Private Equity

Every possible investment choice is either an alternative or a traditional investment. Traditional investments are investments in:

• Long-only, publicly traded investments in stocks.
• Long investments in publicly traded bonds.
• Cash.

In this context, traditional is not a synonym for “common.” Likewise, alternative is not a synonym for “unusual.” Alternative investments include assets such as:

• Private capital.
• Real assets.
• Hedge funds.

Alternative investments often supplement traditional investments held in a portfolio.

Why Consider Alternative Investments?

An investor should consider alternative investments for a number of reasons. To begin with, alternative investments offer a range of investments that have low correlations with traditional investments.

In addition, alternative investments allow investors to enhance the risk-return characteristics of their portfolios and increase their returns. Last but not least, alternative investments improve an investor’s return potential thanks to their higher yields.

Characteristics of Alternative Investments

Alternative investments have the characteristics listed below:

• Investment managers limit their specialization to alternative investments.
• Alternative investments have a relatively low correlation of returns to traditional investments.
• Alternative investments have less transparency and regulation compared to traditional investments.
• Alternative investments have inadequate historical risk and return data.
• Alternative investments have unique tax and legal issues.
• Alternative investments have higher fees, usually made of performance (incentive) and management fees.
• Alternative investments are typically concentrated portfolios.
• Alternative investments usually have limitations on redemptions, such as lockups and gates.

Categories of Alternative Investments

 Alternative investments are divided into broad categories:

1. Private Capital

• Private equity investors might participate directly or indirectly through private equity funds. Private equity funds make investments in both new and established businesses. Note that these firms may not be listed on a public exchange. Alternatively, private equity funds may invest in public companies with the intent to privatize them.
• Private debt is primarily provided to private entities. Examples of private debt include direct lending, mezzanine loans, venture debt, and distressed debt.

2. Real Assets

• Real estate investments are made in buildings or land, either directly or indirectly.  Such investments consist of private commercial real estate debt and private commercial real estate equity, such as the ownership of an office building, public real estate equity, and public real estate debt.
• Infrastructure assets are long-lived, capital-intensive real estate resources such as airports and power plants. An increasingly popular method of investing in infrastructure is the public-private partnership (PPP) strategy, in which case both public authorities and private investors have an interest.

• Natural resources include commodities, agricultural land (or farmland), and timberland.

• • Commodities: These investments may be made in physical commodity products, such as grains, metals, and crude oil.
  • Farmland/agricultural land: Agriculture involves the rearing of animals or plants. Investing in agricultural property, therefore, encompasses a variety of methods, such as leasing farmland or receiving income from the sale of agricultural produce such as corn, milk, or meat.
  • Timberland: Investing in timberland often entails putting money into managed or natural tree plantations to reap a profit when the trees are harvested.

3. Hedge Funds

Hedge funds employ numerous strategies to offer investors optimal returns. These private funds are actively managed—often by “star investors”—and apply aggressive strategies across asset classes.  Most hedge funds use derivatives, high leverage, arbitrage, and other investment strategies unavailable to traditional fund managers. Redemptions are typically restricted in some way such as lockup periods, notice periods, and redemption fees.

4. Other

Other alternative investments include collectibles and other investments that don’t fall into the traditional categories. Collectors have been around for centuries, and the investments are as varied as the collectors themselves. Traditional collectibles such as stamps, cars, furniture, gems, fine art, and others still dominate the market. However, new collectibles, such as baseball cards, action figures, and almost anything you can imagine, offer investors new ways to invest their money outside traditional financial markets.

There are indices used to track the values of certain collectible markets, such as stamps, and these collectibles are auctioned in small markets. It is worth noting that some auctions are open to the public while others are not.

Question

Which of the following is most likely an example of private equity investment?

A. Investing in a mutual fund.

B. Investing in a publicly traded company.

C. Investing in a new or established business not listed on a public exchange.

 Solution

 The correct answer is C.

Private equity investments involve investing in companies that are not publicly traded and are usually acquired by private equity firms or funds. The aim of these investments is to provide capital to help the company grow and improve and eventually sell the company for a profit.

A is incorrect. Investing in a mutual fund (A) is typically a traditional investment strategy where investors pool their money to invest in a diversified portfolio of stocks, bonds, or other assets.

B is incorrect. Investing in a publicly traded company is also typically a traditional investment strategy, where investors buy shares in a publicly traded company on a stock exchange.

Private Capital

Private capital refers to investment in assets that are not available in public markets. Private capital consists of private equity and private debt.

Private Equity

Private equity is an investment in privately-owned or public companies to privatize them. A private equity firm manages a private equity fund as a collection of investments. The company in which the firm invests is referred to as a portfolio company. Some of the primary types of private equity include:

• Leveraged buyouts.
• Venture capital.
• Growth capital.

Leveraged Buyouts

Leveraged buyouts (LBOs) arise when private equity firms create buyout funds, also called LBO funds, to acquire developed private or public companies. This arrangement finances the largest portion of the target company’s price through debt. The collateral for the debt consists of the acquired company’s assets whose cashflows are sufficient to repay the loan.

Upon conclusion of the buyout transaction, the acquired company transitions into private ownership. LBOs are two-fold: management buyouts (MBOs) and management buy-ins (MBIs).

In a management buyout (MBO), the existing management team is retained and incorporated into the acquisition. On the other hand, in management buy-ins (MBIs), the current management team is replaced with the acquiring company’s management. The acquiring company improves such outcomes as cash flow and revenue growth of the acquired company.

