Did Christopher Columbus' trip to America have anything in common with the investments that private equity funds make in non-quoted companies?
This article was born due to my interest in the private equity industry and is the first piece of extensive research I decided to do to better understand how private equity firms operate. It is the industry that sometimes is deemed controversial but arguably populated with some of the smartest and most knowledgeable people on the planet (Phalippou, n.d.).
Content
• The definition and a brief history of private equity;
• The structure of private equity funds;
• Main characteristics of private equity firms and the industry as a
whole;
• A brief explanation of the fundraising process
• How private equity firms and investors make their return on
investment;
• Types of investments private equity firms make;
• The role of the British Private Equity & Venture Capital
Association; or
• Exit strategiesWhat is private equity?
Private equity provides long-term, committed share capital to help unquoted companies grow and succeed… (PE) is invested in exchange for a stake in your company and, as shareholders, the investors' returns are dependent on the growth and profitability of your business (British Private Equity & Venture Capital Association -further BVCA, n.d.). Sometimes, the term venture capital is used to describe private equity; however, the BVCA suggests a difference between them: 'The main difference between private equity and venture capital comes down to the company's age. Private equity will typically invest in a mature company, one which has been in operation for many years, if not decades. Venture capital, by contrast, will invest in new companies, many, if not most, of which will not yet be making a profit, but which have a disruptive business offering with the potential of robust growth. Another distinction could be that private equity firms are likely to take total control over a company by acquiring most shares. In contrast, capital venture funds are generally more likely to buy equity in a company with minority ownership. Glen Arnold, in his book called Financial Times Guides: Financial Markets (2012), provides a similar definition of private equity and its distinction to venture capital:
''Private equity is medium to long-term finance invested in companies not quoted on any stock exchange to profit from their growth. It enables companies that are unable to access further funding from current shareholders or banks to obtain the required funding from other investors. It is not easy to distinguish between private equity and venture capital. Some use the term ‘private equity’ to define all unquoted company equity investment, others confine ‘private equity’ to investment in companies already well established and apply ‘venture capital’ to investment in companies at an early stage of development with high growth potential''
History of private equity
Since it is already quite difficult to provide a specific definition of private equity that could be commonly used by all countries, companies, and investors, it is even more difficult to gauge how private equity originated. C. Demaria (2013), in Introduction to Private Equity: Venture, Growth, LBO and Turn-Around Capital, provides a beautiful anecdote as an introduction to the book:
''After seven years of lobbying Christopher Columbus convinced the Spanish monarchs (Ferdinand II of Aragon and Isabella I of Castille) to sponsor his trip towards the West. His elevator speech must have been the following: I want to open a new and shorter nautical route to the Indies in the West, defy the elements, make you become even more powerful and rich, and laugh at the Portuguese and their blocs on the Eastern routes.''
Little did Columbus know that he was structuring some form of private equity or venture capital deal at the time. His proposition and PE have had some common characteristics, e.g., high risk, high returns (if the trip was going to be successful), funded by external investors (Spanish monarchs). In modern history, the PE market started to emerge in the 1940s with the creation of the Finance Corporation for Industry (FCI) and Industrial and Commercial Finance Corporation (ICFC) in 1945 (BVCA, n.d.). ICFC was set up to provide larger amounts of capital to supply long-term finance to small and medium-sized businesses (Coopey & Clark, 1995). FCI’s main aim was to support large corporations. Both institutions were merged into an organisation called Finance for Industry (FFI) in 1973, which then further was rebranded for Investors in Industry in 1983 (Merlin-Jones, 2010). In 1994, the FFI was privatised to form 3i, today a multi-national investment company.
The British and European private equity industry started to gain momentum in the 1980s, with a peak in 2006-07. The industry was hit as a result of the financial crisis between 2007-09. Arnold (2012) suggested that the European PE market reported some recovery in 2010. However, many fund managers remained a lot more cautious and searched for cheap companies, even though funds had ‘large stockpiles of cash looking for an investment home.’
