Private Equity (“PE”) firms invest in companies, aiming to generate returns for their investors by proactively making improvements and growing the companies before selling them at a higher value. This article, part of our Private Equity Primer Series, explores the PE investment lifecycle, highlighting the key stages and strategies for successful investments. 
 

 

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1. Forming the fund and fundraising

The initial phase of PE lifecycle involves the formation and fundraising of the fund. During the formation phase, the fund manager develops a strategic investment focus, establishes fund terms and prepares key offering materials like the Private Placement Memorandum (“PPM”) and Limited Partner Agreement (“LPA”). Following the formation, the fund enters the fundraising phase, where the manager approaches potential investors to secure capital commitments. The initial closing marks the start of the fund's investment activities, but fundraising often continues to meet the overall fundraising target. 

 

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2. Identifying Potential Investment Opportunities

To generate returns for investors, fund managers will begin by scouting for investment opportunities that align with their strategy. They utilize a mix of methods including market research, professional networks, investment bankers, and direct outreach to potential targets. Advanced data analytics and AI tools are increasingly used to identify trends and promising sectors. Here are some of the traits that PE firms look for when identifying targets: 

• Historically Profitable with Cash Generation Potential

  Fund managers favour companies with a history of profitability and cash flow generation, even if they're currently underperforming. A strong financial past suggests potential for future success. 

• Low Failure Risk with Strong Asset Base

  Considering the leverage involved in PE deals, fund managers prefer companies with low failure risks and a substantial tangible asset base. These assets act as collateral for loans and ensure steady cash flow for debt repayment.

• Opportunities for Productivity Enhancement

  Fund managers often target companies with room for significant performance enhancements. Fund managers use their resources to drive productivity improvements through various levers such as operational enhancements, technology upgrades, and market expansion.

   

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3. Performing Due Diligence and Acquisition

Once a fund manager identifies a potential target company, a comprehensive due diligence process is undertaken. This multifaceted approach involves examining various aspects of the target company to ensure a well-informed investment decision. Some of the factors considered are:

• Financial Performance, e.g. EBITDA and net profit margins, etc.
• Market Position and Competitive Landscape, e.g. market share, growth potential, etc. 
• Legal Review, e.g. compliance, intellectual property concerns, etc. 
• Operational Assessment, e.g. production efficiency, supply chain, management effectiveness, and cost structures, etc. 
• ESG Evaluation, e.g. carbon footprint, adherence to reporting requirements, etc. 

Based on the due diligence findings, the fund manager moves on to the acquisition process that involves finalising the acquisition structure, negotiating the final terms of the deal, including the purchase price, financing structure, securing necessary financing from banks or other financial institutions, and finally closing the deal. 

 

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4. Adding Value and Managing Portfolio Companies

Post-acquisition, fund managers engage actively in the management of their portfolio companies. They might implement strategic changes, improve operational efficiencies, or streamline management practices. The goal is to increase profitability and growth prospects. Fund managers often leverage their network and expertise to provide strategic guidance, access to new markets, and additional capital for growth initiatives.

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Case Study Snapshot:

One notable example of how a PE firm employ a mix of value creation strategies is the acquisition of a US-based discount retailer, Dollar General, by Kohlberg Kravis Roberts (KKR):

Dollar General Corporation is a discount retailer. The Company offers merchandise, including consumable items, seasonal items, home products and apparel. Its merchandise includes brands from manufacturers, as well as its own private brand selections with prices at discounts to brands¹.

1.    Management Changes: KKR brought in a new CEO, Rick Dreiling², who previously ran drugstore chain Duane Reade Inc. He and his new management team was instrumental in boosting sales and implementing operational improvements. The leadership change ensured effective execution of new strategies.
2.    Operational and Product Optimisation: The new team and KKR streamlined Dollar General’s operations by improving supply chain management and reducing operational costs. Concurrently, they optimised their product mix, focusing on high-margin products like private-label goods, and streamlined their assortment by eliminating lower-performing items³.
3.     Growth and Expansion: Dollar General's market expansion involved the addition of new stores and the remodelling of existing ones⁴, at a time when market conditions were favourable due to falling lease rates.
4.    Debt Restructuring and Cost Management: Despite a substantial debt load, KKR effectively managed Dollar General’s financial leverage, improving its Debt-to-EBITA ratio⁵. Additionally, they significantly reduced shrinkage, which includes losses due to factors like shoplifting and mispricing, thereby saving considerable costs and contributing to the overall financial health of the company.

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This article delves into the structure and economics of Private Equity (PE) Funds, a key segment in the global investment landscape. We explore the framework, roles of key stakeholders, fee structures and trends in PE funds.
 

