AIBC 2022 Research
An Introduction to Private Equity
By Michelle Tian, Joshua Ong, and Glen Lee
Born during the industrial revolution, private equity (PE) has emerged to become one of the fastest growing asset classes today, with USD $9.8 trillion worth of assets under management as of 2021. For delegates interested in a broad overview of the industry, this article breaks down the basics of PE, briefly introducing the foundational concepts underlying the asset class and the sub-types of PE investments. We also explore key trends that have shaped the industry over the past few years.
What is Private Equity?
In broad terms, PE refers to the entire class of equity investments in private companies – that is, companies that are not listed on public exchanges, or in the case of public-to-private transactions, cease to be listed once taken over by a PE fund. Thus, PE stretches from venture capital – working with early-stage companies or start-ups – to buy-outs, whereby a PE firm acquires a controlling interest in the company.
Characterized by their ‘buy-to-sell’ approach, PE is part of a broader class of investments in the private markets, and in 2021, had been the best-performing private markets asset class, compared to private debt, real estate, and infrastructure investments. Apart from just providing funding, PE firms can provide mentorship and industry expertise to their portfolio companies, adding value when companies undergo significant changes and growth.
Before we look at some of the key trends in the industry, let us first take a deeper dive into the mechanics of PE. How exactly do PE investments work?
Mechanics of Private Equity
PE firms (also known as General Partners) manage PE funds, which are limited duration, close-ended funds that invest equity stakes in companies. These PE funds are in turn funded by investors (also known as Limited Partners) and today, PE firms derive most of their capital from institutional investors like public pension funds, insurance companies, and sovereign wealth funds.
After raising a specified amount of capital for a fund, PE firms generally use the capital to invest substantial equity stakes in private companies, or, in publicly listed ones that they intend to take private (e.g. the 2013 de-listing of Dell). Usually, these investments result in the PE firm taking a majority stake in the company, or as much as is required to gain control of the business.
After gaining control, PE firms typically play an active role in the management of their portfolio companies. As part of the PE firm’s active management strategy, for instance, it may seek to optimize its portfolio company’s financial structure, incentivize management, or intervene directly in the day-to-day functioning of the business to improve operational performance. Through these methods, PE firms “add value”, generating a return on their original equity investment that can eventually be realized through an exit.
To realize capital gains, fund managers typically sell their stake within a five-to-ten-year timeframe, or at the end of the PE fund’s life. There have traditionally been three primary exit routes for PE firms – trade sales (i.e. sale to a strategic buyer), secondary buy-outs, and initial public offerings (IPO). Increasingly, however, GP-led transactions in the PE secondaries market have also given PE firms the option of extending their holding periods beyond an initially planned timeline, allowing them to follow on and ‘roll over’ their investments to a new fund vehicle instead of necessarily selling their stake at the end of the fund’s life.
Like hedge funds, PE funds generally use the “two and twenty” fee and incentive structure. This refers to a 2% annual management fee, and a 20% share in any profits. Despite the ubiquity of the 20%, however, the 2% annual management fee has been shrinking as PE becomes increasingly saturated and more competitive.
Role of Private Equity Fund Managers
In short, PE fund managers have 5 main roles, to:
● Raise funds
● Source investments
● Negotiate and structure deals
● Build and actively manage a portfolio of investments
● Realize value from investments
Steps of a Private Equity Deal
Assessing and completing any PE deal is a complex process, with the exact steps and structure of each deal varying widely across firms, the specifics of the target company, and the type of transaction. Broadly, however, the process can be broken down into the following steps and can take several months to more than a year to complete.
(i) Deal Sourcing:
The process of PE firms assessing and discovering appropriate investment opportunities. Various methods such as research, internal analysis, networking, business conferences, and conversations are used to discover these investment opportunities.
(ii) Non-Disclosure Agreement (NDA):
An agreement is signed between the target company and the PE firm to ensure that the confidential information regarding the target company is undisclosed. Based on the information gathered, the PE firm decides whether they want to continue pursuing the investment opportunity.
(iii) Initial Due-Diligence:
This involves researching the target company to gain a better understanding of the business and making estimates on the return on investment.
(iv) Investment Proposal & Expression of Interest:
At this stage, the investment team presents an investment proposal to the investment committee, and upon approval, they provide the target company with an expression of interest (formal offer).
(v) Internal Operating Model & Preliminary Investment Memorandum:
An internal operating model is created to detail the revenue and cost breakdown of the target company, with a preliminary investment memorandum (30 to 40-page document) summarizing the investment opportunity for the PE firm’s investment committee.
(vi) Final Due-Diligence & Final Investment Committee Approval:
Prior to the final bid, the PE deal team processes the flow chart while the investment team manages other due diligence processes on the financial, commercial, and legal end. Once the final due-diligence process is complete, the investment committee gives final approval for the valuation to acquire the target company.
(vii) Final Binding Bid:
The deal team sends a final bid to the target company. This bid usually includes details such as the final buying price, financing documents, and preliminary merger agreements.
(viii) Deal Completion:
The deal is considered complete once the target company decides on the most appealing bid and works exclusively with the preferred party to sign the transaction documents.
Types of Private Equity Strategies
Though fundamentally predicated on the same ‘buy-to-sell’ approach, the exact strategy used to generate returns in PE varies. Depending on the stage of the organization’s life cycle at which the investment is made, these PE strategies require different skills and have varied risk-return profiles for investors. Below we lay out some of the main strategies used by today’s PE practitioners, shedding light on the broad and extensive nature of the industry as it currently stands.
Figure 1: Types of Private Equity Strategies. Source: Mergers and Inquisitions.