Figure 1. Annual European private equity market between 2000-2009 (Arnold, 2012). Retrieved from https://ereader.perlego.com/1/book/812030/608 
The structure of private equity
Private equity usually takes the form of a fund that then invests in a group of companies (Arnold, 2012). A range of sources backs the private equity funds… including pension funds, insurance companies, high net worth individuals, government bodies, and banks (Deloitte, n.d.) and corporate investors, academic institutions, sovereign wealth funds, and capital markets (BVCA). The most typical approach in which private equity funds are structured is by setting up a limited partnership.
The limited partnership consists of general partners (GPs) and limited partners (LPs). General partners are the private equity firms that run and manage these funds, seeking and evaluating companies' investment opportunities. They are given a full mandate to invest and oversees companies in the portfolio. Some notable private equity firms based in the United Kingdom are CVC Capital Partners and Permira Advisers or Blackstone and the Carlyle Group in the United States. Other investors in the fund are limited partners (LPs), and these can be institutions or individuals whose primary role is to provide investment capital. Limited partnerships usually have a fixed life of up to 10 years (BVCA, n.d.), and after that period, general partners are likely to return the principal amount invested by limited partners plus any additional returns made.
A simplistic way to describe fee structure is to understand the '2-20 model' typically used by hedge funds and private equity funds. The GPs are paid management fees of around 2% of the total fund per year and a share of 20% in the eventual capital gain, known as the carried interest. The remaining 80% of profits would be allocated between LPs relative to their initial input. Since the private equity deals are long-term, the management fees usually cover administrative and business expenses. It is vital to remember while the '2-20 model' is provided in most academic resources as the leading fees structure in the industry, not every private equity firm will have the same fee structure, which tends to be extremely complex in nature.
Figure 2. Limited Partnership for a typical PE fund. Retrieved from: https://ereader.perlego.com/1/book/992896/9
Although PE funds are often structured as partnerships, it is fair to say that limited partners are, in fact, clients of general partners who hold the fiduciary duty (a commitment to act in the best interest of another person or a company) towards them. Companies that engage in PE deals must ensure that their investment strategy, planning, and execution are sophisticated enough to ensure satisfactory returns are made for their clients.
Figure 2. is a great visual representation of a typical PE fund (a separate entity in the form of a limited partnership) with capital injected by LPs. After a severe and detailed screening, GPs will then pick their portfolio companies that, they think, have high growth potential. Since the share prices are not controlled by the market interactions, but rather negotiated between parties (Caselli & Negri, 2018), it is a common practice for fund managers to look for undervalued companies that may have been experiencing some financial difficulties or other challenges, and thus seeking for the know-how and/or additional funds that a lot of private equity funds can provide. This process is often called distressed investing, also known as turnaround investing or vulture capital. Financially troubled companies can often be bought at a steep discount (PEI Media, n.d.).
Prospective investors of a private equity fund are typically institutions and extremely wealthy individuals (Private Equity International, n.d.) that usually invest a minimum of £100,000 (BVCA, n.d.). Figure 3. shows that in 2008-09, pension funds, private individuals, and fund of funds were major contributors to British PE funds, while in 2008, overseas pension funds invested more than twice as much than a second-biggest investor. In conjunction with the equity funding from the PE fund, debt will usually be a significant portion of the funding to support a transaction (Deloitte, 2017), provided by, e.g., retail and/or investment banks. Leveraged buyout transactions can use even up to 95% (Poniachek, 2019) of debt relative to the investment's total value.
Figure 3. Sources of PE funds between 2007-09 (Arnold, 2012). Retrieved from https://ereader.perlego.com/1/book/812030/607 
According to Talmor & Vasvari (2011), "private investment funds differ depending on the source of their capital or their investment specialisation. Based on their capital source (LPs) and the ownership of the management company (GP), private equity funds can be classified into":
Independent private equity funds are those in which third-party LPs are the main capital source and where the GPs substantially own the company. An independent fund is the most common type of PE fund.
Captive private equity funds are those in which a parent organisation or sponsor (e.g., a bank or an insurance company) provides all the capital for investment. In such a case, the fund's management company is normally a wholly-owned subsidiary of the parent company.
Semi-captive private equity funds are those in a definition that fall between an independent private equity fund and the captive equity fund.
Type of investment
Private equity and venture capital firms can buy into a company through a variety of investment methods. Some are more relevant to venture capital funds or business angels (informal venture capitalists), and others are commonly applied by PE funds. In this article, we will only discuss the types of investments (financing) that PE funds are likely to engage in:
Management buyout (MBO). It is the acquisition of a business from its owners by the existing management team. A team of managers would typically buy a whole business, a subsidiary, or a section from their employers so that they own and run it for themselves.
