The Role of Private Equity Investment Firms

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Private equity is a niche market that very few investors have heard about, let
alone understand. Unlike stocks, futures, and forex, the private equity markets work their magic
behind the scenes. Though they dont get much attention, the fact is, private equity is the
lifeblood of the economy. Without it, the USA could very well fall apart in a decade. You may
be saying, Wow, is that really true? Well, in this article we will answer this question, defining
the the various roles of private equity and its importance to economies worldwide.
In todays market, private equity refers to any money invested with non-public companies
which expects a yield for the use of the capital. Also, private equity can refer to buying public
companies with the intention of making them private in the future. With either definition the idea
is simple, private equity provides funding to companies that do not want to go public. As we
will explain later, by choosing to not go public, there are a number of benefits these companies
can receive by utilizing private equity. Now that weve covered this fundamental concept, lets
define the term private equity firm.
By definition, a private equity firm is a company which pools money to invest in non-public
corporations, hoping to profit from growth. Since the private equity investors give legal
authority to the manager, they can use their expertise to make the best investment decisions. In
most cases, this involves a detailed analysis of the companies they are prospecting, in addition to
whatever diversification strategy they implement. To help you understand what we mean, we will
give you an example. One on hand, private equity firm A invests ONLY in biotechnology
companies, diversifying amongst corporations at different stages of growth. On the other hand,
private equity firm B ONLY invests in in the energy market, looking for late stage venture
capital opportunities. Either way you slice it, the point is, each private equity manager has their
own niche and strategy. By defining their niche, and becoming an expert in that specific area,
the private equity firm can create its unique formula for success.
Private equity firms invest in every major industry, assisting both small and big corporations.
Though they do help many small companies, the real economic impact comes from their
assistance in late-stage venture capital opportunities. By late stage venture capital, we mean
companies which possess strong growth but not enough liquidity to reach their bigger goals. In
many cases, you can have a company with huge potential, but not enough money to meet their
product demand. By giving these companies thefunds to invest, it allows them to grow to
their potential, adding money, ideas and jobs into the economy. The great part is, private
equity creates a positive economic cycle, keeping new companies flowing into the market at all

times. In addition, they provide seed capital for new innovations which better the lives of
everyone. If you take a good look around you, many of the biggest companies in the world have
been funded through private equity. In fact, technology firms of all kinds are receiving private
equity funding right now! For example, even Palm, the once-dominant PDA and smart-phone
provider received $325 Million from Elevation Partners. The reality is, deals like this happen
every day, and most people never appreciate the critical role of private equity.
In summary, if there werent private equity firms around, the markets would be a very scary
place. Companies would either have to go public, or bang their head again the glass ceiling
forever. With private equity funding now available to many businesses, this option has removed
the pressure to go public. As most eventually learn, being in the spotlight isnt the best choice for
some products. With stock markets now recovering, it has become a perfect environment for
private equity firms to profit. Hopefully this new trend continues, because as you now know,
private equity is a market that can make or break any economy.

That Are the Functions of Private Equity?

by Leslie McClintock
Business owners use business plans that detail potential returns to convince outside
investors to lend them investment capital.
The people who start companies aren't always the right people to lead them
through every stage of development. Frequently, after a certain amount of growth,
the existing management team no longer has the skills to grow the company. The
company may also require additional infusions of capital to finance growth and, in
some cases, help prepare for a public offering. Private equity helps provide that
capital, while providing additional management expertise as the company scales
up.
Profits

The first function of private equity funds and partnerships is to provide profit to the fund owners.
They typically identify promising companies that require additional financing to scale up
staffing, nurture a new drug through clinical trials, expand manufacturing or otherwise make
significant investments. After providing the capital, private equity firms then seek to profit either
from ongoing operations or by selling their stakes to downstream investors or to the investing
public through an initial public offering.
Expertise

A private equity firm frequently purchases a controlling interest in the company. This enables the
firm to take control of management and replace managers, as needed, with those with more
experience running larger enterprises. Their expertise can range from operations to finance and
accounting to technical expertise. The company also benefits from the substantial industry
contacts the new management can provide.
Financing

