With Dell Inc. (DELL) in news wanting to go private, the roll of private equity firms is in the spotlight again. Private equity once hid in secrecy; being only a small part of the going-ons on Wall Street, private equity didn’t attract any real attention until the heyday of the 1980s and much later when Mitt Romney, one of the founders of Bain Capital, ran for the presidency.
Private equity funds are fairly simple to understand as a whole. Let’s explore how the world of private equity works.
How Private Equity Funds Work
Private equity funds are set up as a limited partnership by a private equity firm. The firm then reaches out to large investors like university endowments, union pension plans, charities, insurance companies, and extremely wealthy individuals to raise capital. Once invested, the limited partners’ capital is locked up for a predetermined number of years before the fund is liquidated and the principle (and hopefully profits) are returned to shareholders.
The investors are limited partners in the newly established fund. The private equity firm managing the fund is the general partner enabled to make all investment decisions after raising capital.
The name “private equity” explains much of what these funds do. Private equity firms use their raised funds to take companies private from public stock markets, or to invest in companies that are already private. Bain Capital, for example, did both – it took companies private off the public stock market and also invested in small venture capital startups like office supply company Staples.
Why Would Anyone Invest in Private Equity Funds?
Private equity funds are illiquid and managed by active investors. If you’re familiar with common index funds such as those ordinary investors might hold in their investment portfolios, you might be led to believe an investment in private equity funds is a fools game.
History has shown that private equity investments generally turn out to be very good investments. Here’s why:
- Taking companies private is incredibly profitable – When a private equity firm takes a company private from the public markets it has 100% ownership and can thus claim ownership of all profits from the company and have complete control over capital allocation. In short, private equity firms have unlimited control over the going-ons of a company unlike public equity investors – and that means they can claim all cash flows that come from the company.
- Equity returns in short time frames – It wouldn’t be advised to invest in a portfolio of 100% stock if you think you’ll need the money in the next 5-7 years. However, since private equity companies take companies private, reap the full benefits of ownership (profits), and then resell the companies at a later date 5-7 years in the future, private equity investors get equity-like returns in a time period that would really only be safe for fixed-income investments.
- Leverage – Private equity funds take money from investors and then leverage it with bank loans and bond issues from their newly acquired companies to boost returns for their investors. If a private equity firm takes a company private at 10x earnings, a return of 10% per year, it can do very well for its limited partners by leveraging those earnings with cheap debt. Think of it like buying real estate. Real estate is a good investment, but when leveraged with bank loans, it can be an excellent investment.
- Exits – Private equity funds are designed to exist only for a period spanning less than a decade. When the fund reaches the end of its designed life, it “exits” its holdings by selling them. A common exit is to sell a private equity position to a competing firm, or to list private companies in its portfolio on the public markets through an IPO.
In a worst case scenario, private equity funds would love to buy a company from the public markets, earn a respectable return from its annual earnings, and then sell it back to the market in an IPO at a price equal to or higher than its original investment.
Private Equity Fee Schedules
Investors in a private equity fund pay the general partner – the private equity firm running the fund – a management fee. This management fee is similar to what investors might pay in a hedge fund. Generally, a private equity fund must first beat a “hurdle rate” of 6-12% per year before it can start taking fees.
Once the hurdle is beaten, the returns in excess of the hurdle are assessed a management fee. A common fee is 20% of all profits in excess of the hurdle rate. This model gives the private equity firm incredible incentives to deliver stellar returns for investors, since the firm is paid only if it beats its hurdle rate.
Private Equity Criticisms
Critics of private equity funds contest that private equity firms make money for their investors without regard to stakeholders in the business. In most cases, the kinds of companies that private equity firms acquire are already in poor financial health, lacking in a competitive environment, or have poor managers. Private equity firms want to acquire companies cheap, and that means buying companies they believe have more value than Wall Street is willing to realize. Sometimes it means buying companies that everyone knows will go out of business, such as Yellow Pages.
Private equity does earn some of the criticism it gets, however. Private equity firms are known to go a little too far with leverage, sometimes threatening the very existence of the companies they take private. In a recent example, private equity firms added $400 million of debt to AutoTrader just months before filing with the SEC to take it public. In seeking more debt, the private equity funds were able to suck $400 million of cash out of the firm to pay themselves a dividend while seeking to list the weakened firm on Wall Street. This battle goes both ways, of course, seeing as one could make the case that companies today have way too much cash on hand as it is. S&P 500 companies hold more than $1.2 trillion in cash that should arguably be returned to investors.
All in all, for those who can invest in a private equity fund, they make for an interesting investment. Funds deliver generally high returns for their investors and general partners, while correcting some of the ineffeciencies in the public equity markets.