(Arnold, 2012). Such a management team usually does not have enough capital to fund the whole transaction, so they call on the private equity firm to provide the remaining bulk of finance needed to complete the deal.
A management buy-in (MBI). A new management team acquires a company or a part of the company from outside that company. With a similar approach to MBO, a new team of managers has insufficient funds to complete the acquisition. Thus PE firms are needed to provide the rest of the capital. Arnold (2012) suggests that with MBI transactions, PE funds are likely to buy most shares in the company.
Leveraged buyout (LBO). This type of investment occurs when private equity acquires another entity using mainly borrowed funds. Again, LBO may involve the purchase of the whole company, its part, or a subsidiary. The acquisition debt is obtained by issuing bonds or securing a loan and relies on the acquired company on its repayment (Poniachek, 2019). Debt finance will typically amount for between 60-90% of capital structure (Arnold, 2012) or 50-80%, according to Poniachek (2019), but in some cases may be as high as 95%. The debt can be repaid from operating cash flows or capital gains received after selling a company or its part with a profit. One of the major advantages of LBOs is that interest on the debt is deductible, resulting in less tax being paid.
Public-to-private (PTP). It is not uncommon for a company currently quoted on the stock exchange to return to its private legal structure. In such a case, a company's management will involve private equity funds to buy company shares and complete the transaction. Private companies do not fall under the same strict regulation guidelines that are compulsory to follow by publicly traded companies. This may be one of many reasons why a company's management would decide to reverse its status from public to private.
Case Study: CVC Capital Partners acquires Indonesian company: 'Matahari Department Store.'
CVC Capital Partners, a leading investment firm in the United Kingdom- acquired the largest Indonesian department store first introduced to the country in 1972. It was described as Indonesia's leading brand with a strong commitment to responsible sourcing. The transaction took place in Q2 2010 when CVC Asia III private equity fund purchased a 98% stake in the company at an enterprise value of USD$ 892million.
This was the largest LBO deal done by a foreign private equity- led consortium ever undertaken in Indonesia. CVC decided to liquidate the fund by turning the Matahari Department Store into a public company (exit by flotation). Since the whole operation turned out to be immensely successful, CVC Capital Partners remained an incredibly active investor in the Indonesian’s market. The full story can be accessed via this link: https://www.cvc.com/private-equity/case-studies/matahari
The role of the British Private Equity & Capital Venture Association (BVCA)
The British Private Equity & Capital Venture (BVCA) was founded in 1983 as the industry body for private equity and venture capital in the United Kingdom. Its major role is to inform and engage and demonstrate its positive role and significance for the UK economy. BVCA provides market intelligence data, technical updates, or specialist training (more info can be accessed on https://www.bvca.co.uk/). The organization has more than 750 member firms- including over 325 fund managers and 125 institutional investors.
Invest Europe, formerly the European Private Equity & Venture Capital Association (EVCA), has been performing similar tasks in Europe for about the same length of time. In the United States, the National Venture Capital Association (NVCA) represents the U.S. venture capital and private equity industries. By visiting these institutions' official websites, you will view the latest trends and market data available for each region.
Exiting investment
Private equity funds to realise the return on their investment must find an exit route. According to the British Private Equity & Capital Venture (BVCA), there are five options for PE firms to sell their portfolio companies:
Trade Sale
This means that shares of your company are purchased by another firm, often within the same industry. A merger of both companies can be another option.
Repurchase
The company has prospered, and the existing management can purchase its equity, often accompanied by a general recapitalisation of the firm – more debt is taken on (Arnold, 2012).
Secondary purchase
The equity is sold to another private equity firm or investment fund. This may be sold then onto a third buyer (tertiary purchase) and so on. This is often practiced when a company is not ready to go public, but the current private equity group wants to sell their equity.
Flotation
The equity is floated on a stock market through an initial public offering (IPO). Investment banks often supervise the process, and it is a popular method of realising returns on investment by PE funds.
Liquidation
This is the least favourite exit route for any PE fund, and it basically means that a company goes bust and everyone makes a loss.
