A private equity investor engages in the following major tasks:
1. Raise funding: The process of raising the money required for funding is carried out by private investors. Usually, the money is raised from pension and retirement funds, endowments, insurance companies, and wealthy individuals. These are also referred to as Limited Partners.
2. Source, due diligence, and close deals: Private investors also look for potential companies that can be invested in and then work towards closing the deal with them.
3. Manage portfolio companies: Private equity investors work toward improving the operations, cut costs, and strengthening the management of their portfolio companies.
4. Sell portfolio companies (i.e., exit them) at a profit.
Let’s discuss each of them in detail
Fundraising is the most essential part of private equity investment. After all, you can only receive a return when you have invested capital. Private equity firms raise capital from high net worth individuals (people who have large disposal incomes), pension and retirement funds, and others. These are termed as limited partners.
Investors at the firm (GPs or General Partners) venture out to raise funds or they can even hire third-party placement agents to raise funds. Typically, a firm would seek investors who can invest a large amount of capital, instead of going for a number of investors with a small amount of capital. An ideal fund would comprise of a handful of investors.
High net worth individuals generally have a lower threshold of an investment than LPs. Still, the amount would be in millions.
Further, LPs don’t give all their committed capital to GP at once. As and when GPs close an investment deal and need to be funded, they “call capital” from the LPs. The LPs have a limited time period (usually two weeks) to provide capital and close the deal.
Further, a few funds also have the first close and final close. The first close is when the firm has raised a certain amount of money and is ready to make investments and close deals. New LPs can still join by committing capital for a limited period. Final Close, on the other hand, is when the second threshold is reached and new LPs can no longer join the running fund.
Sourcing, diligence, and closing deals
While looking for a potential company for investment, an investor considers multiple factors including the market of the company, its product and strategy, senior management, past financial performance, valuation, and exit opportunities for the future.
The next thing on the to-do list of private equity investors is looking for investment opportunities. Generally, a few deals would come due to the reputation of the GP.
Investment professionals who are proactively looking for investment targets through their own networks or cold calls. Investment banks representing a company can reach out to the firm. Investment banks often run auction where several Private Equity Investor can participate. Firms drop out as their bids are either rejected or accepted.
After a deal has been sourced, the firm’s investment team conducts heavy due diligence to assess the company’s strategy, business model, management team, the industry and market, financials, risk factor, and exit potential.
Due Diligence is conducted in stages that are similar to the stages of the bidding process. Financial and operational information is disseminated progressively to the PE firms depending on the bidders that are still in the running. If an investment team finds the deal promising, they go ahead and present it to the partners for funding.
The final deal comes off after negotiation with lawyers on both sides and the deal will transact. Funds will be released and equity will be traded.
Streamline and improve operations
GPs are not actively involved in managing their portfolio companies. They do not run it. They occupy a space on the board. The level of involvement of GPs in a company is dependent on the amount of stake in the company. The higher the stake in a company, the more involved they are in the daily activities of the company.
Further, GPs or the private equity firms create a quarterly report on the progress of the portfolio companies and financials for LPs. These reports are used by the LPs to mark their portfolio companies and further report on the progress to their own investors.
Exiting portfolio companies
Private equity investors exist in two ways:
- Selling the company to another company
- IPO (Initial Public Offering)
Most exits happen through acquisition. Usually, the exit happens anywhere between 3-7 years of investment since the original investment. During this time, the investors work to increase the value of companies by increasing the revenue of the company (EBITDA), cutting costs, and optimizing working capital (again, increasing EBITDA), selling the company at a higher multiple than the original acquiring price, and reducing debt.
Further, partners are involved in a lot of coordination activities in selling a portfolio company.
However, they may sometime involve investment banks if the transaction is huge or complex.
The investment banks earn a fee on selling the portfolio company.