Alternative Investment : Private Equity

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In finance, private equity is an asset class consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange. A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. So in some cases, Entering of private equity firm in listed company is good sign for company and its future growth.

Equity is ownership in business. Every Business needs Capital for growth. Either it is in form of Debt or Equity. The difference in between Private equity and Listed Equity is the valuation. It’s difficult to find real value of private company and because of this, it is riskier business and even if it is equity, it does not relate with public listed companies.

Many private equity firms conduct what are known as leveraged buyouts (LBOs), where large amounts of debt are issued to fund a large purchase. Private equity firms will then try to improve the financial results and prospects of the company in the hope of reselling the company to another firm or cashing out via an IPO. Private equity has successfully attracted the best and brightest in corporate America, including top performers from Fortune 500 companies and elite strategy and management consulting firms. Top performers at accounting and law firms can also be recruiting grounds, as accounting and legal skills relate to transaction support work required to complete a deal and translate to advisory work for a portfolio company’s management. The fee structure for private-equity firms varies, but it typically consists of a management fee and a performance fee (in some cases, a yearly management fee of 2% of assets managed and 20% of gross profits upon sale of the company). How firms are incentivized can vary considerably. Given that a private-equity firm with $1 billion of assets under management might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees for the firm, it is easy to see why the private-equity industry has attracted top talent. At the middle market level ($50 million to $500 million in deal value), associates can earn low six figures in salary and bonuses, vice presidents can earn approximately half a million dollars and principals can earn more than $1 million in (realized and unrealized) compensation per year. There are two critical functions within private-equity firms: 1. Deal origination or Transaction Execution 2. Portfolio Oversight Deal origination involves creating, maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks and similar transaction professionals to secure both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates referred to private-equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that the funds raised are successfully deployed and invested. Additionally, internal sourcing efforts can reduce transaction-related costs by cutting out the investment banking middleman’s fees. When financial services professionals represent the seller, they usually run a full auction process that can diminish the buyer’s chances of successfully acquiring a particular company. As such, deal origination professionals (typically at the associate, vice president and director levels) attempt to establish a strong rapport with transaction professionals to get an early introduction to a deal. It is important to note that investment banks often raise their own funds, and therefore may not only be a deal referral, but also a competing bidder. In other words, some investment banks compete with private-equity firms in buying up good companies. Transaction execution involves assessing management, the industry, historical financials and forecasts, and conducting valuation analyses. After the investment committee signs off to pursue a target acquisition candidate, the deal professionals submit an offer to the seller. If both parties decide to move forward, the deal professionals work with various transaction advisors to include investment bankers, accountants, lawyers and consultants to execute the due diligence phase. Due diligence includes validating management’s stated operational and financial figures. This part of the process is critical, as consultants can uncover deal killers, such as significant and previously undisclosed liabilities and risks. The second important function of private-equity professionals involves oversight and support of the firm’s various portfolio companies and their management team. Among other support work, they can walk management through best practices in strategic planning and financial management. Additionally, they can help institutionalize new accounting, procurement and IT systems to increase the value of their investment.

Middle-market companies can offer significant financial upside to their private-equity owners. Many of these small companies fly below the radar of large multinational corporations and often provide higher-quality customer service. These companies provide niche products and services that are not being offered by the large conglomerates. Such upsides attract the interest of private -quity firms, as they possess the insights and savvy to exploit such opportunities and take the company to the next level. For instance, a small company selling niche products within a particular region might significantly grow by cultivating international sales channels. Or a highly fragmented industry can undergo consolidation (with the private-equity firm buying up and combining these entities) to create fewer, larger players. Larger companies typically command higher valuations than smaller companies. An important company metric for these investors is earnings before interest, taxes, depreciation and amortization (EBITDA). When a private-equity firm acquires a company, they work together with management to significantly increase EBITDA during its investment horizon (typically between four and seven years). A good portfolio company can typically increase its EBITDA both organically (internal growth) and by acquisitions. A popular exit strategy for private equity involves growing and improving a middle-market company and selling it to a large corporation (within a related industry) for a hefty profit. It is critical for private-equity investors to have reliable, capable and dependable management in place. Most managers at portfolio companies are given equity and bonus compensation structures that reward them for hitting their financial targets. Such alignment of goals (and appropriate compensation structuring) is typically required before a deal gets done.

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About Ashutosh Tilak

Tracking Indian Capital Market since 2010. Finance Student, On this blog I am writing about finance and Investing. You can contact me or @androidashu & @InsideFinanc on twitter