(i) Venture capital
A venture capital (VC) firm invests in early-stage companies or start-ups. VC firms usually give a seed amount in exchange for a share of the target company, often less than the majority share. This incentivizes owners to seek funds from venture capital firms in their early stages as the owners would be able to retain a controlling interest in the company.
The ceiling on returns for VC investments is higher due to the higher potential of growth from start-ups. If successful, individual VC investments can deliver blockbuster returns, returning 100x multiples (or more) of initial capital. However, with a higher possible reward comes higher risk; without having had time to prove their business ideas and financial strength, VC investments are inherently riskier, and the failure rate is high.
Thus, it is not uncommon for VCs to rely on 20% of start-ups in the portfolio to deliver 80% of the returns (the Pareto principle). Think Pinduoduo, NIO, Xiaomi, and WhatsApp, for instance. Although companies like these are rare, they are what enable VC funds to deliver 10x or 15x returns for investors despite the low breakthrough rate.
(ii) Growth equity
A growth equity firm invests in relatively mature businesses undergoing significant transformation, and with potential for dramatic growth. Growth equity investments are thus a source of capital for companies with traction in existing markets and proven business models seeking to enter a new phase of expansion through entering a new market, or acquisition of another firm.
Growth equity firms typically maintain a database of up-and-coming companies that they can reach out to and offer funding when additional financing is required for expansion. To decide whether to make the investment, growth equity firms conduct in-depth due diligence and research into the company’s business and financial history.
Compared to VC, growth equity usually involves a shorter holding period of 3-7 years and is considered less risky than VC as they usually target companies with established businesses.
(iii) Classic buyout
Buyouts are when the previous investors cash in on their shares, and the PE firm/management becomes the controlling shareholder of the company. Sometimes, the target companies might be quoted on the public exchange, and the PE fund forms a public-to-private transaction by removing the company from the stock market. However, in most cases, buy-out transactions involve private companies, such as family-owned companies or a specific division of an existing (public or private) company.
There are two types of buyouts, management buy-outs and management buy-ins. Management buy-outs occur when the existing management buys the assets and takes a controlling share, while management buy-ins refer to the purchase of a business by an incoming management team. The main goal of buyouts is to control the company for a period of time and make improvements to have a return on investment.
(iv) Distressed assets
Like other PE firms, distressed PE firms raise capital and invest it. The key difference is that these firms invest in troubled companies’ debt or equity to take control of the companies during bankruptcy or restructuring processes, turn the companies around, and eventually sell them or take them public. This requires a broader set of skills from the investors, having to be familiar with credit and capital structure, bankruptcy code, and accompanying legal process, and making organizational changes to name a few.
As a rule of thumb, these PE firms look for “good companies” with weak balance sheets, meaning the company has a good business model with an in-demand product or service, but has too high of a debt load or is unable to meet restrictions on its current debt covenants.
Key Trends in Private Equity
With inflation rising to levels not seen across the world in 40 years, a changing regulatory landscape, and increased focus on ESG, the ground for PE dealmakers may be shifting in 2022 and beyond. We examine some of the trends that have been top of mind for PE dealmakers over the past year.
1. Renewed focus on specialization and PE sub-asset classes
As the industry matures and PE investors become more sophisticated, they are increasingly looking for types of specialization that may or may not be offered by a typical buyout fund. We see this in how technology funds and those that invest in tech-enabled sectors like fintech or health tech have become by far the dominant theme in the buyout world. Sub-asset classes like growth equity, infrastructure, and secondaries are also growing at a record pace.
Figure 2: Slowing growth of buyout funds amid increasing capital flows into other PE classes. Source: Bain & Co.
Thus, although classic buyout funds have stood at the center of the PE industry in the past 30 years, over the past decade, they have been losing share to other private equity asset classes (Figure 2). Some examples of innovative PE firms specially tailored to targeted trends include Corten Capital (focused on tech-driven B2B services), and Cove Hill Partners (long-hold fund focused on consumer and tech), both of which have raised huge sums in 2020.
2. Rise of PE in India in the past decade
From 2011 to 2020, the Indian PE industry grew from a nascent industry to a mature ecosystem aggregating a total of USD$234.2B, growing at a CAGR of 19%. Compared to 39.9B in 2020, PE firms also invested a record $63B in Indian companies in 2021, a 57% increase.
In 2021, India also experienced strong exit momentum especially in the consumer technology sector, following the IPOs of Paytm, Nykaa, and Urban Company on the back of positive public market sentiment. These IPOs, alongside a range of successful liquidity events via secondary deals and strategic M&A (e.g. the USD$2.2B exit from BillDesk), could help to solidify India’s PE industry’s footing on the global stage.
In fact, on the back of the flurry of emerging “unicorns” in India, the country is becoming an increasingly attractive investment destination for PE investments – it ranked in the top 3 most attractive emerging market destinations to make GP investments. Not only so, but it has also become India’s single largest source of FDI and an agent of change, providing momentum to the economy.
3. Competition for PE may toughen as SPACs Rise in Asia
2021 saw a rise of special purpose acquisition companies (SPACs) used by companies to access US public equity markets, as well as changes in regulations around SPACs. With Asian-based sponsors demonstrating a keen interest in SPAC IPOs on US stock exchanges, stock exchanges in Asia, particularly Hong Kong and Singapore, have revised their regulatory frameworks surrounding SPACs.
In 2021, the Singapore Exchange allowed SPACs to list, and Hong Kong’s stock exchange will do the same with effect from 1st January 2022. Going forward, SPACs could continue to feature heavily in regional capital raising and deal-making, but this may further drive-up prices for the global PE industry, particularly as large SPACs go on the acquisition hunt. A number of SPACs are already currently exploring de-SPAC opportunities in China and South Asia amid the abundance of PE-backed companies with promising growth opportunities in those regions.