Figuring out what a Private Equity Buyout fund does can be confusing…
There is a lot of misleading information out there, written by people without any insight…
Luckily, we are here to help and the industry definition of a Private Equity Buyout Fund is:
“Private equity buyout funds buy a company owning it for 3-7 years with the aim of making a return on their investment of 15-20% per year for the period the company is held”
In order to do this, well a private equity fund needs to excel in three main areas…
Buy well, sell even better and maximize value while holding the investment.
In the following figure we have summarized what a private equity fund does and below, we will expand on the concepts presented within the figure.
Private equity investors
The investors in a private equity fund are usually large institutional investors (such as pension funds) and high net worth individuals.
A private equity fund will usually have a term of 10 years. It will usually invest in 10-12 investments over a 5-year period (investment period). In the last 5 years it will realize (sell) these investments (realization period).
A Private Equity firm will always have at least two active funds, with the younger being in the investment period and the older in the realization period.
How does private equity funds work?
In the following we will cover how private equity funds work and create value in their investments. After all, a return requirement of 15-20% per year is a high number and significantly more than the 8% per year the stock market delivers. In the figure below we have highlighted what this means in terms of absolute returns. As can be seen, a return of 8% roughly doubles the money over ten years, while ten years at a 20% rate means having a 5.3x return on your capital!
Finding and buying the right companies
During the investment period, the main aim for a private equity fund is to commit its capital and find the right investments. Naturally, there is a significant focus on sourcing these investments with the two primary ways being:
1: Proprietary sourcing, where the firm will draft a letter of intent and make direct contact to the owners of a company. This letter of intent will include their view on the valuation of the company and their plans for the company, should the owners decide to sell it.
Sourcing deals in proprietary processes, that are by nature bi-lateral is the preferred way for most private equity funds. As they are the only buyer in the process this makes it possible to get a company at an attractive price through bypassing an auction process.
However, this is often hard to do for private equity funds, as the company owners will often contact investment banks and run an auction process if they have been approached by a potential buyer.
2: Structured auction processes, where an investment bank is appointed to run a sales process. As part of the process, private equity funds will be contacted due to being a potential buyer. From this point on, the fund will over a period of 3-4 months decide whether or not this company is attractive.
In an auction process, the fund will usually expend significant resources and time in a bid to make itself attractive to the owners of the company. The objective of this is to be in a position to win the auction process even if the fund does not offer the highest price for the company.
A fund will position itself both through building personal chemistry with the owners of the company, as well as presenting a business plan that the owners will hopefully find interesting. Both are important if the current owners of a company will hold a minority position during the private equity ownership (which they usually do).
Creating value in investments
There is an almost endless array of options the fund has to create value when owning an investment. During due diligence, the fund will identify areas that can be optimized and many funds operate with a 100-day plan after acquiring the company, as well as longer term strategic goals.
With that said, there are three main ways in which a private equity fund create value in their investments. These can be grouped into creating value through growth, through process optimization and through financial engineering. Most funds are rather generalist and focus on all three, however, there are also very specialized firms focusing primarily on only one of these levers.
Creating value through growth
Funds focusing on creating value through growth will usually be interested in acquiring companies with high growth rates or strong market positions.
Organic growth initiatives…
… focus on growing the firm through its existing platform. There are three value creation levers, that private equity firms primarily use, presented below.
Geographical expansion focus on taking a well-established business into new geographical areas.
As an example, if you have a successful business in Texas, there is no reason why this business shouldn’t be successful in other states. It would thus be logical to expand this company into states such as Oklohoma, New Mexico and other neighboring states.
Another way to increase revenue is to expand the product line. In doing so, a company will choose a product which can utilize the production channels and marketing efforts that are already part of the company.
As an example, if you have a biscuits factory, it would be natural to start producing and selling cookies. This product uses the same production techniques and is distributed through the same channels (supermarkets) thus creating little risk for the company in introducing these.
The last organic growth initiative that most funds will use is to increase sales and marketing efforts. Often, a company led by individuals with a production or engineering background will have invested less than optimal in these efforts. It is thus a low hanging fruit for private equity funds to focus on.
Creating value through M&A
Besides organic growth initiatives, many private equity funds will engage in M&A activities. Compared to organic growth initiates, participating in M&A requires another skill-set, which company management usually does not possess. This is thus an obvious area for private equity funds to leverage their expertise.
Buy and build M&A focus on acquiring a “platform” company, to serve as (you guessed it) a platform. The aim is to buy a market leader in a very fragmented industry. Despite being the market leader these companies will usually not have a market share higher than 1-2%.
