Private equity is one of the highest profile sectors in the financial markets and has a significant impact on the economy.  Only 25 short years ago, however, private equity was little more than a niche player making modest moves amongst the giants of Wall Street. Private equity has since grown into a major global sector with $686 billion invested at its peak in late 2007.

In ideal circumstances, private equity funds will invest in companies who are under-performing by taking over management, aiding in the development of new products or technologies, and/or strengthening its capital base.  Once this is done, the fund will attempt to 'turn them around' and sell their stake at a large margin for profit at a later time, usually in the public markets.  In some situations, the funds will do what is known as 'asset stripping' where they will break up a company for its assets and sell them separately in order to make a profit on them.  Characteristically, a typical margin on the re-sell of company stake is about 20% and the remainder of the money is returned to investors. Private equity funds have a lifetime of only ten years, at the end of which all investments are sold on. This can vary between companies or when there is an established baseline involved in the contract.

Private equity companies are known for having a highly coveted group of clients, though they tend to do a substantial amount of business with many large reputable investment banks. This is because banks often serve as their financial sponsors and there are often groups within banks who function specifically to oversee this lending coverage. Usually, larger private equity firms get more attention in the media because they are able to make larger acquisitions than smaller private equity companies. Additionally, there are many companies which are not as well known who do more work with smaller and medium sized companies. These companies have actually fared better through the credit crunch than did the larger private equity companies, possibly because they did not have to use as many borrowed resources.

Private equity is sometimes the investment vehicle of choice due to its simplicity. Because there are not any equity investors who get involved in the financial documentation, the relevant government regulations are minimized which leaves management with diffused responsibilities.¹  Also, there is a unified goal between management and the firm’s ownership in the sense that management has a clear incentive to work toward the same goals as the firm in order to increase rewards for all parties.¹ Private equity companies also experience tax advantages and their capital structure tends to be less complex than most normal public corporations.¹

Generally, the private equity industry is comprised of four different types of strategies: Venture Capital, Leveraged Buyout, Mezzanine, and Secondaries/Funds of Funds investors.

• Private equity firms often focus on trying to bring value to existing companies through restructuring or management changes. Within the broad category of private equity known as Venture Capital, firms focus on investing money into new businesses that are in need of capital in order to grow.⁷  Venture Capitalist's funds tend to have an understanding in relation to the impact of products, technologies and marketing strategies on markets and take a minority stake in the company. In many situations for this particular brand of fund, the Venture Capitalists will not take a controlling stake in the company.⁹ 

•  Some companies enter a Leveraged Buyout (LBO), often in cases where a company has a proven product and a stable cash flow but is not performing at the level it could or should be.  Many times, companies who are bought out are more successful, smaller components of larger companies who are not doing well. Other times, a smaller component or subsidiary might not be essential anymore to that larger companie's operation and might secure a strong position in the financial market on its own, so it is bought out. LBO companies are focused on control and deal structure - they are often concerned with the 'worst-case' outcomes and attempts to minimize any potential risks through deal structures. Unlike with Venture Capitalists, when there is an LBO, the company who is purchasing will usually take a controlling stake in the company.⁹

•  A mezzanine fund is a form of financing typically used between business start-up and stock market floatation, where unsecured loans are often offered in return for the ability to take shareholding of that company in the future. Often times, the smaller companies use this to gain access to additional capital from lenders they may not have had exposure to otherwise.⁸  Mezzanine funds are more interested in debt-like securities and usually generate lower returns than the other strategies.⁹  These types of funds have become more prevalent in the last decade as multi-billion dollar specialized mezzanine funds have been raised.

•  The final main strategy in private equity is known as secondaries or fund of funds. This type of fund does not directly invest into operating companies. Instead, it purchases interests from institutional investors into existing private equity assets and can involve the sale of private equity fund interests in private companies.⁹  Essentially, these Asset Managers choose to allocate capital among multiple funds, including both venture capital and LBO, which allows them to diversify a portfolio.⁹  Not only do these Sellers sell the private equity fund investments, but they also sell the remainder of their unfunded commitments to the funds.⁸  

• Other more complex strategies involve real estate investments as a separate asset class, investments in infrastructure  such as public works like bridges, tunnels, and airports - energy, power, and merchant banking where the private equity investment is negotiated in unregistered securities within both public and private companies⁸.

