Private Equity for Advanced
A Close Look to Current Private Equity Landscape
The year 2017 was one of the strongest years for the private equity market. The previous year’s deal volumes maintained the record levels 2016 has reached. Furthermore, the region’s investment sentiment for the year 2017 is at an all-time high.
The past year was strong for private markets that even when public markets rose, investors remain interested and confident about it. Last year, private asset managers upturned a record of about $750 billion across the world. This record shows the private equity market fared well in the year 2017.
One trend stands out in the tide of the capital of the year 2017 and that’s the surge of mega funds. The surge is particularly extant in buyouts and in the United States. The global private equity industry gained healthy gains in the buyout value and exits.
With the global industry having raised an outstanding $3 trillion capital from 2012 to current, they are poised to face a big challenge this year. The challenge is how they are going to put all this capital into work.
Due to high deal multiples and rigid competition, it’s increasingly becoming hard to find and close deals. In that, the best private equity firms are developing their capabilities to thrive in the market’s hard new environment. The PE firms are becoming better and better at detecting the right team early on.
They begin sharpening their skills in leadership assessment. They started fitting roles with talents fitting to the purpose. More and more private firms recognize the importance of building excellent commercial competencies to generate top-line growth.
PE firms also need to fight through the hype generated by digital technology, which can transform the industry process while helping companies’ produce value in the holding period. To advance in your career in the private equity sector, it’s critical to learn concepts further than the fundamentals.
Private Equity Strategy
Have you ever heard about mega buyouts? What does distressed mean? How do you know it is early-stage VC or late-stage VC? What is growth equity? These are some of the terms and concepts you are probably unfamiliar.
The strategies used in private equity are probably one of the concepts you are unfamiliar. Learning about them is vital, as they are what lead you towards earning billions of dollars. Before starting your career in a PE fund, it is great to spend some time to learn more about private equity strategy.
The PE Strategy
The term private equity is an umbrella term referring to varying types of investment involving private companies or public companies that will soon become private due to an investment. A PE strategy has many components.
These components include the stage in which the companies targeted are in, the investment sectors, the geographies targeted, the entry/exit strategy, the value that the firm added, and more. Here are a PE strategy’s key components to which you should know:
The Key Components of a Private Equity Strategy
Stage of Investment
This refers to the main method by which to classify PE firms and strategies. The main three stages of investment are:
- Venture Capital, which PE firms use for investments in companies in the early stages, the stages starting from seed stage to the pre-IPO stage.
- Growth Equity is the next, which denotes investments in companies at a somewhat late stage. These are companies looking to raise their operations and has proven products and/or concepts already producing substantial revenue.
- Distress investing and buyouts are the last stage belonging in the category of a later stage of investment. It involves established companies generating significant cash flow but no longer growing as quickly as before.
In this, a fund could be country-specific (one country) or regional (a region or few countries). Regions could mean Southeast Asia or North America. In terms of target geography, funds could also be distinct if one invested in developed markets or emerging markets.
You can make private equity investments in a wide array of sectors. It could be in real estate, technology, financial services, consumer products, manufacturing, etc. Some PE funds specialize in a single specific sector while some target a number of sectors.
There are also others called generalist funds, also called sector-agnostic funds. Your target sector can also be contingent on to the type of fund. For instance, growth equity funds have more diversified sectors while VC funds have more specialized ones.
Value Added to the Portfolio Companies bу the Firm
PE firms add value to the companies they hold or at least try to. The firm adds value to the company in the forms of strategic expertise, operational expertise or restructuring expertise. It could also be their network of contacts, all of which could result in new partners, suppliers, customers or executives.
A PE firm cannot make money without exiting the companies they hold. As such, an exit strategy is vital in every PE strategy. On that note, the firm evaluates different scenarios as well as identifies possible exit strategies pertaining to possible acquirers, valuation or exit route.
Four Major Disciplines from the Private Equity Masters
Bain Capital is one of the world’s leading global private equity companies. Two young Harvard graduates started the company in 1984. Since its inception, it has raised billions of dollars and is now one of the most successful private companies in the world.
Today, Bain Capital operates in eight countries across three continents. So far, it has upraised 10 private equity funds globally. While many market specialists and economists have conflicting opinions about the company’s success, it doesn’t stop the company from success.
It started as a 7-member company and now, it has over 100 members and is worth over USD $4billion. One of its successful acquisitions is Accuride, an enterprise that used to struggle under the giant Firestone Tire and Rubber Company (Bridgestone/Firestone today).
A Successful Acquisition Story Where Lessons Can Be Learned
Accuride’s business is marginal to the core business of Firestone, which led to the enterprise to starve from managerial attention and resources. Then Bain Capital bought Accuride in 1986, which freed it from the administrative and budgetary restraints of Firestone.
After this bought out, Accuride took quick action. The freedom from Firestone enabled Accuride to become the dominant supplier to several major customers. On that, it was able to capture some of Firestone’s share of profits.
It’s all because of the focused strategy Accuride followed its release from Firestone’s constraints. In less than a couple of years, Accuride is able to increase its sales, double its market share and raise its profits by 66%.
When Bain Capital sold the enterprise only a year and a half after its acquisition, it’s able to earn around twenty-five times than its initial investment. Since then, Accuride continued to thrive and mature in the market.
This was one of the most successful private equity stories in the industry and Bain Capital is only one of those firms that are able to fuel this success. Including Bain Capital, other leading PE firms that found success in the industry are TPG Capital, Carlyle Group, the Blackstone Group, and Goldman Sachs.
These were the industry’s five leading private equity firms known for their many successes in spearheading business transformations. Learning the critical disciplines and strategies provides the executives of public businesses with valuable lessons on earning significant returns in their own units.
Studying Equity Transactions to Learn the Top PE Firms’ Secrets
Through the process of transforming businesses, investors are able to exploit the outstanding returns created by PE firms. In the last ten years, over 2000 private equity transactions are available, from which you can learn and discover the secret to the top PE performers’ success.
The secret lies not in the central structural advantages they have over public companies. Instead, it is in the precise managerial disciplines exerted on these public businesses. There’s widespread assumption that the stock market pressures the PE managers to focus more on increasing their companies’ value.
However, the truth is these public businesses have executives without clear focus on maximizing their economic returns. In contrast, the top PE firms have a clear focus on where to spend their energies. To accelerate the growth of their business’ value, they focus on only a couple of strategic initiatives.
To advance in your private equity career, here are the top management disciplines the leading PE firms implement to reap greater returns. Learning these disciplines and strategies will help an investor earn the most money when capitalizing on private equity.
When a PE firm purchases a business, the first thing they do is to define an investment thesis. The investment thesis is a clear statement indicating how they can make the newly acquired business more valuable in three to five year time.
The top PE firms suggest that the best investment theses are incredibly simple. In it, laid out in simple terms are fundamental changes necessary to transform the business. The thesis serves as a guide to all the actions the company must take to transform and improve.
Compared to simply stating a financial target, which most public companies do, creating a good thesis will provide a clearer basis for action. An overlooked truth pertaining to the top private equity firms, which the investment thesis reveals, is that their focus is mostly on growth and not on cost reduction.
When a firm imposes a more solid strategic focus, the existing business usually faces intense trimming. However, doing so creates a path towards a strong growth for the company. This, in return, generates much bigger investment returns.
At PE firms, the center is the corporate staff, which is also the active shareholder of the units in their business portfolios. The shareholders are at the center of their business, which comes with the obligation of making an investment decision without any sentimentality.
- Lack of Sentimentality
The shareholders must not have sentimentality influencing them so they would maintain the willingness to sell a company swiftly or shut it down. Without getting emotions involved, they can make clear decisions when an opportunity to sell presents or when a performance consistently falls behind.
- Lean Corporate Centers
Similarly, the PE firms’ approach towards headquarters staff is similarly impassive. To them, the staff is a part apart of the transaction costs and the reason why PE firms have extremely thin corporate centers. This is particularly amazing, seeing as they hold portfolios that might be representing billions.
On that note, most of the staffers in corporate centers of PE firms are financiers and deal makers. With only lean staff, their people are those who play important roles. If the firms ever need other expertise, they simply brought outsiders on a contractual basis.
- Hands-On Approach
Another interesting approach of PE firms is their interaction with other portfolio companies. Before, PE firms would only buy and sell companies. They let the existing management team to handle the daily management of every business they hold.
However, today’s approach is different in that the headquarters begin following a more practical approach. Along with that, the PE managers often provide advice and support to the business, getting direct involvement on both the hiring and firing of managers.
When PE firms want to replace managers, they don’t only look within the company, as they want a management team that really has the stakes to succeed. On working with a business, the PE firms usually appoint a senior partner.
- Senior Partner
This senior partner is the one who’s responsible for working daily with the CEO of every business they hold. With only a single high-level contact, PE firms are able to avoid distractions and restructure the relationship between the two.
The advantage is the businesses will not have to struggle with several staffers when inquiring for information. This way, the PE firms, and businesses can have a relationship, which when works well, earns great benefits for the portfolio company.
Most companies today rely on some kind of measurement philosophy or a business scorecard wherein indicated are operational and financial pointers. The enthusiasm for these business metrics has since blossomed to the point where a significant number of large companies use them today.
In contrast, top private equity firms have been resistant to the frenzy of business metrics. Most top PE firms steadfastly believe these metrics do not clarify the management discussions but instead complicate it.
Moreover, they believe that instead of spurring them to take action, the metrics impedes them. The top PE firms do use metrics but their focus is mostly on a number of financial indicators. The indicators they choose are those they find to reveal the progress of the company clearly, in terms of growing its value.
Private equity firms have certain broad preferences pertaining to the measures they track. One big indicator they measure is the cash. Compared to earnings, the PE firms observe cash more closely because they know it to financial performance truthfully compared to earnings.
Several factors can easily manipulate earnings. Another indicator of PE firms’ measures is the return on invested capital. Most of them favor calculating returns as it indicates the actual returns on the money invested in the business.
Private equity managers, however, are more careful to avoid executing a single set of measures to all their business portfolios. PE managers mostly prefer to modify their measures based on the businesses they hold.
In developing measures for their businesses, PE firms use the businesses’ metrics and not theirs. That is, they must use performance measures applicable for the business itself. Another great technique PE firms’ use in their performance measures is by tying it with the compensation of their managers.
The firms often tie the equity portion of the compensation of the manager to the results of their business units. In effect, these managers become executive owners. This type of arrangement earns the managers a stake in the parent company. Public companies can build the same compensation as this.
The Balance Sheet
Private equity firms have a heavy reliance on debt financing. Debt capitalizes nearly 60% of PE firms’ assets on average. This shows a 20% difference than public companies’ typical 40%. It seems not a good discipline but it has great benefit on the managers’ perspective.
The high ratio of debt to equity actually helps the manager to have increased focus. This is because debt financing influences the manager to see cash as a scarce resource. As a result, he is better able to distribute the capital accordingly.
Furthermore, the top PE firms make equity work more than what’s expected. When they look at their balance sheets, they see not only a metric of their performance. Simultaneously, they see it as an active tool to help for the company’s growth.
On that note, the most urbane companies worked to create new methods to convert their assets into new sources for financing. Another way PE firms use the balance sheet is in aggressive management of the business’s physical capital.