it often requires capital that can’t be funded by maintainable cash flow. Acquisition funding is a very common driver for private equity funding, and unlike my comments above for expansion funding, it is often needed by businesses with stable cash flows and only moderate gearing.
As you can imagine, most transactions fit into more than one of the above categories. Expansion deals may consolidate the stock register, acquisition deals may involve ownership transition, and privatisation deals can often trigger some form of equitisation.
I hope that answers the question of What is Private Equity? As a private equiteer, there are many tools in the toolbox, and by using these tools, we can structure deals that appeal to the most stakeholders while also delivering value to our funds.
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