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Basic Framework of PE Funds

A typical PE fund operates over a 10 to 12-year lifecycle, encompassing the fundraising, investment, management and exit phases. At its core, Limited Partners (LPs) commit capital, which General Partners (GPs) deploy into investments. Profits are generated through asset management and divestment, with returns distributed to LPs while GPs receive their carried interest if PE funds meet the returns hurdle. This structure is designed to align the interests of GPs and LPs while maximising investment returns.
 

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In-Depth Look at General Partners (GPs) and Limited Partners (LPs)

GPs are responsible for the day-to-day management of the fund. They identify investment opportunities, conduct due diligence, and make investment decisions. GPs also play a crucial role in managing, adding value to portfolio companies and exiting the investments. Their compensation is typically a combination of management fees and carried interest, aligning their financial interests with the fund's performance.

LPs, on the other hand, provide the capital required for investments. They are typically institutional investors, such as private banks, insurance companies, family offices or high-net-worth individuals. LPs have limited liability, restricted to their capital commitment. They rely on GPs to manage the investments effectively and have limited involvement in the day-to-day operations of the fund.

The relationship between GPs and LPs is governed by a legally binding contract that establishes the terms and conditions of the applicable fund (such as a limited partnership agreement). Those terms and conditions would include the fund’s investment strategy, the rights and obligations of the LPs, how and when profits will be distributed amongst the partners, fees and expenses payable, and governance-related provisions, amongst others. 

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Fund Economics: Fee Structures and Returns

The economics of PE funds are anchored in their fee structures. They charge a management fee and performance fee, also known as carried interest. 

Management fees are typically charged on a quarterly basis and calculated as a percentage of committed capital or assets under management (AUM) that is commonly around 2% per annum. 

Carried interest represents a share of the profits earned by the fund, accruing to the GPs as a performance incentive. Typically, GPs receive 20% of the profits, but only after returning the initial capital contributed by the LPs and achieving a predetermined rate of return, known as the hurdle rate. This structure ensures that GPs are motivated to maximize returns for the investors.

Fee structures can vary based on the type of fund. For instance, evergreen funds or co-investment funds might have different fee arrangements, reflecting their unique investment strategies and risk profiles.
 

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Types of PE Fund Structures

Private Equity (PE) funds can adopt various structures to meet specific investment strategies, regulatory requirements and investor preferences. Here are some of the common types of PE fund structures: 
 

1.    Limited Partnership 

Common in private equity, where limited partners, or investors, provide capital and have limited liability, and a general partner manages the fund. This structure is favoured for aligning interests between investors and managers and for the limited liability protection it offers to investors. 
 

2.    Fund of Funds (FoF)

These funds invest in a portfolio of other funds rather than investing directly in stocks, bonds or other securities. This allows investors to achieve diversification across different managers and strategies.
 

3.    Co-Investment Fund 

In a co-investment fund, investors are provided direct equity exposure at the portfolio company level typically with no fees and carry charged by the underlying GPs. 
 

4.    Evergreen Funds

These funds do not have a fixed lifespan and operate on a perpetual basis. Capital can be raised, and investments can be made indefinitely. Investors often have the ability to enter or exit the fund at predetermined intervals, providing more flexibility compared to traditional closed-end structures.
 

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Wrapping Up

The interplay between GPs and LPs, shaped by structured economic incentives and legal agreements, underscores the essence of PE funds. Diverse in structure, from Limited Partnerships to models like Evergreen and Co-Investment Funds, they address a wide range of investment strategies and investor needs. In the next article of the series, we dive deeper into the lifecycle of a PE fund. 

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This primer provides an in-depth look at different Private Equity (“PE”) strategies, including venture capital, growth equity, buyouts, turnaround strategies, PE fund of funds and secondary fund of funds.

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Types of Strategies

1. Venture Capital (“VC")

Venture capital focuses on investing in early-stage companies with high growth potential. VC firms provide capital, strategic guidance and networking opportunities to early-stage companies in exchange for equity. There are different stages of venture capital financing across angel, seed, early stage, late stage and expansion, which are reflective of a company’s maturity level. As a company grows, additional financing is provided in the form of ‘financing rounds’ to facilitate further development.

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An iconic VC success story is Google, which received US$25 million joint funding from Sequoia Capital and Kleiner Perkins in its early financing rounds in 1999, when Yahoo was still the dominant player in the fragmented search engine market. Sequoia Capital and Kleiner Perkins’ investments eventually led to exponential returns for both firms upon Google’s IPO in 2004, becoming one of the greatest VC investments of all time.

