Many people like the idea of a career in Private Equity, not least because it tends to be associated with high financial reward, but what exactly does Private Equity (PE) involve?
A bit of history
The concept of private investment in commercial ventures goes back centuries, but the concept of PE as we know it today is a relatively modern development. Before World War II, PE investments (originally called "development capital") remained primarily the preserve of wealthy individuals and families. It was the founding of the first two US based venture capital firms in 1946 (American Research and Development corporation and JH Whitney & Co) which marked the beginning of institutionalised venture capital operations. It was only in the 1960s that the common form of PE fund emerged as we know it today.
Why funds?
Funds, usually limited partnerships, rapidly became the main vehicles for private equity investment. They clearly define who’s in charge of the deals, grant the managers guaranteed capital to draw down as opportunities arise, lock in all capital partners (often for 10 years or more) to allow focus on long-term value creation and let passive investors have experienced private equity deal-doers allocate on their behalf. They also give tax transparency – the investors are treated as investing directly in each portfolio company – and give investors the protection of limited liability, meaning that the maximum they can lose is the investment they have made.
The lifespan of a private equity fund is typically 8–10 years, but that period generally doesn’t start until the team has raised substantial capital and it doesn’t end until all assets are sold. So, the lifespan of a private equity fund may stretch to as long as 15 years. It’s also important to note that these stages overlap and that funds also generally overlap - as you raise a new fund, you may be managing and exiting investments from a previous fund.
So what exactly is PE?
Like so many financial disciplines, there are many strands to PE. At its simplest, it is the provision of private capital to businesses in exchange for a shareholding. The term “private” distinguishes it from public (also referred to as “listed”) capital – in other words, it is not listed and traded on any exchange. The term “equity” refers to the fact that this involves ownership of shares in the company, with the investor standing to benefit from the success of the company through a rise in the value of the shares (or indeed the reverse, if the company performs badly).
In reality, of course, it is more complex than that and PE transactions often involve multiple financial instruments, from simple equity all the way to simple debt, by way of many intermediate instruments such as, for example, convertible bonds (a debt instrument which can be converted into simple equity, usually at the option of the investor, with a defined mechanism for establishing the conversion price). Investments can be structured using one or more different instruments and the terms of these can be freely negotiated and written into contract with the aim of meeting specific objectives for both parties – for example, protecting investor downside, or rewarding founders if they meet or exceed specific business targets.
PE strategies
Different PE funds will also have widely different strategies. One defining characteristic of PE strategy is the maturity of the business being invested in. At one end of the scale investors may choose to invest only in start-up businesses – this is often referred to as Venture Capital (VC). The general philosophy behind VC investment is that a high proportion of investee companies will fail, but a small number will perform spectacularly well, and these successes will more than make up for the failures – for example, an investor will happily write off the majority of their investments if they also manage to make an early investment in, say, Amazon or Apple.
Other PE strategies involve geography, for example a focus on emerging or frontier markets, or sector, for example mining or technology. Some may have a particular focus on, say ESG – environmental, social and corporate governance. Many governments also have Development Finance Initiatives (DFIs) whose role is to provide PE funding to businesses in developing countries with a view to encouraging economic development. This funding is not a charitable donation – it is almost always done on the basis that the investments will generate a return – but the criteria used in deploying the capital are usually somewhat different to those used by purely commercial investors. The UK DFI used to be called the Commonwealth Development Corporation (CDC) and has recently been renamed British International Investment (BII).
At the other extreme, financial engineering has created a collection of strategies that can be extremely rewarding for investors, but which have also been known to cause problems for investee companies. For example, the strategy of buying mature companies with strong and stable cash-flows and then putting enormous amounts of debt on their balance sheets. This allows the investor to extract large sums of money from the company involved (through dividends or share buy-backs), but makes the company itself much more vulnerable to an economic downturn or a rise in interest rates. A number of high-profile company failures resulting from this and similar strategies has resulted in PE getting a bad reputation in certain quarters.
This article obviously only scratches the surface of what is a huge subject (I will address other aspects in future articles if there is interest – please let me know!). If you are looking for a career in the sector, it is important to do your research and understand what area of PE you want to focus on, as well – of course – as being able to demonstrate a broad understanding of the subject at interview.