Most private equity funds are not large in terms of the number of employees and most employ no more than 30 people on staff.  However, total profits, even in "smaller" firms, can make in excess of $1.5 billion. Most of the employees (the Principles, Originators, and even the Appraisers and Executors) tend to share in the profit and carried interest, although the more junior number crunchers usually need to work their way up the ranks in order to bring home the large compensation packages.

What is the difference between private equity and hedge funds?

People often erroneously mistake private investment/private equity groups for hedge funds and vice versa. The terms have been used interchangeably at times but they are very different, they have different characteristics, goals, and trends.¹⁰  For this reason, a clear distinction between the two should be made and is highlighted in the points below:

• Both private equity funds and hedge funds currently have more assets and money under management than ever before and they are both constantly looking for new deals so, by nature, the two business' do overlap.

• Where private equity companies strive to purchase all of the equity of target companies, hedge funds are not limited to working with only equity investments. In fact, a hedge fund can even invest in the debt of a private equity company.

• The length of investments is different as well. Hedge funds like to see turnaround times of 6-18 months, where investments by private equity companies might be held for 7 years or even longer, in some situations.¹⁰  

• When investors put their money into a hedge fund, they can usually take their money out much more quickly than they would be able to with a private equity company.¹⁰ 

• Private equity companies put a large effort into the research of an industry as well as a company and its strategic direction prior to investing in them, than hedge funds who are more focused on hold periods, returns, and hedging strategies. 

• Hedge funds tend to execute their due diligence much more rapidly than private equity companies do who are more detailed and customized in their approach.¹⁰  

• Hedge funds have a more straightforward methodology and strive for a higher level of return in their investments than do private equity companies who normally adjust their rate of return on factors including market share, profitability, revenue, and valuation statistics.¹⁰

• Private equity companies will exercise a much greater level of control over any companies which they buy equity of. They will often come in and replace the senior management and/or control the board of directors. In hedge fund investments, management is often left in place while that fund strives toward a position of buy and sell trading in debt or equity.¹⁰

• Volatility is considered potential toward receiving higher rates of return for hedge funds where private equity companies might steer away from making such risky decisions.¹⁰

• Both entities charge sizable fees, but these fees are handled a bit differently between the two investment vehicles. Hedge fund fees are calculated for a shorter time frame and more aggressively where as private equity funds are much more long term and handled later in the process to emphasize the benefits of the longevity of the investment.¹⁰

Private equity is also similar to investment banking in that they are involved in raising money for companies who are on need of capital; however they do not raise money by selling stocks and bonds to public markets on behalf of client companies. Instead, private equity firms raise money from high-net-worth individuals and institutions such as hedge funds. Also, investment banks do not take control over the companies they make public, where private equity firms use the money they have raised to take control over the business they are working with. In most cases, the private equity firms will become co-owners or even sole owners of the company. ¹

MAIN FUNCTIONS

Though private equity is a complex investment vehicle with many characteristics, its functions mainly exist to raise money for companies who are in need of extra capital.⁷  In return for its assistance, the private equity firm will take ownership of and claim stakes in the company it is raising money for.⁷  Once this is done, the fund will attempt to 'turn them around' and sell their stake at a large margin for profit at a later time, usually in the public markets.¹  So in short, private equity funds will invest in companies who are under-performing which, in turn, generates profit for themselves.¹

INDUSTRY TRENDS

• The private equity market has evolved over the last two decades and the pace has accelerated rapidly over the last few years in particular as the economy has experienced significant change. One aspect has remained constant: private equity is one of the highest profile sectors in the financial markets and has a significant impact on the economy, as it brings large sums of money to its clients.²

