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Private Equity

I’ve been thinking…Just what is meant by the term, Private Equity?

The term private equity refers to a pool of capital in financial markets that is privately owned versus publicly owned.  Private equity is also a form of financing used not only for startups and mature companies seeking growth capital, but also as the primary source of funds to finance the negotiated acquisitions of large companies as well as companies in financial distress or bankruptcy.  The term is also used describe a type of specialized financial institution, such as venture capital firms and buyout firms.

The dominant vehicle used to house private equity funds is the limited partnership.  While there are other types of specialized funds (e.g., mezzanine funds and distressed funds), the two most well-known private equity funds are venture capital funds and buyout funds.  The names of these funds are reasonably indicative of their different business models and the type of companies or transactions each fund addresses.  Over the years, the distinctions between private equity funds have been blurred, and now the buyout business is often referred to simply as private equity.

Private equity funds are formed by private equity firms.  Successful private equity firms spawn serial private equity funds (e.g., I, II, III) on average every three to five years.  For the most part, all private equity funds use the limited partnership form of business, with appropriate changes that reflect their individual business models.

Venture Capital (VC) Funds

Take venture capital (VC) funds, for instance.  The VC firm forms a limited partnership and serves as the general partner (GP).   The basic business of a VC firm is to identify and contact founders of startups who need capital to develop or use technologies in which the VC firm’s executive team has deep domain knowledge and interest.  In my experience, deal flow occurs in a number of ways, including (i) from the VC firm’s initial contact with a founder known to be operating in the VC firm’s preferred investment space, (ii) from a founder’s direct contact with the VC firm based on a perceived alignment of the VC firm’s investment reputation with the founder’s business, or (iii) by introductions from other VC firms who have existing relationships with a startup whose business aligns with the VC firm’s preferred investment space.

Typically, the limited partnership has a 10-year life, with the possibility of a reasonable number of short-term extensions.  The 10-year life reflects the belief that VC investments in successful startups often can take an extended time period and multiple funding rounds to fully develop proven technologies, products or services and to prepare the company for a successful exit event, such as an IPO or M&A transaction.  A crucial role of the GP is to raise the funds from limited partners (LPs), mainly institutional investors such as pensions funds.  Besides identifying and contacting promising startups, other key operating roles of the lead VC firm are the initial vetting (called investor due diligence) and negotiation of the amount and terms and conditions of the initial investment on behalf of its associated VC fund and other VC funds that are willing invest in the startup on the same terms and conditions.

The VC fund’s investments in individual startups is in the form of convertible preferred shares, the terms of which are negotiated with the startup and invariably contain significant rights over common shares.  The typical startup requires multiple rounds of funding, and each round is often, and by design, led by a different VC firm.  For example, in the second round of funding, a new lead VC firm performs a reasonable investor due diligence investigation and leads the negotiations for the Series B preferred shares, including price per share, number of shares, pre-money value and the specific preferred share rights of the Series B shares.  The process is repeated for the Series C shares and all subsequent rounds.

While the VC fund’s goal is to “buy low and sell high,” the GP is paid (i) an annual management fee (typically 2%) by the VC fund, and (ii) a profit participation in the VC fund’s net realized gains on the portfolio of investments.  The participation is called a carried interest and is usually set at 20%.

Buyout Funds

Buyout funds are formed by buyout firms, which act as GPs to raise money from LPs.  The basic business of a buyout firm is to leverage the equity raised in the buyout fund with debt provided by others to finance a bid for a viable company in a business in which the buyout firm’s executive team has deep knowledge and experience.  In my experience, deal flow occurs in one of two ways: either from the buyout firm identifying and contacting potential targets who are financially underachieving, or from the buyout firm responding to a request for proposal from an advisor to a target who has already decided to put itself up for auction.

Once a target is identified and contacted, executives of the buyout firm and their teams of legal and financial advisors conduct extensive buyer due diligence with the goal of determining the benefits and costs of a set of feasible operating changes, which will serve as justification for a competitive bid at a valuation that would allow the buyout fund to meet its required rate of return.  Once the target accepts the bid, detailed terms and conditions are negotiated not only with the target but also the other investors lined up by the buyout firm to provide the required debt financing to close the proposed deal.  Once the buyout is completed, the buyout firm’s executives set out to timely orchestrate the value-added operating changes identified in the pre-transaction due diligence investigation.  In my experience, the buyout firm does this by controlling the company’s board and working through a new or existing team of company executives who are financially motivated to timely achieve the value-added changes.  By continuously monitoring progress against plan on the value drivers of the company, the board will have the opportunity to decide on a timely exit transaction that maximizes the buyout fund’s rate of return.

There are key differences between the business models of a buyout firm and a VC firm.  For example, the life of the limited partnership is only half that used in the VC business, reflecting the belief that a portfolio of buyout investments can be sourced, diligenced, negotiated, closed, restructured and successfully exited within the life of the limited partnership.  In addition, the buyout business model charges its portfolio companies a monthly management fee, a deal origination fee for arranging the buyout, and financing fees based on future fundraising by the company.  The VC business model charges none of these fees to the startups receiving VC financing but does charge an annual management fee to the VC fund (as opposed to the startup).