A comprehensive guide to private equity

This guide delves into the intricacies of private equity, explaining what it is, its mechanisms, benefits, and the strategic approaches investors can adopt to navigate this complex yet rewarding landscape.

What is private equity?

Private equity refers to the investment in companies with the intention to restructure, improve, or grow the business before eventually selling it for a profit. These funds are managed by private equity firms on behalf of the investors.

Private equity funds may take over entire private or public companies or participate in these acquisitions alongside other investors. Commonly, they avoid maintaining interests in public companies listed on stock exchanges.

Frequently categorised alongside venture capital and hedge funds, private equity is considered an alternative investment class. The nature of these investments required large amounts of money for a long period of time, thus usually only an option for big businesses and wealthy individuals.

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Understanding private equity

Unlike venture capital, which typically focuses on start-ups, many private equity firms invest in businesses aiming to enhance their value or realise gains before divesting several years down the line. The aim for private equity firms is to acquire a business, improve it, and eventually sell it at a profit.

Private equity firms accumulate funds from clients to create private equity funds. They manage these funds’ investments, earning fees and a proportion of the profits exceeding a specified benchmark, known as the hurdle rate.

Types of private equity deals

The transactions made by private equity firms when purchasing and divesting their portfolio of businesses can be categorised based on the specific conditions surrounding each deal.

Management Buyout (MBO)

This is when the management team of a company, usually in partnership with a private equity firm or other investors, acquires the company from its owners. In an MBO, the management team typically acquires a significant stake in the business, often with the goal of gaining greater control and autonomy over its operations.

From the perspective of private equity firms, participating in MBOs allows them to invest in established businesses with proven management teams, potentially providing opportunities for operational improvements, growth initiatives, and eventual exit strategies such as a sale to another company or an initial public offering (IPO).

Leveraged buyouts (LBOs)

Leveraged buyouts are transactions where a company is acquired primarily through debt financing. The acquired entity’s assets and cash flows serve as collateral for the loans, aiming for a future sale or IPO for profit realisation.

Venture capital

Venture capital focuses on investing in start-ups and early-stage companies with high growth potential. It is pivotal in nurturing innovation across various sectors, from technology to healthcare.

Growth capital

Growth capital investments are made in relatively mature companies seeking capital to expand or restructure operations, enter new markets, or finance a significant acquisition without a change in control of the business.

Distressed investments

This strategy involves investing in companies facing financial difficulties, with the aim of turning around their fortunes and achieving a profitable exit.

The structure of private equity funds

Private equity funds are pooled investment vehicles managed by professional management firms. These funds have a typical lifespan of 10 to 13 years, comprising a commitment period, during which investors commit their capital, followed by an investment period where the funds are deployed into target companies.

The stages of the investment process

1. Sourcing deals: Private equity firms and investors must identify potential investment opportunities.
2. Due diligence: Conducting a thorough analysis of the target company’s financial health, market position, and growth prospects.
3. Financing and acquisition: Structuring the deal and finalising the purchase of the target company.
4. Value addition: Working closely with the management of the acquired company to improve operational efficiencies, strategic direction, and growth.
5. Exit: Selling the investment through various channels such as IPOs, sales to strategic buyers, or to other private equity firms.

Why private equity?

Private equity offers a unique blend of benefits that attract both investors and companies seeking capital. For investors, private equity represents an opportunity to achieve potentially higher returns than those available from public market investments. This is because private equity firms are actively involved in managing their investments, applying a range of strategies to improve performance and increase value. Such hands-on involvement can lead to significant improvements in operational efficiency, revenue growth, and profitability.

Advantages of private equity investment

• High returns: Private equity has the potential to yield higher returns compared to traditional investment avenues, albeit with higher risk.
• Diversification: It offers investors an opportunity to diversify their portfolio beyond public equities and bonds.
• Influence on management: Investors in private equity have a significant say in the management and strategic direction of the companies they invest in, potentially leading to more effective decision-making.
• Access to exclusive opportunities: Investing in private equity provides access to opportunities in emerging and innovative sectors not available through public markets.
• Flexibility: Private equity investments allow parties to tailor the deal and financing options to meet each of their needs.
• Alignment of interests: both the investors and the management teams involved in a private equity investment have the same goal of maximising the value of the business.

How does private equity create value?

Private equity creates value by employing a multifaceted approach aimed at enhancing the performance and increasing the value of the companies they invest in. One of the primary methods is operational improvements, where private equity firms streamline operations, enhance efficiency, and implement best practices to boost profitability. This often involves introducing new management teams, investing in technology, and reducing unnecessary expenses.

Strategic redirection is another key avenue for creating value. Investors may reposition a company to focus on its core competencies, divesting non-essential assets, acquiring complementary businesses, entering new markets, or concentrating on more lucrative product lines. They may also renegotiate existing debt terms, refinance at lower costs, or pay out dividends following performance enhancements.

Private equity firms introduce robust governance frameworks in their portfolio companies and align management’s incentives with performance, often through equity ownership or performance-based rewards. This ensures a focus on driving value.

Private equity firms leverage their extensive networks and resources to facilitate partnerships, forge customer relationships, and open up new markets. Acquisitions or mergers can also offer economies of scale to portfolio companies.

Finally, using the right exit strategy. Private equity firms aim to increase a company’s value with a view to achieving a profitable exit, whether through a sale, public offering, or recapitalisation. The prospect of a well-executed exit strategy often motivates strategic and operational improvements throughout the investment period.

Risks and considerations

While private equity can be highly rewarding, it also comes with its set of risks. These include liquidity risks, as investments are locked in for extended periods, and the risk of loss, as not all investments yield the expected returns. Additionally, the complexity and lack of transparency in private equity investments may pose challenges for some investors.

How Moore Barlow can help

If this is something that you would like to discuss further, a member of our Corporate Law team would be happy to help.

At Moore Barlow, we provide corporate legal advice that is built around you and your business. We put your needs first and give you a succinct explanation of complex legal matters so that you can act quickly and confidently to any opportunities that may arise.