Common terms associated with private equity
So far, we have not covered all common terms associated with private equity and venture capital industry. Most of these terms have universal meaning in financial language; however, the definitions have been provided with the focus on the context of private equity:
unrealised return shows how much the investment has gone up in value since the acquisition of shares of a company
realised return occurs once the fund has been liquidated and the GPs have cash in hand.
proprietary deal flow is the process of sourcing opportunities directly with potential sellers, bypassing intermediaries.
dry powder refers to the amount of committed but unallocated capital. In other words, these are funds that LPs committed to investing in, but the PE firm has not spent them yet.
capital call or 'draw down' is the act of collecting funds from limited partners that have previously committed to investing an agreed amount of money with the PE firm.
placement agents advise and assist private equity firms in arguing their case to prospective investors. They usually receive a negotiated fee, often based on the amount of new capital they managed to raise for the fund.
closings are terms that often refer to different stages of fundraising.
mezzanine debt is a middle level of financing between senior debt and common equity, e.g., convertible debentures.
Initial Public Offering (IPO) or flotation are terms used to describe the process when companies obtain a quotation on a stock exchange.
Any thoughts?
The global private equity industry has seen rapid recovery and growth (especially in 2015 and 2018 in U.S. and 2017 and 2018 in Europe) after the Great Recession of 2007-09. Despite pre-pandemic challenges of the Brexit, U.S. – China war, volatile capital markets, high prices, or the ever-present threat of recession (Bain & Co, 2019), the global private equity (PE) industry continued to make deals, find exits and raise capital at a historic five-year pace. Limited partners (LPs) remain highly enthusiastic and have continued to flood the market with fresh capital (a reference to the private equity market in the U.S. in 2018). Although in 2019, PE-backed buyouts declined in Europe, the effects of the pandemic, such as cheap borrowing or increasing number of distressed companies, encouraged a lot of PE firms to continue trading.
Figure 4. London-based lawyers on PE industry in the UK amid the global pandemic. Available at https://www.legal500.com/fivehundred-magazine/practice-area-focus/private-equity-and-the-pandemic-what-happened-and-what-next/
This piece was inspired by two articles: i) ‘Inter Milan owners in talks over private equity sale’ - Financial Times, and ii) ‘How would a private equity firm invest in the English Football League’ by Sam Georgevic – for Law in Sport. Both articles showed how private equity funds are increasingly interested in investing in football associations and clubs. Questions I asked myself are:
1) Is the increasing interest purely caused by the effect of pandemic and the fact that clubs need capital like never before? or
2) Are football clubs such an attractive investment that PE funds will look to invest in them for years to come, long after the economic recovery from the pandemic?
To understand the answers to these questions, I decided to do extensive research on the private equity industry. This first piece you now have read, which briefly explains what private equity is, was the first step in the process to demystify this exciting investment market.
Further reading
Bain & Company (2019). Global Private Equity Report [online]. Available at https://www.bain.com/contentassets/875a49e26e9c4775942ec5b86084df0a/bain_report_private_equity_report_2019.pdf
BVCA (n.d.). A Guide to Private Equity [online]. Available at https://www.bvca.co.uk/Portals/0/library/Files/Website%20files/2012_0001_guide_to_private_equity.pdf
Georgevic, S. (2020). Law in Sport. How Would a Private Equity Firm Invest in The English Football League? Equity [online]. Available at https://www.lawinsport.com/topics/item/how-would-a-private-equity-firm-invest-in-the-english-football-league
Bibliography
Arnold, G. (2012). Modern Financial Markets & Institutions. [ebook] Pearson. Available at: https://www.perlego.com/book/812030/modern-financial-markets-institutions-pdf
Poniachek, H.A. (ed.) (2019). Mergers & Acquisitions: A Practitioner's Guide to Successful Deals. [ebook] World Scientific Publishing Company. Available at: https://www.perlego.com/book/979077/mergers-acquisitions-a-practitioners-guide-to-successful-deals-pdf
Demaria, C. (2013). Introduction to Private Equity: Venture, Growth, LBO and Turn-Around Capital. 2nd ed. [ebook] Wiley. Available at: https://www.perlego.com/book/999721/introduction-to-private-equity-venture-growth-lbo-and-turnaround-capital-pdf