Even before private equity became a regular feature of partisan political debate in last year's Presidential election, the industry has been steadily gaining prominence in recent years.
Flipping through leading newspapers also reveals that these funds are subject to a range of different and often contradictory perceptions. Private equity funds are either conquering the world (“Private Equity Goes International” or “Private Equity’s Love Affair with China”) or on the verge of seeing their best days behind them (“Defending Private Equity from a Flawed Picture”). They may be a wrestling with divisive internal conflicts (“A Clash Between Venture Capital and Private Equity”) or benefiting from a broad consensus among leading practitioners (“Private Equity Titans Find Common Ground”).
Private equity funds are unregulated investment vehicles formed to facilitate investments in listed and unlisted shares and other securities. Such investments may also include listed companies that, after acquisition by the fund, will be “taken private” and unlisted. Traditionally, these funds have focused on capital appreciation rather than current income. Accordingly, they are usually established as closed-end funds where an investor’s money may be locked up for between ten to fourteen years.
A number of different strategies to access investment opportunities in public and private companies can be grouped under the heading of “private equity.” These strategies may be categorised under three broad headings. First, venture capital funds invest in young, entrepreneurial companies, frequently focusing on new technologies. Second, buy-out funds purchase significant positions in mature businesses, frequently with significant amounts of borrowed money, with a specified exit period. Third, special situations funds are active in a broad array of debt financing and other investments in distressed or rapidly changing companies.
Once a decision is reached by an institutional investor to allocate money to private equity, there are a number of different options available. The investor could identify and invest directly in particular target companies, assuming he has access to potential transactions and the time and expertise to negotiate and oversee. Alternatively, the investor could invest in a private equity fund, which would allow him access to investment professionals with demonstrated abilities and past success, together with the benefits of increased diversification across a number of investments. Finally, the investor could allocate to a fund-of-funds, which would make available to him a portfolio of different private equity funds across strategies and vintage years, many of which he would not have been able to invest in indirectly.
Two features of private equity funds which easily distinguish them from hedge funds, their alternative investment "cousin", are the initial “commitment” made at the launch of the fund to provide up to a certain amount of capital to the fund when required (rather than fully investing a sum of money on the first day), and the fixed life of the fund, ranging from seven to ten years, with all investments having been made during the defined life being realised on or before the termination date.
These features derive from their target investments - typically, illiquid stakes in unlisted companies. For example, private equity funds require a commitment from investors of up to ten years, which may be subject to further extensions. Upon launch, only a fraction of the investor’s capital commitment will be payable, with the balance drawdown as and when investments are identified. As a result, the investment period may range from three to five years with a distinctive drop in performance in the fund’s early years (known as the “J curve” or the “hockey stick”) due to the small amount of invested capital and the effect of organisational expenses and management fees until investments begin to be realised.
Although private equity funds have, until very recently, provided fairly consistent rates of return, they have certain pronounced disadvantages to many investors. These include irregular capital calls, difficulties in forecasting the distribution of cash proceedings, and highly illiquid investments by the fund that can be difficult to value. Private equity funds clearly do not suit every investment portfolio. As a result, typically only the largest institutional investors around the world have allocated their money to these funds.
In most other ways, however, the similarities of private equity and hedge funds far outnumber the differences. They are typically established as unregulated collective investment schemes and have surprisingly similar asset-based and performance-based remuneration. These structural similarities will be discussed and dissected in the following chapter.
Before commencing any rigorous analysis of the private equity industry, it is important to maintain a proper sense of scale when talking about the size of these firms and the funds they manage. A private equity firm managing, say, $4 billion can be referred to a “mid-sized”, even though they may have high-profile institutional investors, such as CalPERS and Harvard University, participating in their fund. The “big guys” in the industry are firms like Henry Kravis’s KKR, Steve Schwarzman’s Blackstone Group, David Rubenstein’s Carlyle, Leon Black’s Apollo or David Bonderman’s TPG Group, who have several times more in investor capital to put to work in each fund they raise.
The many companies that these mega-funds buy and sell every year has meant that growing numbers of men and women in the US, the UK, across Europe and around the world now work for companies owned by private equity funds. These companies are being operated and managed (and often restructured and refinanced) in such a manner as to deliver outsized returns to the investors in the fund.
What does this mean to the man or woman on the street who might be worried about the impact of private equity on his or her life and livelihood?
In a bold move to better explain the private equity business model to the general public, the industry reached out to the “Schoolhouse Rock” generation of middle-age men and women who grew up in the United States watching those toe-tapping, easily-hummable Saturday morning cartoons by producing their own animated defense of their business practices. In May 2012, the Private Equity Growth Capital Council released its own cartoon video on YouTube that walked viewers briskly through the inner workings of leveraged buyouts. Although not as memorable as “Conjunction Junction,” and lacking the emotional arc of “Verb, That’s What’s Happening,” the trade association’s first attempt at animation conveyed several important talking points about the way private equity functioned to work with company in need of capital and expertise in a succinct and understandable manner.
Questions, however, remained in many laypersons’ minds about how private equity fit into the larger economy, even as the trade association earned kudos for at least attempting to tell the story of private equity from the perspective of its most sincere practitioners. Private equity still has a long way to go, though, until the industry has ceased to be a source of fear and misapprehension. That will take some time, especially after the vitriolic language used on the campaign trail last year.
The above is an excerpt from the forthcoming book, "ONE STEP AHEAD - Private Equity and Hedge Funds After the Global Financial Crisis," which will be published by Oneworld in the fall. Click here for more information.