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Key Characteristics 

• High Risk, High Reward: Early-stage companies present a significant risk due to their unproven models and competitive markets but offer the potential for outsized returns if they succeed
• Long-term Horizon: VC investments require a commitment to a longer holding period compared to buyouts, as startups often take time to develop their products, gain market share and become profitable
• Sector Specialisation: VC firms often concentrate on high-growth sectors such as technology, biotech, or green energy, which can experience rapid shifts and require deep industry knowledge

 

2. Growth Equity

Growth equity, which straddles between VC and buyouts, is a strategy where investors typically take a minority stake in relatively mature companies that are poised for expansion but are less established than typical buyout targets. Investors often adopt a passive role, preferring to keep the existing management in place to drive the company's growth. These firms are generally beyond the startup phase and are seeking capital to scale operations, enter new markets, or make significant acquisitions without altering the core structure or strategy of the business.

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Airbnb, Spotify, and Uber are standout examples of companies that received crucial growth capital from TPG, a PE firm with a growth equity investment arm. At pivotal moments in their development, TPG’s investments enabled these firms to scale operations, expand into new markets, and refine their products and services. With this support, they evolved from promising startups into global leaders in their respective industries. TPG’s growth funds played a key role in driving the technological advancements and market expansions that powered the success of these iconic companies.

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Key Characteristics 

• Less Risk than VC: Companies are more established, reducing the risk compared to VC investments
• Balance of Debt and Equity: Growth equity deals often use a balanced mix of debt and equity, with lower levels of leverage used compared to buyout transactions
• Moderate Return Expectations: Returns are typically lower than VC but higher than buyouts

 

3. Buyouts

Buyouts, particularly leveraged buyouts (“LBOs”), involve the acquisition of a company, typically with a significant portion of the purchase price financed through debt. LBOs make up a significant portion of the global PE AUM. The acquired company's assets often serve as collateral for the loans. The PE manager executing a buyout aims to drive the company’s growth, profitability, and improve its market position, followed by a resale or public offering.

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The acquisition of Hilton Hotels by Blackstone in 2007 is a classic LBO deal – financing was done with $20.5 billion (78.4%) debt and $5.6 billion (21.6%) equity. Blackstone utilised its expertise to restructure Hilton’s operations and strategically divest non-core assets. They also appointed a new CEO with experience in the hospitality industry to steer the business through the Great Financial Crisis. By the time Blackstone took Hilton public in 2013 and subsequently sold off its remaining shares, the firm had generated $14 billion in profit, almost quadrupling its original equity investment.

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Key Characteristics 

• Debt Leverage: LBOs typically involve high leverage, which can amplify returns but also increase financial risk if the company's cash flows fail to service the debt
• Target Mature Companies: Buyout targets are usually mature companies with established revenue streams and steady cash flows. These characteristics make it easier to service the debt incurred during the buyout process. The target companies often have significant assets that can be used as collateral for the debt and are seen as stable investments with potential for improvement
• Operational Improvements and Value Creation: Post-acquisition, the focus of a buyout strategy is often on improving the profitability and overall value of the acquired company

 

4. Turnaround Strategies

Turnaround strategies in PE involve investing in companies that are underperforming or struggling financially, with the goal of improving their operations and restoring profitability. PE firms with expertise in turnarounds will typically take an active role in restructuring the company's operations, management and strategy.

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One of the turnaround stories involved Burger King, which was acquired by 3G Capital in 2010. Burger King was struggling with declining sales and an outdated image. 3G Capital restructured the company, revamped its menu and modernised its stores. The firm's efforts paid off when Burger King's profitability improved and it was able to go public again in 2012.

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Key Characteristics 

• Focus on Underperforming or Distressed Companies: Turnaround strategies involve investing in companies that are struggling financially or operationally
• Operational Overhaul and Restructuring: The strategy often includes a significant restructuring of the company’s operations, management, and strategy to restore profitability
• Potential for High Returns: While risky, successful turnaround investments can yield high returns due to the relatively lower entry valuations of distressed companies

 

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Types of Funds

1. Fund of Funds

PE fund of funds involve investing in a portfolio of PE funds rather than in individual companies. This approach allows investors to diversify their holdings across multiple PE strategies, geographic regions and industry sectors. Fund of funds managers select and combine PE funds to create a balanced investment portfolio of between 10 to 50 fund investments over several vintage years. Fund of funds are particularly suitable for allocators with smaller or less experienced investment teams who might not have the capability or resources to carry out the allocation process in-house. By entrusting a fund of funds manager to navigate the complexities of the PE landscape, these investors can benefit from a more hands-off investment approach while still gaining exposure to a variety of PE strategies and managers.

