Private equity investment funds have become an increasingly popular alternative investment in recent years. There are some notable features that characterize most private equity funds. First, private equity funds invest in private companies rather than public companies. The illiquidity of private equity investments means there is no active secondary market. Also, the concentrated nature of private equity portfolios offers limited diversification benefits. However, strong excess returns can make the risks worthwhile for investors. When analyzing potential private equity investments, valuation is challenging since the companies are private. Different approaches are used depending on the nature of the investment. For example, leveraged buyouts are valued very differently from venture capital in early stages. Overall, private equity professionals tend to use multiple techniques when conducting valuations, exploring many possible future scenarios for the business. There are also important structural considerations with private equity funds. Carried interest compensates the general partner with a share of profits, subject to a hurdle rate. Rights like tag-along and drag-along help align incentives between private equity firms and management of portfolio companies.
Private equity funds create value via financial engineering, incentives, and operational improvements
Private equity funds seek to create value through various means, including optimizing the financial structure, incentivizing management, and creating operational improvements. Private equity can be thought of as an alternative corporate governance system compared to most public companies where ownership and control are separated. The combination of ownership and control is considered a fundamental source of private equity funds’ ability to generate returns. A key role of the general partner (GP) is assessing potential investments. But valuation is challenging since the companies are usually privately held. The valuation approach depends on the nature of the investment. For a startup company, very different techniques are needed compared to a leveraged buyout. Private equity professionals tend to use multiple valuation methods, exploring many scenarios for the company’s future. For buyout deals, the ability to access debt financing can significantly influence the scale of private equity activity. It also appears to affect observed valuations in the market. Since private equity funds aim to acquire, add value, and exit investments within the fund’s lifetime, they are considered buy-to-sell investors. Planning the exit strategy is a critical role for GPs – a well-timed, well-executed exit can be an important source of value creation.
Common exit routes include IPO, sale to a strategic acquirer, or secondary sale
In addition to the challenges private equity funds face in assessing potential portfolio investments, valuing the investments on an ongoing basis also poses difficulties. This is because these investments do not have readily observable market values, and significant judgment is involved in valuing them before the fund exits each company in the portfolio. The two main metrics for gauging continuing and final performance of private equity funds are internal rate of return (IRR) and multiples. Comparing returns across different private equity funds and relative to other asset classes is demanding because differences in timing of cash flows, risk and composition of portfolios, and vintage year effects are significant.
Legal rights align incentives between private equity firms and portfolio company management
Private equity firms often structure contractual rights to align their interests with management teams of the portfolio companies. Two such rights are tag-along rights and drag-along rights. These protect management’s interests rather than the PE firm’s interests. They ensure that any potential future acquirer of the company cannot gain control without making an acquisition offer to all shareholders, including management. Another common right is reserved matters, which require the private equity firm’s approval for certain major strategic decisions like acquisitions or divestitures. This protects the PE firm’s equity interests. Finally, a liquidation preference ensures the private equity firm’s payout is higher than that of other investors, including management of the portfolio company.
In summary, private equity investment funds have distinct features like concentrated portfolios, lack of liquidity, challenging valuations, and incentive alignment mechanisms. Despite risks like illiquidity, the potential for strong returns makes private equity an appealing option for qualified investors.