Private equity
From Wikipedia, the free encyclopedia
In finance, private equity is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.
There are a wide array of types and styles of private equity and the term private equity has different connotations in different countries.[1]
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[edit] Types of Private Equity
Private equity investments can be divided into the following categories:
- Leveraged buyout, LBO or Buyout: refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically more mature and generate operating cash flows.
- Venture capital: a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture Capital is often sub-divided by the stage of development of the company ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that is often used to fund expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth.[2]
- Growth capital: refers to equity investments, most often minority investments, in more mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.
[edit] Other Strategies
Other strategies that can be considered private equity or a close adjacent market include:
- Distressed or Special situations: can refer to investments in equity or debt securities of a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (e.g., a change in government regulations or market dislocation). These categories can refer to a number of strategies, some of which straddle the definition of private equity.
- Mezzanine capital: refers to subordinated debt or preferred equity securities that often represents the most junior portion of a company's capital structure that is senior to the company's common equity.
- Real Estate: in the context of private equity this will typically refer to the riskier end of the investment spectrum including "value added" and opportunity funds where the investments often more closely resemble leveraged buyouts than traditional real estate investments. Certain investors in private equity consider real estate to be a separate asset class.
- Secondary investments: refer to investments made in existing private equity assets including private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. Often these investments are structured similar to a fund of funds.[3]
- Infrastructure: investments in various public works (e.g., bridges, tunnels, toll roads, airports, public transportation and other public works) that are made typically as part of a privatization initiative on the part of a government entity.[4][5][6]
- Energy and Power: investments in a wide variety of companies (rather than assets) engaged in the production and sale of energy, including fuel extraction, manufacturing, refining and distribution (Energy) or companies engaged in the production or transmission of electrical power (Power).
- Merchant banking: negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.[7]
[edit] History and evolution
The seeds of the private equity industry were planted in 1946 when the American Research and Development Corporation (ARD) decided to encourage private sector institutions to help provide funding for soldiers who were returning from World War II. While the ARD had difficulty stimulating any private interest in the enterprise and ended up disbanding, they are significant because this marked the first recognized time in financial history that an enterprise of this type had been formed. In addition, they had an operating philosophy that was to become significant in the development of both private equity and venture capital: they believed that by providing management with skills and funding, they could encourage companies to succeed and in doing so, make a profit themselves. During the course of their unsuccessful journey, ARD did succeed in raising approximately $7.4 million, and they did have one rousing success; they funded Digital Equipment Corporation (DEC). By the 1970s such private participation had permeated into the private enterprise formation, but until the late 1970s, the task was being largely carried out by investment arms of a few wealthy families, such as the Rockefellers and Whitneys.[8] In the 1980’s, FedEx and Apple Inc. were able to grow because of private equity or venture funding, as were Cisco, Genentech, Microsoft, Avis, Beatrice Foods, and Dr Pepper.[9]. Despite these successes, through a series of "debt-financed leveraged buy-outs (LBOs)" of established firms, the PE firms were being seen with acrimony and being casted as irresponsible corporate raiders- as a threat to the free capitalist structure. The extreme example of this phenomenon is described in the bestselling book,[10] where the two PE firms Forstmann Little and Kohlberg Kravis Roberts, were described as "Barbarians at the Gate" for their aggressive $25 billion pursuit for RJR Nabisco.
[edit] Investments in Private Equity
Institutional investors provide private equity capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets and will typically include private equity as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds). Most institutional investors, do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through fund of funds to allow a more diversified portfolio than an investor could construct.
Private equity firms generally receive a return on their investments through one of the following avenues:
- an Initial Public Offering (IPO) - shares of the company are offered to the public, typically providing an partial immediate realization to the financial sponsor as well as a public market into which it can later sell additional shares;
- a merger or acquisition - the company is sold for either cash or shares in another company;
- a Recapitalization - cash is distributed to the shareholders (in this case the financial sponsor) and its private equity funds either from cash flow generated by the company or through raising debt or other securities to fund the distribution.
[edit] Investment features and considerations
Considerations for investing in private equity funds relative to other forms of investment include:
- Substantial entry requirements. With most private equity funds requiring significant initial commitment(usually upwards of $1,000,000) which can be drawn at the manager's discretion over the first few years of the fund.
- Limited liquidity. Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to achieve liquidity before the manager realizes the investments in the portfolio as an investor's capital is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
- Investment Control. Nearly all investors in private equity are passive and rely on the manager to make investments and generate liquidity from those investments. Typically, governance rights for limited partners in private equity funds are minimal.