Venture Capital

Venture capital (VC) involves providing financial support to or investing in private companies with high growth potential. Financed companies are usually start-up companies. Nevertheless, venture capital is also applicable to companies at any stage of growth, provided the company in question qualifies for funding. It is, however, imperative to note that the venture capital extended to a start-up company will demand higher returns due to high-risk potential. Equally noteworthy is the fact that venture capitalists are active investors.

Venture capitalists invest in companies and earn an equity interest. In other words, they provide funding in the form of debt. Given the foregoing clarifications, we have three stages of venture capital financing:

Stage 1: Formative-stage Financing

Such funding is extended to a company that is at the formation stage. The process of formative-stage financing includes the following:

1. Pre-seed capital or angel investing: Funds are provided at the conception or idea stage. The funds are invested in turning a business idea into a workable business plan. At this stage, funds are sourced from individuals dominantly made up of family and friends. Note that venture capital (VC) funds are usually not utilized at this point.
2. Seed-stage financing (seed capital): This is the stage where VC is used. The funds are used for product development and market processes such as market research.
3. Early-stage financing (early-stage VC), or start-up stage financing: This is where funds are given to companies on the verge of launching operations.

Stage 2: Later-stage Financing (Expansion Venture Capital)

Later-stage financing involves providing funds to companies after starting commercial production and sales. Nevertheless, note that this happens before they venture into an initial public offering (IPO).

Stage 3: Mezzanine-stage Financing

In mezzanine-stage financing, the financed company is prepared to go public. The company is thus financed until its IPO is completed or sold. Note that the term mezzanine implies that a company is financed as it transitions from a private company to a public company.

Other Private Equity Strategies

Another type of private equity is growth capital, also called growth equity or minority equity investing. Growth capital involves minority equity investments. It is a case in which a firm owns a less-than-controlling interest in more mature companies seeking funds for expansion or restructuring, venturing into new markets, or funding major acquisitions.

Usually, it is the management of the receiving company that requests growth capital. The requisitioning company aims to profit by selling a percentage of its shares before it goes public. Quite simply, the company aims to retain its existing management and consolidate its accomplishments.

Exit Strategies

The main objective of a private equity fund is to revive or improve an underperforming company and then exit when the financed company’s valuations are high, usually after an average of five years. Nevertheless, the exit timeline can run between less than six months to over ten years, based on the competitive environment of the portfolio company, general economic cycle, interest rates, and a company’s performance.

Some of the exit strategies include:

• Trade sale.
• Initial public offerings.
• Recapitalization.
• Secondary scales.
• Liquidation or write-off.

Trade Sale

Trade sale involves selling a company to a strategic buyer, for instance, a competitor, through auction or private negotiation.

Advantages of a Trade Sale

• There is an immediate cash exit for the private equity fund.
• There is the motivation for strategic buyers to pay more because they anticipate integration with their businesses.
• The trade sale is fast and simple.
• Transaction costs are lower compared to an IPO.
• There are lower levels of disclosure and hence higher confidentiality compared to an IPO.

Disadvantages of Trade Scale

• There is potential opposition from the management.
• It is less attractive to portfolio company employees than those for an IPO since employees can monetize the shares.
• There is a limited number of potential trade buyers.
• There is a possibly lower price for the sale compared to an IPO.

Initial Public Offering (IPO)

The initial public offering exit strategy involves selling shares (including all or part of shares owned by private equity firms) to the public by a portfolio company.

Advantages of an IPO

• There is a chance of selling shares at the highest price.
• There is a high chance of management approval since it is retained.
• It enhances a private equity firm’s publicity/visibility.
• If private equity holds onto some shares, there will be future upside potential.

Disadvantages of an IPO

• High transaction fees are paid to investment banks and lawyers.
• It involves long lead times.
• There is an imminent risk of stock market volatility.
• An IPO calls for high disclosure requirements.
• It may involve a lockup period.
• IPOs are suitable only for larger companies with appealing growth profiles.

Recapitalization

These are actions a private equity firm takes to enhance leverage in a portfolio company while paying itself a dividend from a new capital structure. Recapitalization is considered an untrue exit strategy. This is because private equity firms usually retain ownership and do not allow private equity investors to withdraw funds from their investments to pay investors. However, recapitalization can be considered a sign of a future exit.

The downside of recapitalization is that GPs can use it to influence the internal rate of return of the funds.

Secondary Sales

Secondary sales involve selling a company to another private equity firm or another group of investors.

Write-off or Liquidation

A write-off exit strategy happens when a private equity firm adjusts its investment value downward in a portfolio company. A write-off may lead to liquidation if the transaction doesn’t work out.

Risk or Return of Private Equity

Private equity funds’ capacity to invest in private companies, their impact on portfolio companies’ management and operations, and their use of leverage contribute to their higher return potential than traditional investments. Investing in private equity, such as venture capital, carries a higher risk than investing in common equities. Investors, therefore, demand a higher return in exchange for taking on more risk, including illiquidity and leverage.

Question

Which of the following exit strategies will most likely yield the highest value to a private equity firm?

1. Liquidation.
2. Trade sale.
3. IPO.

Solution

The correct answer is C.

The highest price can be achieved through an IPO.

A is incorrect. Liquidation has the potential to attract the lowest price compared to the other exit strategies, which include secondary sales, recapitalization, and trade sales.

B is incorrect. A trade sale involves selling a company to a strategic buyer, for instance, a competitor, through auction or private negotiation. An IPO is a more attractive option.