Private Equity Investments (2024)

Introduction

Private equity’s shift from a niche activity to a critical component of the financialsystem is evident from investors’ financial commitment: around $2.8trillion globallyas of mid-2018. And that’s just the equity portion. The use of debt means transactionvalue is often two or three times the actual equity raised. Blackstone, Carlyle, andKKR are household names and publicly traded companies of significant size. Privateequity funds may account for 15%–18% of the value of all mergers and acquisitions,and the market capitalization of Alibaba, Amazon, Facebook, and Google has raisedthe profile of venture capital investing.

We take two approaches to illuminate our subject: In Section 2 the perspective isprimarily that of the private equity firm evaluating potential investments. Valuingacquisitions is particularly complex; except for public-to-private transactions, therewill be no market prices to refer to, and the challenges are considerable. In Section3 we take the perspective of an outside investor investing in a fund sponsored bythe private equity firm.

Definitions of private equity differ, but here we include the entire asset class ofequity investments that are not quoted on stock markets. Private equity stretchesfrom venture capital (VC)—working with early-stage companies that may be without revenuesbut that possess good ideas or technology—to growth equity, providing capital to expandestablished private businesses often by taking a minority interest, all the way tolarge buyouts (leveraged buyouts, or LBOs), in which the private equity firm buysthe entire company. When the target is publicly traded, the private equity fund performsa public-to-private transaction, removing the target from the stock market. But buyouttransactions usually involve private companies and very often a particular divisionof an existing company.

Some exclude venture capital from the private equity universe because of the higherrisk profile of backing new companies as opposed to mature ones. For this reading,we refer simply to venture capital and buyouts as the two main forms of private equity.

Many classifications of private equity are available. Classifications proposed bythe European and Private Equity Venture Capital Association (EVCA) are displayed inExhibit 1.

Private equity funds may also be classified geographically, by sector, or both. Certainspecialists target real asset classes, such as real estate, infrastructure, energy,and timber, or they seek out emerging or niche sectors, such as agribusiness or royaltiesin pharmaceuticals, music, film, or TV.

US private equity enjoyed a far larger market size historically than private equityin other regions, with few restrictions on hostile takeovers. Buyouts subsequentlyexpanded to Europe and then Asia as friendly deals became commonplace. In broad terms,around four-fifths of the money has been flowing into buyout, growth, and other typesof private equity in both the United States and Europe, with buyout amounts far exceedingother types. The sheer scale of buyouts means that an individual deal can absorb billionsof dollars in capital. Buyout funds have benefited from increased allocations giventheir ability to absorb far higher capital amounts and to deliver historically higher-than-averagereturns.

Venture capital deals, in contrast, tend to drip, providing small amounts of feedmoney. Still, advances in technology and communications are causing the number ofventure capital funds and the availability of start-up capital to grow. Investor attentionstarted to shift to China in 2015, an especially active year for raising capital.VC funds targeting Asia had more than US$200billion in 2017, up from US$50billionin 2010.

Most private equity money comes from institutional investors, such as pension funds,sovereign wealth funds, endowments, and insurance companies, although many familyoffices and high-net-worth individuals also invest directly or through fund-of-fundsintermediaries. Venture capital investors include government agencies and corporationsseeking to promote regional investment or gain insight into, and possibly controlof, emerging businesses and technologies.

Private equity investment is characterized by a buy-to-sell orientation: Investorstypically expect their money to be returned, with a handsome profit, within 10 yearsof committing their funds. The economic incentives of the funds are aligned with thisgoal.

The member should be able to:

1. explain sources of value creation in private equity;

2. explain how private equity firms align their interests with those of the managers of portfolio companies;

3. distinguish between the characteristics of buyout and venture capital investments;

4. interpret LBO model and VC method output;

5. explain alternative exit routes in private equity and their impact on value;

6. explain risks and costs of investing in private equity;

7. explain private equity fund structures, terms, due diligence, and valuation in the context of an analysis of private equity fund returns;

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8. interpret and compare financial performance of private equity funds from the perspective of an investor;

9. calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund.