Private equity (“PE”) refers to some level of ownership of non-publically traded companies or assets (such as real estate, oil/gas/coal/minerals, or infrastructure). PE investing means buying a percentage (up to 100%) of non-publically-traded companies or assets, improving or growing said non-publically-traded companies or assets, and selling them for profit at a later time. As McKinsey reports, PE is an attractive alternative investment class as it outperforms public market equivalents with net global returns of over 14 percent in 2020 for 2017 vintages.
Private equity firms form investment partnerships to raise capital from limited partners (“LPs”), typically large institutional investors like pension funds, endowments, foundations, insurance companies, and banks.
PE investments can be made at any stage of the business lifecycle: from early-stage startups to mature companies. PE investment funds in the aggregate are diversified across economic sectors, and geographies and typically have long holding periods of 10 years. This alternative investment class continues to grow rapidly, with new PE global fund commitments in 2021 that were 14% above 2020 levels, with $1.2 trillion raised across the full private capital spectrum, the highest ever reached, according to Bain.
Broadly speaking, there are five types of private equity investment strategies:
- Buyouts
- Venture Capital
- Growth Capital
- Distressed Investments
- Mezzanine Capital
Let’s dive into these categories of private equity investment in detail. Note that these categories overlap in several areas, which we’ll explore.
Buyouts
A buyout is a transaction in which one investor purchases a controlling stake in a company from its existing shareholders.
Buyout transactions have been on an exponential rise, with nearly 12x growth over the past decade. PE dry powder (the amount of committed capital not yet drawn or invested) stands at a record $2.3 trillion, most of which is attributed to Buyout funds.
This trend continues as PE investors seek higher returns and new ways to deploy capital. PE’s ability to invest across asset classes—including real estate, natural resources, consumer businesses, and technology—has expanded investment opportunities for LPs while also providing attractive risk-adjusted returns for General Partners (“GPs,” managers of the PE investment funds).
There are two types of buyouts: Leveraged buyouts (“LBOs”) and management buyouts (“MBOs”).
Leveraged Buyout
In an LBO, a PE firm finances the acquisition of a company using a combination of debt (“leverage”) and equity and then sell the company to another party later for a profit.
It is common for LBO firms to use up to 60% debt to acquire control of target companies and then sell them off for a profit once they have been restructured or grown sufficiently. Cash generated by the business during the holding period is used for growth initiatives, acquisition of other companies, and debt service. The sale (exit) of the business may be in the form of an initial public offering (“IPO”), acquisition by a competitor (strategic acquirer), or selling to a larger PE fund (financial buyer).
One famous example of an LBO is Blackstone’s 2007 acquisition of Hilton. Many analysts deemed the acquisition a failure when the economy fell into crisis. By 2013, the situation had reversed, and Hilton went public, transforming the deal into the most profitable PE deal ever, generating a net profit of $14 billion.
One sub-type of LBO is called a secondary buyout (“SBO” or “Secondary transaction”). This is the purchase of a company, usually at a discounted price, from another PE firm that initially acquired the company in a previous LBO transaction. This may be done for multiple reasons, but usually when the selling PE firm is at or near the end of its fund life and is required to return capital to its investors.
Another type of secondary transaction is when an investor in a PE fund needs liquidity before the fund terminates at the end of its stated lifespan. In these cases, the LP solicits bids from interested buyers, but the GP must approve the sale of the fund. These transactions usually have steeper discounts, depending on current market conditions.
Secondary buyout funds have grown tremendously in the past decade. In 2010, secondary buyouts represented 36 percent of all PE-backed exits and were the source of 14 percent of all buyout transactions. Those percentages have increased to 48 percent and 18 percent today, respectively.
Management Buyout
An MBO is essentially just an acquisition of shares in a private company from management. This can occur when there is financial distress within the company when the founder(s) see an opportunity for growth outside of the current business model or simply when the founder(s) seek greater control.
Management buyouts are a popular way for private equity firms to invest in promising growth companies. They also represent an attractive option for founders seeking to sell their company or fund managers looking to grow their team.
Management will approach existing shareholders and offer them cash for their stake in the target company. Once enough shares have been acquired by management, they will use them as leverage to acquire control.
One famous example of an MBO was Michael Dell’s $25 billion payment to take Dell private in 2013. Five years later, Dell’s estimated worth was $70 billion, nearly three times its value at the time of the MBO.
