Demystifying Private Equity

By Temi Adelami


WHAT IS PRIVATE EQUITY?

Private equity (PE) refers to capital investment made into private companies i.e., companies that are not publicly traded. They are usually exchanged for some form of equity stake/ownership within a private company.

Conversely, private equity - buying shares on the stock exchange.


Note: private credit is different, this refers to a source of financing that could fund similar purposes to buying real estate, buying other companies, funding new tech, pay down debt, working capital etc. Private equity investors tend to be pooled together into a fund i.e., hedge funds. Conventional investment categories such as public stocks, bonds and cash.


  • Venture capital and angel investing are subcategories of private equity transactions

  • Private equity = investor will invest money and buy ownership to a part of the company

  • Debt transaction/private credit = investor may give a company a loan in return for getting that loan back in the future with interest on it

  • So, its ownership vs loan


WHAT ARE BONDS?

  • Fixed income e.g., an IOU

  • If I issue a bond, I am taking money from you and give you interest on that money

  • Government bonds = typically the most secure type of bond

1. This is because for example, the UK government: you would never expect

them to default on its debt obligation

2. So, UK government bonds would have a lower interest rate than a borrower

who was much riskier e.g., a retail borrower you do not know the reliability of


WHAT IS A TYPICAL PRIVATE EQUITY STRUCTURE?

LIMITED PARTNERSHIP

  • Freedom from many legal constraints

  • Easy to set up/low capital requirements

  • Disclosure obligations – do not have to tell/disclose publicly a lot of info about the work they are doing = much flexibility

  • A big attraction to private equity funds

  • They are also tax transparent

1. = the limited partners are treated for tax purposes …. The investors just get

taxed on their investment and their returns on the end = little to no tax =

profits can be maximized

2. But If you had a limited company, it would have to pay tax on profit, then

distribute funds to investors, investors then have to pay tax on distributions

they received as well

  • Investment Manager will take a management fee

1. Usually, part of the fund group


HOW DO PEOPLE INVEST MONEY INTO THIS STRUCTURE?

  • LP (limited partner/s) will invest capital contributions

  • Will be asked for a specific amount of money when they acquire a partnership

  • Capital used to pay legal fees, admin fees, etc

  • LP not usually asked to contribute all their capital at the time of subscription, usually staggering because funds do not want to sit on excess money as it will dilute the returns and make them look worse

  • If an LP fails to provide funds when called for, it is dealt with seriously under the Limited Partner agreement

1. Can result in forfeiture of all or some of the LPs interest, or force the LP to

sell their interest in the company, either externally or either to the other LPs

internally


Limited partnership agreement or ‘Waterfall’

  • Works to share profits between the partners and management team

  • Private equity = you use other people’s money to make a lot of money


Profits typically allocated between the management team and the investors/limited partners until the management team achieves a certain level of return, depending on the transaction.


No.1 thing you pay out = investors original commitment amount

Then pay hurdle, typically an interest around 8 to 10%

Then catch up 80-20 in favour of management team

Then after this catch up profits split in reverse, so the investors get more than management team

Management team earn a disproportionate amount to how much they contribute

Investment manager receives a management fee


Private equity = a route to acquire financing to achieve whatever purpose you have at the time

E.g. your company took on a loan a few years back and you may wish to pay this loan off, you may wish to go down private equity to source funds


ADVANTAGES

  • Not necessarily just underperforming companies that go down this route, it is just a route

  • Involves a lot of money

  • Tends to be used by bigger companies

  • Clear incentives

  • Clear focus for the management team who have a strong track record in operating in a particular investment strategy

  • For companies that use this, it is much easier to manage and there tends to be less formal structure and less regulation = easier to make profits due to fewer rules and scrutiny


If you are a private equity manager, you are looking to make as much money as possible so will look at underperforming companies to try and turn them around = this will make the most money.


THE DEAL PROCESS – STEPS/STAGES

DUE DILIGENCE

  • What do the company actually want?

  • What is the goal?

  • Will management go ahead with the deal? Flesh out the details in meetings

  • Once investment committee says yes, moves to the fundraising team

  • Investment manager has duty to understand what is going on

  • Can take up to 12-18 months, especially in real estate where you will be buying a portfolio of properties


FUNDRAISING

  • Separate team raise the funds

  • Or if private equity firm that is yet to spend all of the money its raised, that will just be drawn out from fund and used for the transaction

  • Can be smooth if your fund has not yet spent all the money raised

1. You may have a target of 500mill, but may have commitments/capital

contributions from various investors… will not be asked for all money upfront,

maybe half but then further funds will later be requested to execute on these

deals


EXECUTION

  • Getting all legal documents /structure in place so company can execute on whatever they need the money for

  • Consists of

1. Transaction management

a. On top of transaction documentation

b. Make sure it reflects what the investment committee agreed to

c. If new structure to be set up, need to be liaising with those setting it up

(often in different jurisdictions)

2. Engaging 3rd party professionals

a. Legal fees to be signed off

b. Ensure no unrealistic assumptions and work is all within scope

3. Issuing engrossments

a. Prepare investor documentation