A private equity investment in a company typically involves a transformational, value-added, active management strategy.
The private equity fund seek a high-quality management team and a strategic plan to grow and improve the business. Private equity investors usually own the business for a number of years and work with the company's management to develop and improve performance, operations and strategic direction.
Over the past few decades, private equity has grown to represent a strong force in the economies of Europe and North America. It exerts substantial influence on many developed economies and long-term portfolios held by institutional investors.
In general, there are three stages in a private equity investment; the initial transaction, the development of the portfolio company and the sale of the company.
Investors in private equity are primarily large international institutions. Most of the funds raised come from public or private pension funds, fund-of-funds, life insurance companies, foundations and endowments or banks. However, smaller investors and individuals can also invest in private equity funds by way of listed vehicles or funds.
Investors tend to invest in private equity because they seek higher returns and portfolio diversification. They are also keen to spread their risk as the correlation to public markets is limited, even if private equity can be cyclical.
Private equity companies
In the early days private equity companies were often owned by different banks, but today the majority of private equity activity is undertaken by independent private equity firms owned by their management and leading professionals. These executives are expected to commit their own capital to the funds, investing in parallel with their investors; typically between 1 and 3 per cent of the total capital committed. This is a requirement from fund investors who thereby ensure that their interests are aligned with the manager of the fund, the so-called General Partner.
The funds in general have no permanent capital. Instead, investors commit to contributing capital up to a predetermined level, which is then drawn down by the investment manager to make investments into various portfolio companies and to cover the costs of the fund.
How private equity works
A fund is typically invested over a three to six-year period. When the fund exits a portfolio company, the proceeds are normally returned to the investors immediately, which means that every fund has a limited life span, typically between eight and 13 years. A new fund is usually raised when the previous is fully invested. At every such fund-raising, there is an extensive evaluation of the private equity firm, its operations and track record, as well as in-depth due diligence.
Private equity firms report back to their investors on a regular basis, usually quarterly, in accordance with established industry guidelines for reporting and valuation of portfolio companies. Regular communication in connection with new investments and/or divestments is also common as is an annual investor meeting.
It is common that the fund’s investment in a portfolio company is organised through a holding company. This structure does not affect the taxation of the underlying portfolio company’s revenues, its cost structure or regular taxation. The portfolio company pays the usual taxes in the countries where it has operations and where it is domiciled.
A crucial part of the operations of a private equity fund is to secure a good supply of promising investment opportunities or companies with development potential. This is known as a deal flow.
Investment opportunities typically arise from family businesses seeking new owners, spin-outs from larger corporations or from private equity funds that operate at an earlier stage in the value chain and have developed and financed the company as far as they can. Privatisations and public to private transactions of listed companies are other sources.