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Since its inception in the midst of the twentieth century, Private Equity investing has risen as a powerful economic force that has minted several billionaires and multimillionaires.
Private Equity (PE) blends two of the most powerful ingredients for wealth creation: Business ownership and Leverage.
If you are an entrepreneur or a business owner, you probably have heard the term thrown around, but you might not exactly know what it is about.
In this article, I will provide a soft introduction in the topic and provide some insights on how an entrepreneur might benefit from it.
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What is Private Equity?
“Private equity” refers to exactly what the two words allude to. It is equity, i.e. capital, that is not allocated on a public exchange, but remains private, i.e. it is not publicly listed or traded.
Private equity is composed of investment funds and investors that directly invest in private companies and/or that engage in buyouts of public companies, resulting in the delisting of their public shares.
As with every other strategy of capital allocation, the end goal of PE is to achieve a positive return on investment.
Since the basis of private equity investment is direct investment into a company, PE firms typically obtain control of the operations of the company.
The term “Private Equity” is very broad and encaptures various strategies that might not be very similar, including Leveraged Buyouts (LBOs), Venture Capital (VC) and even Angel Investing.
However, in most cases, PE refers to LBOs. In a typical leveraged-buyout transaction, a private-equity firm buys majority control of an existing or mature firm.
In order to do so, the PE firm usually utilizes extensive use of debt financing to purchase the company, which they restructure and attempt to resell for a higher value.
We will see an example later on to make this clearer, since that is the core of the PE investment model.
How does a typical Private Equity firm work?
On a high-level, a PE firm pools investment capital with the purpose of deploying that capital to private companies.
The source of this investment capital is usually high net worth individuals, large institutional investors, university endowments, or even sovereign funds.
After raising the funds, the job of the PE firm is to discover opportunities where that capital can be effectively deployed so that it is put into work.
The process goes like this:
1) Find a company with specific characteristics
PE firms typically target mature companies with established cashflows and high predictability. They usually shy away from startups which are handled by the VC firms.
2) Obtain ownership of the company
The PE firm will then use a mix of equity (their own capital) and leverage (issuing debt) to buy a portion, or more probably, the whole company.
PE firms use extensive debt financing something that boosts their returns, but at the same time poses risks to the viability of the company. Think of the mix as 20% equity and 80% debt.
3) Improve operations and increase efficiency
After the PE firms assumes ownership and control of the company, they get into work. They bring in experienced operators and executives and optimize the operations increasing efficiency and margins. They can also aim for revenue growth by capturing market share or introducing new products.
4) Resell the company for a higher value
Since the company has now higher revenues and improved profit margins, it has become a more valuable asset. As a final step, the PE firm resells the company to another business (via and M&A transaction) or to the public (via an IPO) for a higher price.
This is much harder that it might seem, so for their troubles, PE firms are lucratively compensated.
The fee structure for private-equity firms typically consists of a management fee and a performance fee (in some cases, a yearly management fee of 2% of assets managed and 20% of gross profits upon sale of the company).
That means that if a private equity firm has $1 Billion of Assets Under Management (AUM), they are going to generate $20M per year just in fees, without taking under account the possible upside upon a company sale.
This is the reason that private equity is a powerful vehicle for wealth creation.
How does a Private Equity generate returns?
In order to better understand how a PE firm can generate returns for their investors (and itself), we are going to discuss a basic example.
Before we begin, note that the most prominent metric that PE firms use is Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).
Let’s assume that company ABC generates $500M in annual revenues and $100M in annual EBITDA, for an EBITDA margin of 20%.
The owner of ABC agrees to sell the company to a PE firm for a valuation multiple of 5 times EBITDA, i.e. for $500M.
The PE firm brings in experienced business people, restructures the company, trims excessive fat, introduces a new product line, tightens margins and after 5 years is able to double revenues to $1B and also increase margins to 30%, generating EBITDA to the tune of $300M.
The PE firm decides to sell the company to a larger competitor. Since ABC is now larger, more robust and more powerful, it commands a multiple of 8 times EBITDA, i.e. the acquisition price will settle at $2.4B.
In this example, the original investment of $500M exploded into a value of $2.4B in only 5 years.
You can see that by purchasing and restructuring an underperforming business, high returns on investment can be achieved.
The PE model takes this a step further by using leverage to finance the transaction.
In our case, the original $500M might have been split into $100M of straight equity (the firm’s capital) and $400M in debt (from banks or capital markets), thus the returns would be even higher.
How can an Entrepreneur benefit from Private Equity?
For entrepreneurs and business owners, Private Equity brings to the table a very important element: Liquidity.
There are other benefits that it can provide, such as operational expertise, but the main aid of PE is Capital.
In my mind, there are two main scenarios that an entrepreneur might benefit by partnering with a PE firm.
1) Selling partial or complete ownership of the business
This is a transaction that allows the business owner to liquidate his position (partially or wholly) in the company and transform “paper wealth” to actual cash.
Consider the case where you have grown your company for a decade, scaled it to a fairly large corporation but you have gotten tired and wish to cash out.
In this scenario, a massive portion of your wealth is tied up to an illiquid asset, your private shares of the company.
If the business is not big enough to warranty an IPO, then you are “stuck” with it. One way out is if you sell the company directly to a PE firm.
2) Obtaining a combination of capital and strategic operations expertise to grow the business
This is an approach that allows the business owner to get an infusion of capital but also bring on-board some strategic partners that can help him spur further growth.
This type of equity investments referred to as Growth Capital and it usually involves minority investments in mature companies that are looking for capital to expand operations, enter new markets or finance a major acquisition without a change of control of the business.
These types of companies might not be in position to get debt financing from traditional avenues like banks or the credit markets, or they might be able to do so, but prefer not to because they want a strategic alliance in the form of a PE firm.
In this scenario, the business owner sells part of his ownership to an outside firm, but does not relinquish control of the business.
Finally, please note that Venture Capital (VC) is technically a subset of Private Equity, but in practice VC is a different beast and stands on its own.
In this article, I provided a high level introduction of what Private Equity is, how it works and how it can be utilized by entrepreneurs and business owners.
It’s possible that you have an encounter with a PE firm in your entrepreneurial career, so it pays to have a good understanding of how their model works.
Who knows, you might even end up selling your profitable business to a PE firm for several millions!