The Private Equity (PE) industry is a very important part of the overall financial services industry. It is made up of thousands of companies around the world that play a key role in financing private companies that are not traded publicly on any stock exchange.

The capital used by PE firms to fund their activities is normally raised from institutional investors (such as large pension funds or banks), insurance companies, high net worth individuals/families, and the partners at the PE firm. PE firms compete for investors’ capital by developing a comprehensive business strategy and through developing a solid track record of successful investments. Once funds are committed, the PE firm can start to make investments and typically would aim for investments in 7-10 portfolio companies per fund. Each fund usually has a pre-determined life span, in which at some point the investment will be realized through a planned sale or exit.

​PE funds and firms are distinctly different from hedge funds, in that hedge funds normally invest in and develop a proprietary trading platform of securities rather than making investments in operating private companies. Venture capital funds are a distinct subset of the PE industry that invest in early or development stage private companies. Most PE firms use some degree of leverage or borrowing to finance an acquisition, and therefore will avoid the inherent risk of investing in early-stage companies.

​Many PE firms specialize in specific types of deals, industries, or deal sizes.

A typical PE firm is made up of two distinct components: the General Partner (GP) and one or more Limited Partners (LPs). The LPs provide the majority of the capital and the GP manages the day-to-day operations of the PE firm. The GP makes the investments on the behalf of the LPs, and often is advised by an investment committee made up of some of the LPs and even outside directors or advisors in some cases. The GP will charge a management fee to the funds for operating the company and will share in any profits (referred to as carried interest) the funds generate when an investment in a portfolio is sold. Normally the LPs receive their paid-in capital back first, plus a hurdle rate return, with the remainder shared at a pre-determined split between the GP and the LPs.

By far, the most common deal type PE firms use is the Leveraged Buy-Out (LBO). This is where a PE firm will utilize different types of loans, along with their equity to finance a transaction. A Management Buy-Out (MBO) is a management-led LBO, where management raises funds through one or more PE Firms, along with their own capital to finance an acquisition. A BIMBO is a Buy-In MBO, where outside management targets a company for an acquisition, with backing from a PE Firm, and takes over managing the company post-acquisition.

During much of the ’80s, LBO’s were used to finance mega-deals with as little as 10% equity contribution by PE Firms. The degree of leverage has been steadily decreasing and post-recession levels are now often below 50% debt, which has lowered the risk profile of LBO financed companies considerably.

​There are many other types of PE deals as well. Some PE Firms focus on PE Recapitalizations, where a founder or majority owner aims to sell part of the company to take “some chips off the table.” These can be structured as either minor or major equity positions by the PE Firm. Others specialize in providing mezzanine capital, which is a form of subordinated debt or preferred shares. Still others provide growth capital to fund a company’s growth strategy, which may be in the form of either debt or equity. Others focus on only distressed or turn-around investments, public company spin-offs, etc.

The capital structure of a typical PE portfolio company may be made up by a combination of:

1) Senior debt – this is the debt financing supplied by a bank or other institution that is secured by the company’s assets. It is the first capital to be repaid if a company fails.

2) Junior debt – this debt financing often is not secured and as a result, is a more expensive source of capital than senior debt, and as such, it is subordinated to the senior lender.

3) Mezzanine capital – this type of capital can be in the form of subordinated debt or as preferred shares. Often warrants are associated with this type of financing.

4) Preferred shares – this type of capital has characteristics of both debt and equity. Preferred shares may pay dividends and are senior to common equity, but subordinated to debt financing. Normally, preferred shares have no voting rights.

5) Common shares – this is the riskiest type of capital and these shareholders control the company.

The way a deal is structured is critical to the success of a portfolio company. When cash flows are relatively predictable and regular, more debt is typically used. When cash flows are uncertain and irregular, too much debt can cripple a company’s ability to operate normally and may place the shareholders at great risk if it were to experience a downturn. Financial engineering uses leverage to multiply the rate of return on a PE Firm’s equity investment. Most PE Firms use some degree of financial engineering to ensure that their minimum rates of return are realized.

Operational improvement strategies are a much more important component of modern PE Firms’ strategies than they were a few short years ago. These strategies can include add-on acquisitions, a core competency in a specific industry, technical or business support, synergies with other portfolio companies, training programs, HR support and many others. Today’s modern PE Firm brings a lot more to the table than capital and operate more like industry players than financial services companies.

While every PE Firm has its own specific investment criteria, some of the common characteristics for a typical Leveraged Buy-Out strategy consist of the following:

Often a PE Firm will look at add-on acquisitions to a portfolio company as a key component of its growth strategy. This could include add-ons to consolidate across horizontal space (similar companies) or vertically (up and down the value-chain). If a portfolio company’s management is meeting or exceeding the PE firm’s expectations, then the GP is more likely to agree to fund further growth through acquisitions.

Working with management

​Most PE Firms will carefully examine management’s track record before investing. Some PE Firms prefer to place their own management into key positions including the CFO and CEO. Others prefer to invest with existing management. Regardless, most will want management to have an equity position to ensure the alignment of interests.

Normally, PE Firms will place some of their key staff on the portfolio company’s board and will provide a supportive and governance role in the organization.

Day-to-day operations remain with management within well-defined boundaries and board-approved policies.

Capital is a commodity. While it can be a scarce commodity that has real value, all Private Equity (PE) firms have it. By itself, it is only one component that can drive business growth and improvement. When considering a sale of all or part of your business to a PE firm, the first question you need to ask yourself is, “what else besides capital do they bring to the table?” A modern, well-run PE firm can contribute a great deal to your company to make it bigger, better, and a lot more profitable.

The experience and skills of the key people in the PE firm combined with your company’s in-depth understanding of the business and knowledge of the market are what can take the business to the next level.

The partners and key staff at a modern PE firm can often provide an outside viewpoint, experience, and expertise in a wide array of areas such as those listed here.

A Private Equity recapitalization is where the owner(s) sells only a portion of the business and remains with the business in a senior executive role to help the Private Equity firm operate and grow the business through its next phase. The seller receives a portion of the value of the business in cash (i.e. essentially, “takes chips off the table”) and reduces their ownership risk, but maintains upside appreciation potential over the longer term.

The retention of equity in the business by the seller demonstrates confidence in its future potential and lowers operational risk for the PE firm, allowing them to pay higher values than would otherwise be possible.