Although increasingly important in all the major economies, private equity is a sector that many people still know little about. This is not surprising—the amount of public information about the transactions, the performance and the activities of private equity funds is limited. But the amount of money raised by these funds over the last few years has been enormous—more than $400 billion (Rs16.4 lakh crore) in 2006 alone. These funds are increasingly looking at large companies—many of them publicly quoted—as potential takeover targets. And the focus of private equity funds is starting to shift from the traditional markets of the US and Europe towards countries such as India and China.
The way private equity firms manage companies differs significantly from the traditional public-company model, and has led some to question whether private equity is a new, and superior, form of corporate governance. In this two-part article, I will lift the veil on this sector and look at whether those who work in private equity are really the new kings of capitalism.
In this article, I’m going to start right at the beginning and explain what is meant by private equity, how the funds are organized, and where the money flows from and to. In the second article, to be published on 28 May, I will look at the performance of PE funds over recent years and discuss how private-equity firms may add value.
But let’s start right at the beginning and define what is meant by private equity. Definitions differ, but when I talk about private equity, I mean the entire asset class of equity investments that are not quoted on stock markets. So, the private-equity class stretches from venture capital—working with really early-stage companies that, in many cases, will have no revenues, but potentially good ideas or technology—right through to large buyouts, where the private-equity firm buys the whole company.
How is the invested money split between venture capital and buyout deals? Well, in broad terms, around four-fifths of the money has been flowing into buyouts in recent years. In part, this is due to the sheer scale of buyouts where an individual deal can absorb several billion dollars of capital. In contrast, venture-capital deals tend to drip feed money into companies as they develop. But it is also because investors have increasingly been focusing on buyout funds, as the average returns earned have tended to be higher. More on this in the next article.
Most of the money comes from institutional investors such as pension funds, endowments and insurance companies. Most of the pure private- equity funds are structured as limited partnerships. This isn’t the time to go into fine legal distinctions, but essentially these are tax-efficient investment vehicles of a limited duration—almost always with a 10-year life.
Now, a critical aspect of private-equity funds is that they are not investors who buy to own the companies for the long term—they are buy-to-sell investors. They want to make their investments, create value and then exit. They are judged on two measures of performance—the main one is their cash-on-cash returns. For whatever sums they commit, the investors care about how much they get out, net of all the payments to the fund. A good investment might earn three, four or even higher multiples of the original sum invested. Alternatively, the investment may disappoint and return a fraction of the original sum, or, in many cases—particularly with venture capital—be worthless after a few years.
The second performance measure is the internal rate of return that investors achieve—which depends on how long it takes for the investors to get their money back. So, a profit achieved in two years will have a higher internal rate of return than if the same profit took four years to achieve. Given these performance measures, the private-equity firm has sharp incentives to create value, to exit the investments and return the money to the investors. And the partnership agreements do not let them reinvest the proceeds in the next available opportunity. Funds have to go out and raise capital again, by launching a new fund. If performance has been poor, this won’t be easy.
The other aspect of these funds that I want to highlight is the remuneration of the private-equity firm. There are two components to the remuneration—a percentage for managing the fund, which is typically 2% per annum. So, over the 10-year life of a $1 billion fund, the management fees might add up to $200 million. These annual fees can yield very large sums of money, especially when one considers that the funds are extremely lean organizations with few employees and even fewer partners who enjoy a share of the profits.
This profit share is the second part of the remuneration and is referred to in the private- equity world as carried interest. The carried interest is typically set at 20% of the net profits earned by investors and is only payable when the investment is realized and the cash has flowed back to investors. So, if a $1 billion fund returns $3 billion to its investors, the profits would be $2 billion, and the lucky few in the private-equity fund who enjoy a share of the carried interest would share 20% of this—that is, $400 million. Life in the top funds can be good! Perhaps now you start to understand why private equity is the hottest job on the block for business-school students.
Funds themselves are also getting bigger, and so larger and larger companies are becoming potential targets for private-equity funds. There are few public companies that can really feel insulated from the attentions of private-equity funds, and the number is shrinking each year. But what of the returns—has private equity been a good investment? The answer is, perhaps, surprising—as I will discuss in the second part of this article.
(Tim Jenkinson is professor of finance at the Saïd Business School, University of Oxford)
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