Key Characteristics 

• Diversification: By investing in multiple funds across various PE strategies, geographic regions and industry sectors, funds of funds spread the risk across different managers and strategies. This diversification potentially lowers the overall portfolio risk
• Access to Top Managers: Fund of funds can provide access to top-performing PE firms and niche strategies that might otherwise be inaccessible to individual investors due to high minimum investment requirements
• Simplified Diligence Process: Investors in fund of funds only need to conduct a diligence process around the fund of funds manager they invest with. This manager then takes responsibility for sourcing potential investments, carrying out due diligence, and monitoring the other managers holding the investors' capital

 

2. Secondary Fund of Funds

Secondary fund of funds focuses on purchasing existing interests in PE funds from other investors who are seeking early liquidity by exiting before the end of the fund’s life.

Key Characteristics 

• Accelerated Investment Pace: Unlike a primary fund of funds, which commits capital over time, secondary fund of funds provides immediate exposure to a portfolio of underlying PE fund investments
• Shorter Time to Liquidity: These funds typically have a shorter investment horizon as they invest in funds further along in their life cycle
• Discounted Prices: Secondary assets are often purchased at a discount to their net asset value

Wrapping Up

In summary, PE is not a one-size-fits-all asset class; it offers various paths for capital deployment and return generation. Building on this understanding of the diverse strategies within PE, it's important to delve deeper into the structural, economic, and relational aspects that underpin these investment approaches. 

In our next discussion, we will explore PE fund structures, the economic dynamics at play, and the key players involved.

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With trillions of dollars under management, Private Equity (“PE”) is a term you have likely encountered, yet its inner workings might seem cloaked in complexity. This series of educational guides is designed to unravel the intricacies of PE, offering a comprehensive overview that covers the what, who and how to give you a clearer understanding of the world of PE. 

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What Is Private Equity?  

At its core, PE refers to a form of capital investment made into private companies, or the acquisition of public companies with the intent of taking them private. Unlike the stocks of publicly traded companies that anyone can buy or sell on open stock exchanges, PE investments are not publicly listed. The goal of PE is straightforward: to invest capital into a company, nurture and grow it, and eventually exit with a profit, thus generating a significant return on the investment. 

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One example of a PE success story was the acquisition and eventual sale of fashion retailer Hugo Boss, by Permira, a PE firm. Permira saw the fashion house's potential and transitioned it from a wholesale model to a predominantly retail-focused brand. Under their ownership, Hugo Boss's global footprint expanded, especially in Asia, increasing the number of its own retail stores threefold, which significantly bolstered profit margins. Sales soared by 60%, EBITDA more than doubled, and the share price hit record highs. Permira’s strategic guidance cultivated Hugo Boss into one of the top global fashion brands, culminating in a successful exit in 2015 that made Permira about twice its original investment after seven transformative years. 

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Where Does Private Equity Fit In The Range Of Asset Classes?  

PE holds a unique place in the investment landscape, distinctly set apart from traditional asset classes. Traditional assets, forming the bedrock of most investment portfolios, include well-established options like equities, bonds and cash. These are known for their liquidity, historical performance data and regulatory oversight. 

On the other hand, alternative asset classes encompass a range of investments that diverge from these conventional options. PE falls under this category, offering investors a different path to potentially augment growth and hedge against market volatility. Unlike traditional assets, alternative investments like PE often require specialised knowledge and come with a different risk-reward profile. They are sought for their potential to diversify portfolios and their typically lower correlation with standard market movements.  

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Who Invests In Private Equity?  

PE investing is traditionally dominated by institutional investors, which includes banks, sovereign wealth funds, pension funds, university endowments, and insurance companies. Family offices have also increased their investments into PE. These groups of investors are typically characterised by a high degree of financial sophistication, with the necessary resources and expertise to commit to the longer investment horizons that PE requires, distinguishing it from the more liquid public markets. Increasingly, however, recent trends have started to open avenues for retail investors to participate in PE, democratising access to this asset class. 

How Does One Access Private Equity Investment Opportunities?  

Accessing PE investment opportunities has traditionally been limited to institutions and high-net-worth individuals due to the exclusivity of most PE funds. However, the landscape is evolving with the introduction of innovative financial platforms and products that make PE more accessible to a wider audience. New avenues include fund of funds, which aggregate investments from various individuals to participate in PE funds, and publicly traded PE firms such as Blackstone (NYSE: BX) and Apollo Global Management (NYSE: APO). Additionally, digital platforms are now offering access to PE with lower minimum investments for accredited investors. Despite the emergence of these opportunities, it's important for potential investors to fully grasp the unique risks of PE to make well-informed investment decisions.  