• Starting in 2003, private equity experienced a tremendous amount of growth whose momentum did not begin to lose steam until the middle of 2007 as it, like every other financial sector, has been effected by the onset of the credit crunch. In 2007, there was $686 billion of private equity invested on a global level, which is significantly larger than the amount invested in 2006, and more than two times the investments to private equity in 2005.⁸  Since the middle of 2007, the habit of using borrowed money has proven to be troublesome for private equity funds ¹ as lenders have lost interest in investing in unstable companies as a result of leveraged buyouts ¹. Some reports seen by Thomson Reuters have recorded a 69% decrease in leveraged lending between quarter 1 of 2007 and quarter 1 of 2008 1, and 2008 saw almost a 40% decline in investments when compared to 2007.⁸  Still, 2009 is seeing sharp declines as well. In order to move forward without as much credit from the large banks, many companies are now trying to put a higher percentage of their own money into deals or even trying to buy smaller components of public companies rather than purchasing the entire organization.¹

• One of the current more common techniques used by private equity companies is known as a 'leveraged buyout' or LBO. In this case, the fund will use this technique for part of or all of a company's purchase costs and the acquirer will use debt instruments to raise the capital which is necessary to buy that company. Many times, the acquirer will also use the target company's own assets as collateral. Other times, the Managers of that company will do what is known as a 'management buyout', where they will even help the private equity fund to raise the money needed to purchase a stock of the firm they are running ¹.   
 
• Private equity firms have become increasingly involved in the acquisition of retailers as they often have positive cash flows. These positive cash flows are typically a result of retailers not needing to pay manufacturers until 30-60 days after a sale is made. This allows the private equity firms to negotiate an extra 1-2 months on payment terms so they can 'sit' on that cash allowing them to maximize their cash flow and investment options .¹²

CORPORATE STRUCTURE

Positions in private equity typically fall under one of four categories: number crunching, appraising and executing deals, originating deals, and in support roles such as marketing, human resources, and finance ⁷.

Those who go down the 'number crunching' road are often employed through a two-year contract and function to analyze and potential accounts of the companies which their employer is looking to invest in, and build complex financial models. These models are then used to calculate the worth of the companies being considered and, in some case, assist in the forecasting and transaction modeling ⁷. Often times, these Analysts work with the Lawyers to undertake the due diligence that will allow deals to work properly ⁷. Once these Analysts have done their part, the models are now analyzed by others, usually with more experience, who will make decisions regarding the worth of the company and the advantages and disadvantages in investing in it at their asking price. These are the people who appraise and execute deals who are also referred to in some companies as 'Principles' ⁷. If these individuals determine that there is a potential profit in the future as a result of investment, a deal will be executed. This can involve obtaining legal documentation, negotiating the correct price, and any other tasks necessary to make the transaction happen.

At this point, the information is passed to an originator, who is often even more senior than a Principle and is often a partner of a fund. The Originator will oversee the entire deal as it is in process and in building relationships with Senior Managers or Advisers. Usually, the Originator is involved in a large amount of travel but also takes away the largest percentage of profit from the deal ⁷. The Originators, along with the principles, are also responsible for following through after a deal takes place in order to take a firm position in the company which has been taken over and ensure that profitability is maximized ⁷.

Other support roles in private equity might involve support in the selection of companies to review and invest in. This includes investor relations where some employees communicate with investors and raise money for future funds including pension funds, wealthy individuals, or insurance companies ⁷.

Regardless of which company, candidate, or specific role, one thing is for certain: private equity firms only want to hire superior employees who are incredibly driven, mature, hard-working, and intelligent ². As competitive as the market has always been, it is even more saturated now as there has been an increased interest in private equity among financial professionals and there are certainly more qualified people than there are jobs today ².

Regardless of his or her background, in order to secure a role in any capacity for a private equity firm, a candidate should start early in an attempt to stand out among all of their peers and competitors. Almost all private equity funds hire professionals at the junior level as analysts in support roles ².