The private equity firm can provide financial support for the company in a number of ways. The
firm can take direct ownership of a majority or minority interest in the company, for example. If
the company's owners want to raise capital but do not want to dilute their ownership interests by
issuing stock, they may seek out a private equity firm to provide mezzanine financing, a type of
senior debt issue. Occasionally, the lender will include an option to convert the debt into stock at
a certain price per share. These debt securities are called "convertibles."
Private Equity's Role in the Capital Markets

Looked at more broadly, private equity firms have a role in helping financial institutions and the
wealthy diversify their investment portfolios. Private equity opportunities may have a very low

correlation to performance in the stock or bond markets. They also give investors and investment
managers access to vehicles with potentially higher returns than conventional investments and
publicly-traded securities, albeit at a cost of lower liquidity and higher risk.

Private Equity 101: What is private equity and how does it

work?
Thu, 19-Mar-2009

Public Value: A Primer on Private Equity report by the Private Equity Council in 2007
provides a good overview of private equity. A copy of the Public Value: A Primer on Private
Equity is below or can be downloaded here. The report covers the following topics:

Private Equitys Model of Corporate Governance

What is Private Equity?

Private equity is an asset class that generally invests in unlisted

companies. From a practical standpoint, private equity is an ownership
structure that enables a private equity firm and its investors to acquire
companies either public or private that have significant potential for
growth, in some cases because they are undervalued or underperforming. Generally, the private equity firm invests time, energy,
talent and capital to improve the companys performance and
prospects. After several years, usually between four and five (and up to
seven years for some firms), the private equity firm sells the company,
hopefully at a premium to the purchase price.

In a nutshell, a private equity firms goal is to increase the value of the

underlying asset for the investors and sell for a capital gain.

How Does Private Equity Work?

o

Private equity firms (also known as the general partners GPs) raise
capital from investors (or limited partners LPs) in a limited
partnership legal structure. Key terms of private equity firms:

Targeted investor returns: 30% internal rate of return (IRR)

(More likely in the mid-20s due to the global financial crisis and
intensifying competition in private equity)

Investor commitment: 10 years

Portfolio company investment horizon: 3 to 5 years (and up

to 7 years for some firms; longer investment periods will become
more typical especially in light of the global financial crisis)

Annual management fee: 1% to 2% of committed capital

(typical fee of 2% is falling to 1.4% and possibly lower given the
global financial crisis)

Profit split: Capital gain profit split of 80% to the investors and
20% to the GPs (also known as 80/20). Distribution of proceeds:
(i) Investors receive their invested capital offset by any bad
investments plus 8% to 9% on the total invested capital (also
known as the preferred return or hurdle rate) along with any fees
paid by the investors, (ii) If there are proceeds after the hurdle
rate, the profits are split where the investors receive 80% and
GPs receive 20% of the net overall fund profits (GPs 20% is also
known as carried interest or carry).

Clawback: Requires private equity firms or GPs to return

distributions of carried interest to the extent of any subsequent
losses in other investments of the fund. In other words, if the
private equity firm generates losses on some investments, it
shares in the downside because its carry from other successful
investments is offset by the deals gone sour.

Investors in private equity funds include sovereign wealth funds, public

pension funds, corporate pension funds, union pension funds, funds-offunds, family offices, wealthy individuals, endowments, foundations,
insurance companies, banks and financial services companies.

Private Equity Performance: Superior Returns

o

Between 1980 and 2005, top-quartile private equity firms, on average,

delivered 39.1% annualized returns. According to the report, this is net
returns, after all fees, expenses and the GPs carry.

Private Equity Value Creation

o

Private equity firms need to focus on improving performance and

enhancement of value versus financial engineering, especially in light
of the global financial crisis and competition reducing any significant
upside from financial engineering.

Some examples of the value-add that private equity firms bring in

addition to the capital:

Deep expertise. Private equity firms develop vast network of

experts that they can draw on to complement the management
teams of the companies they acquire. These experts include
former CEOs, CFOs, consultants, deep subject matter experts,
etc.

Performance culture that rewards entrepreneurialism.