- Unfunded Commitments. An investor's commitment to a private equity fund is drawn over time. If a private equity firm can't find suitable investment opportunities, it will not draw on an investor's commitment and an investor may potentially invest less than expected or committed.
- Investment RisksGiven the risks associated with private equity investments, an investor can lose all of its investment. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development or in companies with high amounts of financial leverage. By their nature, investments in privately held companies tend to be riskier than investments in publicly traded companies.
- High returns. Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.
[edit] Liquidity in the private equity market
The private equity secondary market (also often called private equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private equity assets.
Increasingly, secondaries are considered a distinct asset class with a cash flow profile that is not correlated with other private equity investments. As a result, investors are allocating capital to secondary investments to diversify their private equity programs. Driven by strong demand for private equity exposure, a significant amount of capital has been committed to secondary investments from investors looking to increase and diversify their private equity exposure.
[edit] Private equity fundraising
Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund that they have invested in.
- Fund of funds. These are private equity funds that invest in other private equity funds in order to provide investors with a lower risk product through exposure to a large number of vehicles often of different type and regional focus. Fund of funds accounted for 14% of global commitments made to private equity funds in 2006 according to Private Equity Intelligence Ltd.
- Individuals with substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.
As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004 there were 26 investors in the average private equity fund, this figure has now grown to 42 according to Private Equity Intelligence Ltd.
It is also worth noting that the managers of private equity funds themselves will also invest in their own vehicles, typically providing between 1–5% of the overall capital.
Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles. The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services according to Private Equity Intelligence Ltd. Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner.
The amount of time that a private equity firm spends raising capital varies depending on the level of interest amongst investors for the fund, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital where they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerably longer, with managers of less popular fund types (such as European venture fund managers in the current climate) finding the fundraising process more tough. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months.
Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for a new investor to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.
[edit] Size of industry
A record $365bn of private equity was invested globally in 2006 up nearly three times on the previous year. Private equity fund raising also surpassed prior years in 2006 and totalled $335bn, up a quarter on 2005. Improved market confidence and trading conditions and strong performance along with stable long-term returns have contributed to this growth. Buyouts have accounted for a growing portion of private equity investments by value in recent years, and increased their share of investments from a fifth to more than four-fifths between 2000 and 2006. By contrast, the share of early stage or venture capital investment has declined during this period.
The regional breakdown of private equity activity shows that in 2006, North America accounted for around 60% of global private equity investments (down from 67% in 2000) and 47% of funds raised (down from 69%). Between 2000 and 2006, Europe increased its share of investments (from 21% to 24%) and funds raised (from 21% to 44%). This was largely a result of strong buyout market activity in Europe. In recent years, there has been a rise in the importance of Asia-Pacific and emerging markets as investment destinations, particularly China, Singapore, South Korea and India. Asia-Pacific’s share of investments increased from 6% to 14% during this period while its share of funds raised remained unchanged at around 8%. [11]
The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels.
In terms of the regional split of fundraising, the majority of funds raised in 2006 were focusing on the American market, with 62% of capital raised in 2006 focusing on the US. European focused funds account for 26% of the global total, whilst funds focusing on Asia and the Rest of World account for the remaining 11%.
Venture capital is considered a subset of private equity focused on investments in new and maturing companies.
Mezzanine capital is similar class of alternative investment focused on structured debt securities in private companies.
[edit] Private equity firms
According to an updated 2008 ranking created by industry magazine Private Equity International[12] (published by PEI Media called the PEI 50), the largest private equity firm in the world today is The Carlyle Group, based on the amount of private equity direct-investment capital raised over a five-year window. As ranked in this article, the largest 10 private equity firms in the world are:
- The Carlyle Group
- Goldman Sachs Principal Investment Area
- TPG
- Kohlberg Kravis Roberts
- CVC Capital Partners
- Apollo Management
- Bain Capital
- Permira
- Apax Partners
- The Blackstone Group
The full list is located here.
Because private equity firms are continuously in the process of raising, investing and distributing their private equity funds, capital raised can often be the easiest to measure. Other metrics can include the total value of companies purchased by a firm or an estimate of the size of a firm's active portfolio plus capital available for new investments. As with any list that focuses on size, the list does not provide any indication as to relative investment performance of these funds or managers.