Private equity companies tend to hire MBA candidates for most positions although, at the junior level, professionals are expected to fulfill high expectations and if they have not yet received an MBA, they are often expected to do so. This being said, there are many situations where candidates are brought into private equity from the investment banking sector and, at times, consulting training programs, but there is often an expectation for those candidates to work toward their MBA at that point ². This is known as the pre-MBA hiring program where private equity firms often hand select qualified candidates for these programs by seeking out those who are just completing two year programs from some of the larger investment banks ². Often times, offers are made for these candidates a full-year before their employment is expected to begin ². For those who are coming from a banking or consulting program, most have an impressive program involving participation in high-profile projects for reputed financial firms. PE firms prefer candidates who have 2-3 years of experience in an investment bank, management consulting firm, or accounting firm. MBAs are highly sought after here ¹.

STRATEGIES IN PRIVATE EQUITY

In an ideal circumstances, private equity funds will make money by investing in companies who are under performing, attempt to 'turn them around', and sell their stake at a large margin for profit at a later time, usually in the public markets ¹. In some situations, the funds will do what is known as 'asset stripping' where they will break up a company for its assets and sell them separately in order to make a profit on them ¹.

In order to move forward without as much credit from the large banks since the credit crunch starting in 2007, many companies are now trying to put a higher percentage of their own money into deals or even trying to buy smaller components of public companies rather than purchasing the entire organization ¹.

Generally, the private equity industry utilizes one of four different types of strategies: Venture Capital, Leveraged Buyout, Mezzanine, and Secondaries/Funds of Funds investors.

Often times, private equity firms focus on trying to bring value to companies who have already been set up through restructuring or management changes ¹. Within the broad category of private equity known as Venture Capital, firms focus on investing money into new businesses ¹ who are in need of capital in order to grow ⁷. Venture Capitalist's funds tend to have an understanding in relation to the impact of products, technologies and marketing strategies on markets and take a minority stake in the company. In many situations for this particular brand of fund, the Venture Capitalists will not take a controlling stake in the company ⁹.

Some companies enter a Leveraged Buyout (LBO), in which case that company has a proven product and a stable cash flow but is not performing at the level it could or should be. Many times, companies who are bought out are more successful, smaller components of larger companies who are not doing well. Other times, a smaller component or subsidiary might not be essential anymore to that larger companies operations and might secure a strong position in the financial market on its own so it is bought out. LBO companies are focused on control and deal structure - they are often concerned with the 'worst-case' outcomes and attempts to minimize any potential risks through deal structures. Unlike with Venture Capitalists, when there is an LBO, the company who is purchasing will usually take a controlling stake in the company ⁹.

A mezzanine fund is a form of financing typically used between business start-up and stock market floatation where unsecured loans are often offered in return for an ability to take shareholding of that company in the future. Often times, the smaller companies use this to gain access to additional capital from lenders they many not have had exposure to otherwise ⁸. Mezzanine funds are more interested in debt-like securities and usually generate lower returns than the other strategies ⁹. These types of funds have become more prevalent in the last decade as multi-billion dollar specialized mezzanine funds have been raised.

The final main strategy in private equity is that of secondaries or fund of funds. This type of fund does not directly invest into operating companies. Instead, it purchases interests from institutional investors into existing private equity assets ⁸ and can involve the sale of private equity fund interests in private companies ⁹. Essentially, these Asset Managers choose to allocate capital among multiple funds, including both venture capital and LBO, which allows them to diversify a portfolio ⁹. Not only do these sellers sell the private equity fund investments, but they also sell the remainder of their unfunded commitments to the funds ⁸.

Other, more complex strategies involve real estate investments as a separate asset class, investments in infrastructure such as public works like bridges, tunnels, and airports; energy and power, and merchant banking where the private equity investment is negotiated in unregistered securities within both public and private companies ⁸.

Most private equity funds are not large in terms of the number of employees. Most funds employ no more than 30 people on staff. However, total profits, even in "smaller" firms, can make in excess of $1.5 billion. Most of the employees (the Principles, Originators, and even the Appraisers and Executors) tend to share in the profit and carried interest, although the more junior number crunchers usually need to work their way up the ranks in order to bring home the large compensation packages ⁷.