More recently, Tesla founder Elon Musk tweeted that he was considering an MBO, but without having the funding secured, this led him to be charged by the SEC for securities fraud.
Venture Capital
VC firms provide capital to promising early-stage startups in exchange for equity in the business. They do this to help nurture these young companies until they are self-sustaining enough to be sold off or taken public on the stock market.
The advantage of working with VC firms is that they have experience doing due diligence on potential startups and connections within the industry that can be invaluable when it comes time for fundraising.
Venture capital has a long-term time horizon and invests across seed and post-seed companies, or Series A, B, C, and beyond.
Beyond constructing a diverse portfolio, VCs engage in post-construction activities to grow the value of their investments, including networking, acquiring smaller startups, consulting, and building teams. In 2020, global VC funding soared to just over $300 billion.
Most of the world’s most successful companies today wouldn’t have been possible without venture capital, including Facebook, Google, Twitter, Spotify, and many others. With venture capital outperforming public markets over many periods while providing opportunities for portfolio diversification, VC investing is hotter than ever and shattering records.
How VCs find startups
A team of researchers has conducted a large-scale study of how VCs make investment decisions, publishing their results in Harvard Business Review.
They found that 30% of deal leads come from VC’s former colleagues, another 30% come from outbound contact, 20% come from referrals by other investors, 10% come from cold emails from entrepreneurs, and 8% come from referrals through the VC’s existing portfolio.
In short, networking is the largest source of venture capital investment leads. Startup accelerators and incubators are common for startups and VCs to network. Top incubators include YCombinator, Techstars, and 500 Startups.
Ultimately, incubators provide the knowledge, resources, and connections to help startups succeed, which has obvious advantages for VCs seeking investments compared to non-incubated startups.
That said, investing in startups is notoriously risky, and even many startup alumni of prestigious incubators like YCombinator fail. Just as most startups fail, most incubators and accelerators do as well. As a result, low-quality incubators are a lose-lose for startups and VCs, while high-quality incubators are a win-win.
Growth Capital
Growth capital firms invest in mature businesses with plans to help them expand or restructure their operations to become even more profitable and attractive investments.
Growth capital investments overlap considerably with venture capitalists because both types of investors share similar goals: helping their investments grow into viable enterprises before selling them off or otherwise exiting at higher profits later.
Distressed Investments
These investments are typically made when an investor purchases debt instruments from distressed sellers seeking liquidity after defaulting on loans or other financial obligations. They also require less up-front investment but offer lower returns than other forms of private equity investments due to their riskier nature.
This form of investing is commonly called “distressed-to-control” or “loan-to-own.” When looking for distressed investments, PE firms seek fundamentally good companies with problematic balance sheets that can be improved.
Distressed firms and deployed several strategies, including:
- Distressed Debt Trading – buying debt at a discount to par value and selling once the price rises
- Distressed Debt Non-Control – buying debt at a discount to par value to gain influence in the restructuring or bankruptcy process
- Distressed Debt Control – buying debt that will be converted into equity and achieving a controlling stake
A common way to find distressed investments is through the distressed firm itself. This means working with the firm to extend credit (such as bonds or a revolving credit line) on behalf of the fund. It’s common for multiple funds to extend credit such that none of the funds are overexposed to the default risk of one investment.
Mezzanine Capital
Mezzanine capital refers to subordinated debt or preferred-equity instruments representing a claim on a company’s assets (such as cash flow). In simpler terms, mezzanine capital relates to the order of repayment: Mezzanine gets paid back after other forms of debt but still before equity.
The advantage of mezzanine capital is simple: It typically pays an investor 12-20%, which is higher than the rate of return on ordinary debt. Unlike business angels or venture capital, which are considered “high risk,” mezzanine capital is considered “medium risk.”
Note that mezzanine capital is not mutually exclusive with other areas of private equity, and it’s often used to finance LBOs, recapitalizations, and corporate acquisitions.
Takeaways
With Gridline, you can gain exposure to private equity with lower capital minimums, transparent fees, and greater liquidity.
This opens the world of private equity investment to everyone. Our approach is simple: We provide access to the masses through a marketplace to search for investment opportunities at your fingertips and build an optimized portfolio while we handle the back-office work.
Private equity’s outsized returns and the opportunity for portfolio diversification that improves risk and volatility characteristics have led to the exponential growth of this alternative investment class.