A bit of history
The concept of private investment in commercial ventures goes back centuries, but the concept of PE as we know it today is a relatively modern development. Before World War II, PE investments (originally called "development capital") remained primarily the preserve of wealthy individuals and families. It was the founding of the first two US based venture capital firms in 1946 (American Research and Development corporation and JH Whitney & Co) which marked the beginning of institutionalised venture capital operations. It was only in the 1960s that the common form of PE fund emerged as we know it today.
Why funds?
Funds, usually limited partnerships, rapidly became the main vehicles for private equity investment. They clearly define who’s in charge of the deals, grant the managers guaranteed capital to draw down as opportunities arise, lock in all capital partners (often for 10 years or more) to allow focus on long-term value creation and let passive investors have experienced private equity deal-doers allocate on their behalf. They also give tax transparency – the investors are treated as investing directly in each portfolio company – and give investors the protection of limited liability, meaning that the maximum they can lose is the investment they have made.
The lifespan of a private equity fund is typically 8–10 years, but that period generally doesn’t start until the team has raised substantial capital and it doesn’t end until all assets are sold. So, the lifespan of a private equity fund may stretch to as long as 15 years. It’s also important to note that these stages overlap and that funds also generally overlap - as you raise a new fund, you may be managing and exiting investments from a previous fund.
So what exactly is PE?
Like so many financial disciplines, there are many strands to PE. At its simplest, it is the provision of private capital to businesses in exchange for a shareholding. The term “private” distinguishes it from public (also referred to as “listed”) capital – in other words, it is not listed and traded on any exchange. The term “equity” refers to the fact that this involves ownership of shares in the company, with the investor standing to benefit from the success of the company through a rise in the value of the shares (or indeed the reverse, if the company performs badly).
In reality, of course, it is more complex than that and PE transactions often involve multiple financial instruments, from simple equity all the way to simple debt, by way of many intermediate instruments such as, for example, convertible bonds (a debt instrument which can be converted into simple equity, usually at the option of the investor, with a defined mechanism for establishing the conversion price). Investments can be structured using one or more different instruments and the terms of these can be freely negotiated and written into contract with the aim of meeting specific objectives for both parties – for example, protecting investor downside, or rewarding founders if they meet or exceed specific business targets.
PE strategies
Different PE funds will also have widely different strategies. One defining characteristic of PE strategy is the maturity of the business being invested in. At one end of the scale investors may choose to invest only in start-up businesses – this is often referred to as Venture Capital (VC). The general philosophy behind VC investment is that a high proportion of investee companies will fail, but a small number will perform spectacularly well, and these successes will more than make up for the failures – for example, an investor will happily write off the majority of their investments if they also manage to make an early investment in, say, Amazon or Apple.
Other PE strategies involve geography, for example a focus on emerging or frontier markets, or sector, for example mining or technology. Some may have a particular focus on, say ESG – environmental, social and corporate governance. Many governments also have Development Finance Initiatives (DFIs) whose role is to provide PE funding to businesses in developing countries with a view to encouraging economic development. This funding is not a charitable donation – it is almost always done on the basis that the investments will generate a return – but the criteria used in deploying the capital are usually somewhat different to those used by purely commercial investors. The UK DFI used to be called the Commonwealth Development Corporation (CDC) and has recently been renamed British International Investment (BII).
At the other extreme, financial engineering has created a collection of strategies that can be extremely rewarding for investors, but which have also been known to cause problems for investee companies. For example, the strategy of buying mature companies with strong and stable cash-flows and then putting enormous amounts of debt on their balance sheets. This allows the investor to extract large sums of money from the company involved (through dividends or share buy-backs), but makes the company itself much more vulnerable to an economic downturn or a rise in interest rates. A number of high-profile company failures resulting from this and similar strategies has resulted in PE getting a bad reputation in certain quarters.
This article obviously only scratches the surface of what is a huge subject (I will address other aspects in future articles if there is interest – please let me know!). If you are looking for a career in the sector, it is important to do your research and understand what area of PE you want to focus on, as well – of course – as being able to demonstrate a broad understanding of the subject at interview.