Private Equity Investments

Introduction

Private equity’s shift from a niche activity to a critical component of the financial system is evident from investors’ financial commitment: around $2.8 trillion globally as of mid-2018. And that’s just the equity portion. The use of debt means transaction value is often two or three times the actual equity raised. Blackstone, Carlyle, and KKR are household names and publicly traded companies of significant size. Private equity funds may account for 15%–18% of the value of all mergers and acquisitions, and the market capitalization of Alibaba, Amazon, Facebook, and Google has raised the profile of venture capital investing.

We take two approaches to illuminate our subject: In Section 2 the perspective is primarily that of the private equity firm evaluating potential investments. Valuing acquisitions is particularly complex; except for public-to-private transactions, there will be no market prices to refer to, and the challenges are considerable. In Section 3 we take the perspective of an outside investor investing in a fund sponsored by the private equity firm.

Definitions of private equity differ, but here we include the entire asset class of equity investments that are not quoted on stock markets. Private equity stretches from venture capital (VC)—working with early-stage companies that may be without revenues but that possess good ideas or technology—to growth equity, providing capital to expand established private businesses often by taking a minority interest, all the way to large buyouts (leveraged buyouts, or LBOs), in which the private equity firm buys the entire company. When the target is publicly traded, the private equity fund performs a public-to-private transaction, removing the target from the stock market. But buyout transactions usually involve private companies and very often a particular division of an existing company.

Some exclude venture capital from the private equity universe because of the higher risk profile of backing new companies as opposed to mature ones. For this reading, we refer simply to venture capital and buyouts as the two main forms of private equity.

Many classifications of private equity are available. Classifications proposed by the European and Private Equity Venture Capital Association (EVCA) are displayed in Exhibit 1.

Private equity funds may also be classified geographically, by sector, or both. Certain specialists target real asset classes, such as real estate, infrastructure, energy, and timber, or they seek out emerging or niche sectors, such as agribusiness or royalties in pharmaceuticals, music, film, or TV.

US private equity enjoyed a far larger market size historically than private equity in other regions, with few restrictions on hostile takeovers. Buyouts subsequently expanded to Europe and then Asia as friendly deals became commonplace. In broad terms, around four-fifths of the money has been flowing into buyout, growth, and other types of private equity in both the United States and Europe, with buyout amounts far exceeding other types. The sheer scale of buyouts means that an individual deal can absorb billions of dollars in capital. Buyout funds have benefited from increased allocations given their ability to absorb far higher capital amounts and to deliver historically higher-than-average returns.

Venture capital deals, in contrast, tend to drip, providing small amounts of feed money. Still, advances in technology and communications are causing the number of venture capital funds and the availability of start-up capital to grow. Investor attention started to shift to China in 2015, an especially active year for raising capital. VC funds targeting Asia had more than US$200 billion in 2017, up from US$50 billion in 2010.

Most private equity money comes from institutional investors, such as pension funds, sovereign wealth funds, endowments, and insurance companies, although many family offices and high-net-worth individuals also invest directly or through fund-of-funds intermediaries. Venture capital investors include government agencies and corporations seeking to promote regional investment or gain insight into, and possibly control of, emerging businesses and technologies.

Private equity investment is characterized by a buy-to-sell orientation: Investors typically expect their money to be returned, with a handsome profit, within 10 years of committing their funds. The economic incentives of the funds are aligned with this goal.

The member should be able to:

1. explain sources of value creation in private equity;

2. explain how private equity firms align their interests with those of the managers of portfolio companies;

3. distinguish between the characteristics of buyout and venture capital investments;

4. interpret LBO model and VC method output;

5. explain alternative exit routes in private equity and their impact on value;

6. explain risks and costs of investing in private equity;

7. explain private equity fund structures, terms, due diligence, and valuation in the context of an analysis of private equity fund returns;

8. interpret and compare financial performance of private equity funds from the perspective of an investor;

9. calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund.