Wednesday, 14 November 2012

What is Private Equity?

Almost everyone would have heard about the Private Equity industry in some form or another.  If you are young and interested in finance, the chances are that you have seen it mentioned on message boards as the holy grail of jobs to get.  If you are a bit older you may have seen many businesses that you worked for, that were listed on the stock exchange or that you patronise being bought out and changed by private equity firms.

This post will take a very high level look at the private equity industry - what they do, where they come from and how they make money.

What are private equity firms?

Private equity firms are essentially fund managers that, instead of buying shares in publicly traded companies, buy whole companies (whether public or private) using a significant amount of leverage (debt) and then pay down the debt from the operations of the business and then on sell the company at a later date.

Private equity firms typically raise their funds from pension or superannuation funds, who give the funds to the private equity business for ~5 years to make a return.  Although the structures vary, it is relatively normal for the private equity firm to have a 2/20 type model.  They charge 2% of the funds under management and 20% above a certain benchmark return rate (much like hedge funds).

Who typically works at private equity firms?

The core of private equity firms are usually ex-investment bankers or management consultants (depending on the firm).  Because the main feature of private equity is the way in which the business is financed when it is taken private they will often have significant experience when it comes to both capital and debt markets.

Although employees of private equity firms will always sit on the boards of companies they own and control, they will almost never get involved in the management of the business.  When they buy a business, private equity firms normally use one of two management approaches

  1. They buy the business with existing management (often called a Management Buy-Out) in which case the existing management stays in place
    • There are a few reasons why private equity firms will not change the management that is in place
      • If it is a well run company there is no reason to.  Why would you change the way a cash generating successful business is run if you do not have to?
      • Those participating in the management buy out are particularly well rewarded and so management has an incentive to help the private equity firm take over the company through the provision of detailed information and data rooms as well as business plans
  2. They replace the existing management with a 'first in class' management team
    • If the business is a cash cow but not particularly well run then it is quite common for Private Equity firms to hire the best operators in the world to run the business
    • They attract these people because of the pay opportunities and upside they offer them
How exactly do they make money?

At it's core the private equity model is relatively simple (although the execution of this can get particularly complex).  Below is a pretty standard way for a private equity firm to make money:
  1. Private Equity firm buys business A for $100 which represents a 10x multiple on their free cash flow ($10)
  2. They finance the acquisition with $20 of equity and $80 of debt at a debt cost of 8% (i.e. the debt costs them $6.40 per year)
  3. They cut costs brutally in the business and all non essential capital expenditure is removed to improve the free cash flow position of the business.  The free cash flow of the business is now $12.50.
  4. Every year the private equity firm uses the free cash flow to pay down the debt in the business. Assume they hold this business for 5 years
    • In year 1 they pay $6.40 in interest and pay off $6.10 in debt
    • In year 2 they pay $5.91 in interest [(80-6.1)*8%] and pay off $6.59 in debt
    • In year 3 they pay $5.38 in interest [(73.9-6.59)*8%] and pay off $7.12 in debt
    • In year 4 they pay $4.82 in interest and pay off $7.68 in debt
    • In year 5 they pay $4.20 in interest and pay off $8.30 in debt
  5. At the end of year 5 they have a business that is still making $12.50 a year but because they have been paying down this debt so aggressively they only have $44.21 in debt left
  6. They sell this business at exactly the same free cash flow multiple they bought it at however they get more money for it because they cut so many costs out.  They also have much less debt than they started with
    • They receive $12.50 * 10.0x = $125
    • They repay the $44.21 in debt
    • They are left with $80.79 for investors
  7. The return they earned on their invested capital is (80.79 / 20)^(1/5)-1 = 32.2% p.a.
As competition for these high cash flow businesses became more intense among private equity firms their returns got squeezed so that now they are more like 20% - 25% p.a. so they started using more exotic strategies including trying to get expansions on the multiple they bought at to increase their returns etc.

Note that there are always a risk in these types of businesses.  The debt burden on them is HUGE and there are many instances where the businesses have failed and the private equity firms have lost all their money because they could just not finance the debt that they had.

Can I do this myself?

This is a question that is not asked by enough people - however there are many people that use this particular approach to businesses.  Where there are high cash flow businesses, such as franchises there are those that are comfortable enough with their own abilities to use this model to fund their businesses expansions.  Like private equity firms - some are wildly successful while others go bust because they have been too aggressive.

If you have any questions about the private equity industry feel free to post them below.  I have never worked in this particular industry however have plenty of friends that do so I'll see what I can find out for you.

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