As an example, assume the Enterprise Value of a company is USD 100m when its acquired by the PE fund. This company will then buy a large number of smaller competitors and industry players in this fragmented industry. The companies bought may be as small as having an enterprise value of USD 1m.
It is not unheard of to merge 20-25 companies into the platform company. These small companies can usually be bought for very low multiples (4-5x EBITDA).
If you can integrate these into the platform company which will usually trade at 8-10x EBITDA, the revenue and EBITDA in the acquired company will in an instant be worth twice as much as the fund paid for it. This is referred to as multiple arbitrage.
Strategic acquisitions is a more “classical” form of M&A that is often reported on in the news. This takes the form of buying 1-3 large competitors or companies with complementary offerings.
The aim is to reach significant synergies through geographical expansion, acquiring new product lines (as with organic growth) and/or to save on administration and overhead.
Creating value through operational improvements
PE funds creating value through operational improvements, will usually be acquiring stand-alone companies struggling with low margins.
Alternatively, companies are also acquired through complex corporate carve-outs where a larger company for one reason or another, wants to sell one of its divisions or brands.
Optimization of production processes is pretty self-explanatory. This will usually entail a thorough review of all processes and product lines. The aim is to streamline production processes and to assess which product lines are profitable and which are not.
For smaller (up to USD 200m in Enterprise Value) companies, it is not unusual for a large quantity of product lines to simply not be profitable.
Besides the obvious benefit of not producing something of value to the company, this will also free up space on the production floor.
New IT and reporting systems. Often, the IT and reporting systems in smaller companies will be of a low standard, with procedures being sub-optimal. Further, there will often be IT-systems that “do not talk together”.
Streamlining these processes can often lead to large savings in administration and other overhead costs.
New board of directors (“BoD”). Upon acquisition of a company, a PE fund will almost always insert a new board of directors. Usually, several members of the PE fund will be on the board.
Also, many family owned companies will have a BoD that is “more for show”. A PE fund will populate the board with industry experts and usually instill quarterly meetings.
New management resources. In some cases, the management of the company acquired will need augmenting. Sometimes, a CEO or other top management will need to be replaced and in other cases, a company simply needs to add management resources in order to continue its growth path.
In both instances, the network of a PE fund can bring significant advantages.
Creating value through financial engineering
Creating value through growth and operational improvements is very operational in nature.
This is in stark contrast to financial engineering which focus on financing part of the acquisition of a company with debt. To see how this creates value (to equity holders) consider the following example.
A company is bought for USD 200m. It is financed 50/50 by debt and equity corresponding to USD 100m in both. Two years later, the company is sold for USD 300m. The bondholders get their money back and the private equity fund doubled its money and made USD 200m on the deal.
If this deal had been financed entirely by equity, the fund would “only” have made 50% on its investment.
It is the same mechanics that are at work in homeowners’ mortgage. Houses are financed with a high degree of leverage and if the price of the house goes up, the homeowner receives all the upside and become substantially richer despite putting in only a small amount of equity.
Selling portfolio companies
This leads us to the last part of the puzzle for a private equity fund. It has acquired a company, created value during ownership and now it has to exit the investment.
In doing so, there is a large degree of timing of factors controlled by the fund (company-related) and factors outside the control of the fund (macro-environment).
While there is no definite checklist, we will present some examples to highlight what constitutes good exit timing:
Investments have proven their worth (company factor)
Consider a company that has pulled all organic growth levers. In the years in which the investments were made, the company realized somewhat lower earnings compared to earlier years due to these investments.
Now, during the last financial year, the company has seen a significant uplift in earnings due to these investments. It would thus be an advantageous time to sell as the investments have proven their worth.
Contrast this to a company that has just made these investments. Sentiments in the company is that these investments will be worth a lot of money, however, there is nothing to show for it.
No sane buyer would attribute full value to these company estimates and thus, this would constitute bad exit timing.
A recession (macro factor)
During a recession, there are fears over the development of the economy and companies usually trade at discounts compared to long-term values. It will thus be near impossible to get the price the company would command in a “normal” market.
Further, there is less capital available during recessions and this would inevitably lead to fewer potential buyers, impacting the price further.
Financial market shock (macro factor)
The Brexit event in June 2016 led to severe uncertainty over British economy. While it did not constitute a recession, it created a large amount of uncertainty in the market.
Financial markets do not like uncertainty and thus, selling a company in the wake of Brexit would constitute bad market timing.
As a matter of fact, many potential M&A deals fell through due to Brexit.
The above only applies for private equity buyout funds. While this is usually what is referred to when talking about “private equity” there are also other forms of private equity firms. These include venture capital funds, hedge funds and natural resources funds, which we hope to cover with deep dives in the near future.