If you don’t work in finance, you’ve probably still heard a lot about investment banks, but you might not be very familiar with private equity firms. We generally say private equity firms are the “buy-side,” because they use the raised capital to buy financial securities of private companies. On the other hand, we say investment banks are the “sell-side,” because they mostly sell securities on behalf of their clients.
So, what are the Characteristics of Private Equity Firms?
Private equity firms raise money from pension funds, university endowments, fund-of-funds (a fund that invests in other private equity funds), high net-worth individuals, foundations, insurance companies, etc. With the raised capital, they invest in other private companies as part of their portfolio companies.
Private equity firms are structured under Limited Partnership Agreements (LPAs), which define specific terms and conditions between general partners (GPs) and limited partners (LPs). Private equity firms are the GPs and their investors are the LPs. A GP manages the fund and has full liabilities, while LPs don’t participate in the fund management and only have limited liabilities.
GPs earn a fund management fee, which is usually 2% of the invested capital of the fund. GPs could also earn a carried interest, or carry. This fee is usually 20% of the excess return. To earn the carry, the GPs must outperform the hurdle rate, which is the minimum return required by the LPs. The carry can be a huge incentive for GPs to do their best in managing the fund.
1. Leveraged buyout firms (LBOs) are mostly large private equity firms in terms of revenue, such as Blackstone and KKR. They tend to purchase a controlling interest of the companies. One of the characteristics of LBOs is that they acquire other companies using a small amount of equity and a large amount of debt, as the high debt levels can significantly boost their equity returns.
2. Growth equity firms are mid-size private equity firms, such as Summit Partners and TA Associates, that operate with the goal of scaling the portfolio companies' business.
3. Venture capital firms are relatively small private equity firms, some examples being Accel and Sequoia Capital. They tend to purchase minority stakes and invest in early-stage companies.
The goal of private equity firms starting a fund is to exit the fund for a profit after its investment period. While owning the company, private equity firms will try to increase the value of the portfolio company by providing capital, strategic guidance, or the opportunity to synergy with their other portfolio companies. Some of the exit options for private equity funds are through initial public offerings (IPOs) or sales.
1. Initial Public Offerings (IPOs)
Private equity firms can bring a private company to the public through initial public offerings. This means they can sell some or all of their stakes to the public market. People like me (as an example) will be able to purchase some of the shares of the company.
2. Sales
There are two kinds of sales—strategic sales and secondary sales. In strategic sales, private equity firms can sell the company to a strategic acquirer, which aims to improve its competitive advantage and market position through a merger and acquisition transaction. In secondary sales, private equity firms can sell the company to other private equity funds.
To conclude, these are just some of the basics when it comes to understanding private equity firms. If you are interested in learning more, you can use the references I used through my research about private equity firms.
References
James Chen. (2020, April 30). Private Equity. Retrieved from https://www.investopedia.com/terms/p/privateequity.asp
Tara Mastroeni. (2021, January 26). What is Private Equity? Retrieved from https://www.businessinsider.com/private-equity-investment
Michael Ng. “The Essentials of Private Equity - What You Need to Know!” Udemy.com, December 2020, https://www.udemy.com/course/the-essentials-of-private-equity/