[edit] Private equity fund performance
In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments. In the majority of cases the only groups with knowledge of fund performance were investors in the funds, academic institutes (as CEPRES Center of Private Equity Research) and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.
The application of the Freedom of Information Act (FOIA) in the certain states in the United States, the United Kingdom and other countries, has made certain performance data more readily available. Specifically, FOIA has required certain public agencies to disclose private equity performance data directly on the their websites[13].
The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years (i.e., from 2003-2007) in comparison with other asset classes such as public equities. In contrast other fund investment types, venture capital most notably, have not shown similarly robust performance.
Within each investment type, manager selection (i.e., identifying private equity firms capable of generating above average performance) is a key determinant of an individual investor's performance. Historically, performance of the top and bottom quartile managers has varied dramatically and institutional investors conduct extensive due diligence in order to assess prospective performance of a new private equity fund.
It is challenging to compare private equity performance to public equity performance, in particular because private equity fund investments are drawn and returned over time as investments are made and subsequently realized. One method, first published in 1994, is the Long and Nickels Index Comparison Method (ICM). Another method which is gaining ground in academia is the public market equivalent or profitability index. The profitability index determines the investment in public market investments required to earn a target profit from a portfolio of private equity fund investments.[14]
[edit] Further reading
- Cendrowski, Harry (2008). Private Equity: Governance and Operations Assessment. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-17846-1.
- Maxwell, Ray (2007). Private Equity Funds: A Practical Guide for Investors. New York: John Wiley & Sons. ISBN 0-470-02818-6.
- Leleux, Benoit; Hans van Swaay (2006). Growth at All Costs: Private Equity as Capitalism on Steroids. Basingstoke: Palgrave Macmillan. ISBN 1-403-98634-7.
- Fraser-Sampson, Guy (2007). Private Equity as an Asset Class. Hoboken, NJ: John Wiley & Sons. ISBN 0-470-06645-8.
- Bassi, Iggy; Jeremy Grant (2006). Structuring European Private Equity. London: Euromoney Books. ISBN 1-843-74262-4.
- Thorsten, Gröne (2005). Private Equity in Germany — Evaluation of the Value Creation Potential for German Mid-Cap Companies. Stuttgart: Ibidem-Verl. ISBN 3-898-21620-9.
- Lerner, Joshua (2000). Venture Capital and Private Equity: A Casebook. New York: John Wiley & Sons. ISBN 0-471-32286-5.
- Lerner, Joshua (2000). Venture Capital and Private Equity: A Casebook. New York: John Wiley & Sons. ISBN 0-471-32286-5.
- (2005) Exposed to the J Curve: Understanding and Managing Private Equity Fund Investments. London: Euromoney Institutional Investor. ISBN 1-84374-149-0.
[edit] See also
- History of private equity and venture capital
- List of private equity firms
- Leveraged buyout
- Management buyout
- Financial sponsor
- Venture capital
- Mezzanine capital
- Private equity secondary market
- Private investment in public equity
- Taxation of Private Equity and Hedge Funds
- Investment banking
- Mergers and acquisitions
- Global assets under management
[edit] References
- ^ This article uses the American definitions for most terms. The British Venture Capital Association provides An Introduction to Private Equity, including differences in terminology.
- ^ In the United Kingdom, Venture Capital is often used instead of private equity to describe the overal asset class and investment strategy described here as private equity.
- ^ A Secondary Market for Private Equity is Born, The Industry Standard, 28 August 2001
- ^ Investors Scramble for Infrastructure (Fiancial News, 2008)
- ^ Is It Time to Add a Parking Lot to Your Portfolio? (New York Times, 2006
- ^ [Buyout firms put energy infrastructure in pipeline] (MSN Money, 2008)
- ^ Merchant Banking: Past and Present
- ^ The New Kings of Capitalism, Survey on the Private Equity industry
- ^ Private Equity: Past, Present, Future, by Sethi, Arjun May 2007, accessed October 20, 2007.
- ^ Barbarians at the Gate: The Fall of RJR Nabisco.
- ^ Private Equity 2007.pdf
- ^ Top 50 PE funds from Private equity international
- ^ In the United States, FOIA is individually legislated at the state level, and so disclosed private equity performance data will vary widely. Notable examples of agencies that are mandated to disclose private equity information include CalPERS, CalSTRS and Pennsylvania State Employees Retirement System and the Ohio Bureau of Workers' Compensation
- ^ See Phalippou and Gottschalg's 2007 paper, Performance of Private Equity Fundsfor an overview of the profitability index
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