The Private Equity Critics and the Research

This chapter explores the major criticisms levelled at the private equity sector. It clarifies some misrepresentations and myths in the light of experience over the evolution of the market and the weight of systematic evidence summarized in this book. It is important to distinguish between analysis at the fund level and at the level of the underlying individual investments. The majority of studies in the finance literature are at the fund level and discuss private equity as an investment strategy. Analysis at the investment level is often done by case study, which always risks creating general conclusions from specific examples. The chapter then looks at areas which are under-researched. These areas include performance and returns; deal structures; the private equity process; new and secondary markets; and the political environment.

The Private Equity Market

This chapter defines private equity, describes the origins of the private equity market, and examines the data on the size and growth of the private equity industry. Private equity is risk capital provided outside the public markets. The businesses invested in by private equity range from early stage ventures, usually termed venture capital investments, through businesses requiring growth or development capital to the purchase of an established business in a management buyout or buy-in. Much, but not all, of the investing done in the private equity market is by private equity funds. The objective of a private equity fund is to invest equity or risk capital in a portfolio of private companies which are identified and researched by the private equity fund managers. The chapter then considers what private equity fund managers do. It also provides a brief history of private equity before assessing how big the private equity market is.

The Private Equity Fund

This chapter discusses private equity funds. It looks at the typical fund structures, who invests in private equity, and compares and contrasts alternative investment options. A private equity fund is a form of ‘investment club’ in which the principal investors are institutional investors, such as pension funds, investment funds, endowment funds, insurance companies, banks, sovereign wealth funds, family offices/high net worth individuals and funds of funds, as well as the private equity fund managers themselves. Private equity funds have a limited life, meaning that there is a pre-agreed date on which they will stop making new investments and subsequently be wound up. Typically, a fund invests in new projects for six years and is wound up in ten years. There is a standard extension period of two years in most fund agreements, hence they are generally known as ‘ten plus two’ limited life funds. In the past few years, some longer-term funds have started to be raised by some fund managers. These are typically targeting growth capital. The chapter then differentiates limited partners (external investors) from the general partner (the manager). It also studies the economics of private equity, examines the details of a representative Limited Partners Agreement as well as taxation, and describes the secondary fund market.

Financial Markets, Financial Instruments, and Financial Engineering

This chapter focuses on debt and equity. Debt is a contractual obligation to pay an amount to a lender on given dates; it may be secured or unsecured. The cost of debt is interest. Banks and other lenders provide the debt in buyouts. This debt may take many forms and be provided by many different market participants, including one or more of commercial banks, debt funds, investment banks, dedicated mezzanine providers, hedge funds or similar specialist funds, or the public markets via high yield bonds. The chapter then provides a brief background of the 2008 global financial crisis. It also addresses the risks of leveraged lending and defines deep discounted securities (DDS) as well as mezzanine finance. Finally, the chapter explains the structure and terms of a standard Loan Markets Association (LMA) leveraged finance contract to give a sense of the size and complexity of the contract and the negotiations surrounding it.

A Detailed Worked Example of a Leveraged Buyout

This chapter explores the major criticisms levelled at the private equity sector. It clarifies some misrepresentations and myths in the light of experience over the evolution of the market and the weight of systematic evidence summarized in this book. It is important to distinguish between analysis at the fund level and at the level of the underlying individual investments. The majority of studies in the finance literature are at the fund level and discuss private equity as an investment strategy. Analysis at the investment level is often done by case study, which always risks creating general conclusions from specific examples. The chapter then looks at areas which are under-researched. These areas include performance and returns; deal structures; the private equity process; new and secondary markets; and political environment.

Doing A Deal

This chapter details the process of a private equity transaction. There are two sides to every corporate transaction: those acting with or for the purchaser and those acting with or for the owners of the target company, the shareholders. Private equity funds outsource many functions. The chapter looks at the advisory relationships at three stages of an asset’s ownership cycle: acquisition of the target company, during the ownership life, and finally at disposal. It considers both what the advisers are doing and the incentives that this creates in the broader private equity market, particularly focusing on reciprocity. The chapter also examines the auction process that lies at the heart of many private equity deals. The key contracts in a private equity deal include the Articles of Association, the Investment Agreement, and the Sale and Purchase Agreement. The chapter then describes the Heads of Terms, which is a non-binding agreement that sets out the key terms of the deal prior to starting to draft the formal contracts.

Measuring Private Equity Performance

This chapter explains how to measure private equity performance. One of the key distinctions to be focused on is the gross versus net performance of a fund or investor. Gross returns are the returns earned by the private equity fund before fees are paid to the manager. Meanwhile, net returns are the returns earned by the investors in the fund after the fees of the manager have been deducted. Various measures are applied to monitor and adjust for the timing differences between total return and receipt of cash flows. DPI measures distribution as a percentage of paid-in capital, while TVPI measures total value as a percentage of paid-in capital. However, the most commonly used measure is the Internal Rate of Return (IRR). IRR is a cash flow measure that allows for the timing of cash flows. The chapter then highlights the importance of understanding both the overall industry returns and their variance and volatility over time. The variation in returns between the most successful and least successful fund managers is a key statistic to understand the performance and risks of the industry.