Private Equity Flashcards
Traditionally, what is Private Equity (PE)?
The heavily-leveraged acquisition of controlling stakes in private companies with a moderate-to-high growth potential over the medium-to-long term.
A public company can be the target of a PE acquisition, where it will be taken private as a result. Debt-to-Equity in leveraged buyouts (LBOs), considering mezzanine finance, is typically 75:25. Holding periods typically range from 3-10 years, with the average being 5-7 years. PE is similar to Venture Capital (VC) in its modus operandi, mainly differing in that it typically targets early-medium to late stage corporations.
How does Private Equity generate profit?
By using its controlling stake to optimize and grow its portfolio company, thus increasing its value beyond the initial purchase price and realizing a gain on resale.
This strategy is not executed directly by either the PE House or Fund, but rather on their behalf by professional managers, who they typically (but not necessarily) bring in from outside.
Legally speaking, how is a Private Equity Fund (PE Fund) typically structured?
As a Limited Partnership (LPs), which comprise at least one general and limited partner.
See: Limited Partnership Act 1907.
The primary document governing this structure is the Partnership Agreement, but in an LBO, there will be other critical documents. The former partakes in managerial decision-making whereas the latter does not. However, the former is exposed to unlimited liability whereas the latter is not. These entities are regulated by the FCA under §19 FSMA 2000.
Why are PE Funds typically structured as LPs?
To insulate the Fund’s investors against risk and to benefit from the structure’s tax transparent treatment.
How is a Leveraged Buyout Structured?
- Level 1 | Managers and Investors: The Fund will hire a Manager to act as General Partner for the LP.
- Level 2.1 | NC1: The Fund and its Manager will invest into NC1 in exchange for shares and notes.
- Level 2.2 | NC2: NC1 will invest all of its capital into NC2 through either an intercompany loan or share subscription. Junior and Mezzanine Lenders will invest in exchange for security and covenants.
- Level 2.3 | NC3: NC2 will invest all of its capital into NC3 by the same means as NC1. Senior Lenders will invest in exchange for security and covenants.
- Level 3 | Acquisition: NC3 purchases the Target, who will provide the Senior Lenders with security and guarantee.
Why do both the Manager and Private Equity Fund invest into a Target’s equity?
To align the interests of shareholders and managers, namely by erasing the distinction.
Importantly, the Fund will invest more heavily into the Target’s equity than will the Manager (≥70%) because it wishes to maintain ultimate control over the Board. Important to note, however, is that much of a Fund’s equity investment will also be mezzanine in nature. Further, the Manager’s return is largely comprised of a fixed salary. Thus, it cannot be said that owner/controller distinction is completely erased.
‘Skin-in-the-Game’ aside, how else does Private Equity align the interests of Shareholders and Managers?
The market’s illiquidity and Bad-Leaver provisions act to strongly bind Managers’ interests. Also, the Funds expertise, combined with its ultimate power, allows it to effectively monitor its Managers.
What is the Purpose of Structuring a Leveraged Buyout as such?
To subordinate investors’ priority.
The debt’s ranking is inverse to the stage at which it is invested, i.e. NC3 ranks first. The purpose of subordination itself is to accommodate different risk appetites, and by extension, yield targets.
What is the Purpose of using so much Leverage?
To multiply potential returns. Smaller own capital investments into an LBO increase relative ROI, and the using external capital allows a House to invest its own capital into more Funds.
Debt tends to be a cheaper investment than both equity and retained earnings. Debt is likewise more customizable and speedier to acquire than equity. Houses are thus well-advised to seek debt from a variety of providers in a variety of forms, as exemplified by the typical LBO structure. Leverage, however, is hard-capped by the portfolio company’s cashflow, which is used to service the debt (principal and interest), and its collateralizable assets.
What is the Lifespan of a Private Equity Fund?
PE Funds have no hard-and-fast lifespan, but generally last for 10 years. The first two years are spent investing, the next four capitalizing on those investments, and the final four realizing value gained therefrom.
During the Fund’s life, investors’ capital is subject to a Lock-Up provision that prevents them from divesting. Once the Fund is unwound, all capital must be returned to the investors.
What are a Private Equity Fund’s exit routes?
In order of most to least common:
- Trade Sale to a Trade Buyer.
- Secondary Buyout to another Fund.
- IPO.
A Trade Buyer is one who is in the same business as the company being sold. Secondary buyouts may be explained by Funds’ varying focus on different levels of market capitalization, i.e. one Fund losing interest in a company once it reaches a certain size while another takes interest. IPOs tend to be the least favorable because they do not consitute a clean break for the Fund and their unguaranteed success which requires hedging.
For the Private Equity Fund, what are the Problems posed by the Illiquidity of their assets, i.e. portfolio companies?
A lack of quoted prices may make it difficult to either find a buyer or to consistently sell at an optimal price.
Illiquidity is an attribute of the extremely high barriers to entry in PE.
What is the Advantage of Non-Amortizing Debt from the perspective of the Private Equity Fund?
It is less strenuous on the Target’s cashflow, thus enabling higher leverage.
According to Gullifer and Payne, what Advantages do Portfolio Companies enjoy over Public Companies?
- Better-aligned shareholder/manager interests.
- Better profitability, due to the use of leverage.
- Better monitoring from shareholders, due to Funds’ sophistication and concentration of power.
- Better-optimized Boards, due to their relatively smaller and more specialized compositions and more regular assembly.
- Better managerial discipline, due to a more optimal debt:equity ratio and proximity to the capital markets.
- Fewer corporate governance compliance obligations, due to their private nature.
- No short-term pressure from shareholders to regularly return capital or increase stock prices, due to PE’s modus operandi.