Private equity firms work closely with senior managers of
portfolio companies on developing core strategic initiatives that
will drive improvement in company performance and value.

Managerial and functional capabilities. Private equity firms

generally have deep industry expertise from prior investments
that can be utilized. Additionally, private equity firms have longstanding relationships with experts who are deeply versed in
topics that range from information technology to human
resources.

Nimble ownership structure. The private equity firm and the

company CEO form a tightly-knit group that can agree quickly
and move decisively. To align interests and provide incentive,
private equity firms tie a far greater share of senior manager
compensation to company performance (typically between 2%
to 8% of the company).

The Functions of Private Equity

The Carlyle Group is a U.S. private equity firm.
Private equity is often discussed in the financial and business press. At times it is maligned; at
other times, championed. Private equity has existed since capitalism began. Long before public
stock markets existed, companies had to tap private individuals and businesses for the equity
needed to start and grow their businesses. As this has morphed into more formal private equity
and venture capital firms that seek out businesses to invest in or buy, the crucial functions still
remain.
Expansion Capital

Private equity and venture capital firms provide the funds that businesses need to finance growth.
Often firms that have inconsistent operating cash flow due to operational issues or changing
market conditions cannot qualify for enough bank financing. In addition, rapidly growing
businesses often use up their operating cash flow in acquiring assets or personnel. Because their

operating cash flow may turn negative due to these expenses, they also do not qualify for debt
financing. In addition, if these companies obtained all the financing they needed in the form of
debt, they may be unable to make the debt payments.
Discipline

Private equity often provides the discipline companies need. For public companies taken private
through a private equity transaction, discipline is less of a function. These companies had to meet
the standards and expectations of the public markets. However, for many private companies,
those without external boards and oversight often operate the companies according to the
owners whims. Owner-managers often have different criteria than those that are purely
shareholders. Private equity generally demands that companies operate efficiently to drive an
increase in shareholder value and put the personnel, systems and processes in place to ensure
this.
Management

Private equity provides management. Many companies that private equity firms invest in have
thin layers of management. They often have the founder or founders in various roles and may
have one or more vice presidents. Private equity provides not only the capital to hire more
management, but also the expertise and resources to identify and screen management. Private
equity also may replace some or all of the current management with outsiders skilled in a
particular industry or market niche. In addition, private equity provides board members with
varying perspectives and insights.
Contacts

Private equity provides contacts and resources. Fast-growing technology firms can harness the
know-how from a venture capitalist firms stable of past and current companies. These firms can
connect with industry insiders who can help the company obtain contracts, partnerships and
exposure that they would either not have had access to or would not have known about.
Overall Function

The overall function of private equity is to drive an increase in shareholder value. A consequence
of this is better capitalized, better managed, more resourceful and disciplined companies.
Beneficiaries of private equity grow faster and stronger, use the services of more companies and
employ more people. This creates a ripple effect, producing a significant positive impact on the
U.S. eco

The Role of Management Expertise in Private Equity

-May 1, 2013
Private equity-backed companies dont just benefit from the capital injection provided by private
equity, but also gain from the management and operational expertise that PE firms bring to a
partnership. This plays into the initial planning and capital investment, as well as the
management phase of a partnership.
A commonplace practice is to employ a 100-day plan at the beginning of an investment, created
collaboratively by private equity managers and leadership teams at the companies in which they
invest. A recent, 100-day plans cover a range of strategic issues, including operational,
administrative, financial reporting issues, and more.
Private equitys management expertise can be highlighted through collaboration and identifying
opportunity throughout a partnership, as well. We saw this highlighted in the Carlyle Groups
investment in AxleTech, as well. Working with Carlyle during its ownership, CEO Mary
Petrovich led AxleTechs foray into the fast-growing military sector, targeting its heavy-duty axle
and suspension systems toward military vehicle manufacturers building heavy armored vehicles
for American soldiers in Iraq and Afghanistan. Im very passionate about private equity, says
Petrovich, because its not only made a difference in my life; its made a difference in the lives
of 1,000 other employees of AxleTechs.
See the AxleTech video case study below, and click here for more examples of how companies
across America benefit from private equity investment