Read the next article to find out why investors have sought out PE.

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In the diverse landscape of the investment assets, Private Equity (“PE”) stands out as a distinct and compelling avenue for those looking to diversify their portfolios and potentially achieve higher returns. 

But what exactly is PE?

 

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Definition Of Private Equity

PE is a form of investment where investors directly invest in private companies or buy out public companies to take them private. Unlike publicly traded stocks, PE investments are not listed on stock exchanges.

For a comprehensive understanding, explore the first article of our PE deep dive series to kickstart your educational journey into the world of PE.

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Private Equity Industry Overview

The PE industry has experienced rapid growth over recent years, expanding its influence across global markets. This surge is driven by increasing investor interest, attracted by the potential for higher returns and the industry’s ability to drive transformation in portfolio companies. In particular, PE buyout funds have consistently outperformed public markets over various investment periods, as evidenced by the higher pooled net Internal Rate of Return ("IRR") across 5-, 10-, and 20- year periods when compared to the MSCI World Public Market Equivalent ("PME") as of Q3 2023. PE now commands a significant portion of the investment landscape, playing a pivotal role in shaping business growth and innovation worldwide.

• PE industry’s assets under management (AUM) has enjoyed significant growth of approximately 12.7% per annum since 2000¹ 
• Since 2000, U.S.-focused PE Funds have represented at least half of global PE AUM¹ and is widely considered the largest and most developed market for PE Fund investing

¹Preqin, March 2024

 

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How Private Equity Works

The PE process involves identifying potential investment opportunities, acquiring stakes in companies, actively managing these investments to enhance their value, and finally, exiting these investments through a sale or IPO to realise a profit.

To learn more, check out our in-depth guide to the PE Lifecycle.

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Types Of Private Equity Investments

Type of PE Investments	Description
Buyout	This is the strategy of acquiring a controlling interest in a company, often to take it private and restructure it for profitability.
Growth Equity	This involves investing in established companies to help them expand or restructure without taking control away.
Venture Capital	Venture capital is funding given to early-stage, high-potential startups in exchange for equity.
Turnaround Strategy	This is a plan to revive a struggling company by improving its operational, financial, and strategic positioning.
Fund of Funds	A fund of funds invests in a portfolio of various private equity funds rather than directly investing in companies.
Secondary Funds	Secondary funds buy existing investments in private companies or funds from other investors, rather than investing directly.

 

To learn more about each strategy, read our in-depth guide to Types of Private Equity Strategies.

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Key Players In Private Equity

Key players in PE include General Partners ("GPs") who manage the PE funds, Limited Partners ("LPs") who invest in these funds, and portfolio companies that are the investment targets. The relationship between General Partners and Limited Partners, shaped by economic incentives and legal agreements, underscores the essence of these funds.

Deep dive into the PE ecosystem in our guide to PE Fund Structures, Economics, and Stakeholders.

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Benefits And Risks Of Private Equity

PE offers several benefits, including the potential for higher returns, which are potentially higher than public markets. This is partly due to PE firms' active management strategies and their ability to tap into exclusive opportunities that are not accessible in public markets. Furthermore, PE serves as a good tool for portfolio diversification. Its performance is not directly correlated with the fluctuations of the stock market, and it spans a diverse range of sectors and industries. 

On the flip side, PE investments come with their own set of risks. Investing in PE can be unpredictable in terms of cash flow and requires firm commitments, with penalties for not meeting these commitments. Another risk is their illiquid nature, meaning that these assets cannot be quickly sold or converted into cash. Investors in PE face long lockup periods, during which their capital is tied up and inaccessible, presenting a significant long-term commitment.

Read about why investors turn to PE and the risks considerations of PE in our deep-dive articles.

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Impact Of Private Equity

PE plays a significant role in the economy by investing in and growing businesses, which can lead to job creation and economic development. Additionally, an increasing focus on sustainability investing by PE firms is contributing to environmental stewardship and social responsibility, driving positive changes in business practices and innovations in green technologies. PE firms bring expertise and resources to companies, helping them innovate and expand.

 

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Why Is It Easier To Access PE Today?

1. Growth of digital investment platforms has simplified the process of investing in PE and lowered the minimum investment thresholds for accredited investors.
2. Innovative PE products, such as PE bonds targeted at retail investors, offer a more efficient way for investors to invest in PE.
3. More educational resources about PE are available to investors today.

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