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Private Equity as an Asset Class

Private equity is an asset class which involves private ownership (equity) of assets – in a very simplified example, look at private equity as any controlling or influential ownership in a business (we will provide an expanded example below). Private equity looks to achieve above market returns that are uncorrelated with stock indices. As such, private equity is an excellent source of diversification in an investment portfolio.

Any investment that offers above market returns and reduce a portfolio’s risk profile is attractive to most asset managers. However, generally only large institutional investors and ultra high net worth individuals have access to private equity funds. This is not to say that private equity is less risky than public equities, just that the lack of correlation with the general market can enhance the average risk-adjusted return.

The asset class is not readily available to most investors, as private equity holdings are opaque (difficult to ascertain value readily, in contrast to a publicly traded stock like TELUS, where you can see the value the investing public prescribes it every day) and illiquid (private equity positions tend to be 1) large and 2) a controlling stake in an entity – this position cannot be easily sold off without a process with substantial transaction costs, unlike paying TD Waterhouse $10 to sell a block of your TELUS shares).

Limited partners (LPs) in a private equity fund may find it difficult to cash out before the life of the fund ends and all the capital is deployed. This can be 5-10 years, notwithstanding the use of secondaries private equity funds.

Types of Private Equity Firms

  • Buyout/Succession Capital
  • Growth Capital
  • Management Buyout
  • Special Situations
  • Distressed (including loan-to-own)
  • Turnaround
  • Non-Strategic Divisions

How Private Equity Firms Make Money

There is a distinction between private equity itself and the private equity firms that bankers recruit for. Anyone who buys a house and rents it out can consider themselves dabbling in private equity – how private equity firms operate is a little different.

Private equity firms raise funds to invest in various opportunities. Funds of funds, pensions, institutional investors and high net worth individuals will contribute as limited partners. The private equity firm will be the general partner and charge a management fee for assets under management (usually 2%) and they will be eligible for incentive pay (usually 20%, known as carried interest or profit participation).

Often, the general partner (GP) will only be allowed to participate in abnormal profits should contracted hurdle rates be met (the fund has to return more than 20%, for instance). There is an abundance of contractual language that protects the limited partners. The GP may also have a high water mark, so that any losses will need to be recovered before profit participation can commence. Also, there may be clawbacks if the fund does well and distributes to the GP before performing poorly – the GP may have to return those distributions.

Once the funds are raised, this vintage is locked up for a certain period while the fund invests. Once businesses are improved through the steady hand of private equity management and cost cutting and debt is paid off, everyone is happy.

What You Do as a Private Equity Associate

On the investment banking side, you are sending teasers to clients for prospective investments. In private equity, you are the client. Associates will flip through these teasers and toss 95% of them in the garbage as they do not meet hurdles or have commercial flaws that are obvious.

On the 5% of deals that are screened further, a lot of analysis goes into what makes the investment worthwhile and at what valuation. Corporate finance knowledge is essential, especially an understanding of optimal capital structure to ensure returns for investors are at their maximum.

Once an investment is targeted a sincere attempt to purchase is considered, there is an abundance of commercial, transactional and legal due diligence that needs to be performed. This is a large reason why PE firms prefer investment bankers and consultants with ample deal experience.

Private Equity Returns

From our synopsis above, we mention that private equity is uncorrelated with the stock market and tends to generate above market returns. This is because the return profile is based on the cash flows of the company.

Let us assume you have $100,000 and open a bar using the money – you do not borrow any money from the bank.

The bar generates $200,000 in net revenue from beverage sales (taking into account the cost of the beer) and you have to pay two bartenders, rent for the real estate and miscellaneous overhead. After your expenses, you have $40,000 in pre-tax earnings.

The government takes 25% of your earnings in tax and you are left with $30,000 – this translates to a 30% return on investment and 30% return on equity (given you did not take on any debt).

This is a good example of the low correlation with market. To some extent, there will be some sort of relationship between your business and the market (if the stock market is bad, the economy tends to be bad, and sales at the bar tend to be bad).

However, this relationship affects your return less so than other factors (did you pick the right location for the bar, is it well managed) – as such the realized cash return will likely be much more consistent than fluctuations in the market which reflect not just earnings, but factors such as valuation multiple expansion and momentum.

The expected return on the bar (30%) is also much higher than the expected return on the stock market (~8%). This is because return must be commensurate with total risk (which includes business specific or idiosyncratic or diversifiable risk) – otherwise no one would bother taking on an active business when they can passively invest.

The Benefits of Leverage

The term leveraged buyout or LBO is synonymous with private equity. A leveraged buyout entails using a substantial amount of debt to purchase an operating business, and the reason why is steeped in corporate finance theory – if your cost of debt is lower than your unlevered return on investment, you can boost your return. Let’s first walk through how leverage improves returns.

To demonstrate, let us go back to the example of the bar. The bar generates a 30% return on an unlevered basis. Let’s say that you manage to take out a $50,000 loan from your parents (the bank will obviously not fund this unless the bar has a steady operating history and makes certain assets available for first lien collateral) which has interest of 10% per year.

This means that your personal cash outlay is $50,000 and you have an operating return of $40,000. You pay $5,000 in interest to your parents, which gives you a pre-tax profit of $35,000. After tax, you have $26,250 in net income. Measured against your initial investment of $50,000, you have juiced your return on investment to over 50% from 30%. You have enhanced your return in two ways: 1) a lower cost of funding; and 2) the tax savings from interest (interest is tax-deductible).

A Basic Example of the Leveraged Buyout (LBO)

Let us assume that Matt purchases your bar in a leveraged buyout, with the same logic – except he wants to layer on as much debt as possible and exit his investment after 5 years. Matt buys the bar from you for $200,000 (you are happy and Matt has run a model, so he hopes he will be happy).

However, Matt layers on as much debt as he can – he gets $50,000 from the bank with an amortizing loan which has a first lien security on the bar and all of the beer. Matt also manages to raise $100,000 in high-yield debt via private placements from his Bay Street friends. Matt’s cash outlay is $50,000.

However, he has experience running bars and feels he can improve the pre-tax and pre-interest operating profit to $60,000. He thinks he can sell the bar to a chain at a 6x multiple of operating profit in a few years and achieve a 30% internal rate of return.

That is a simple example of an LBO.

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