Private Equity– Changing Face of Capitalism: Dark- & Bright-Side of the World Financial Markets…

“Private equity is becoming a life-stage for CEO’s. It’s something we’ve never seen before. Perhaps the lesson to remember best is this: the Private Equity world is now attracting the ‘best and brightest’ of the corporate world…” ~Jeffrey A. Sonenfeld

Private equity firms have been castigated as “smash and grab merchants”, “deal flippers”, and criticize severely as “locusts that fall on companies and stripping them before moving on.” They have been accused of misleading promises, dodging tax and threatening social stability. Yet they are the emerging giants of the financial world, an alternative asset class that is increasingly attracting investor interest. Consider these facts:

  • The biggest five private equity deals together are larger than the annual budgets of all but 16 of the world’s largest nations. The five biggest deals involved more money than the annual budgets of Russia and India.
  • The annual revenue of the largest private equity firms and their portfolio companies would give private equity four of the top 25 spots in the Fortune 500. These firms have more annual revenue than companies, such as, Bank of America, JP Morgan Chase, and Berkshire Hathaway.
  • The top 20 private equity firms alone control companies that employ nearly 4 million workers.

Private equity investments are primarily made by private equity firms, venture capital firms, or angel investors, each with their own set of goals, preferences, and investment strategies, yet each providing working capital to target companies to nurture expansion, new product development, or restructuring of the companies’ operations, management, or ownership.

Among the most common investment strategies in private equity are: leveraged buyout (LBO), venture capital (VC), growth capital, distressed investments and mezzanine capital. Private equity is risk capital invested in businesses that aren’t listed on public-stock exchanges, or won’t be after they’ve been taken over, and de-listed. It’s also a shorthand term for firms that specialize in raising capital for new enterprises, financing management buyouts, and restructuring companies to realize the full value of their assets.

Over $90 billion of private equity was invested globally in 2009, a significant fall from the $181 billion invested in the previous year. The 2009 total was more than 70% down from record levels seen in 2007. Deal making however gathered momentum during the year with larger deals announced towards the end of 2009. With bank lending in short supply, the average cost of debt financing was up and private equity firms were forced to contribute a bigger proportion of equity into their deals.

Private equity funds under management totalled $2.5 trillion at the end of 2009. Funds available for investments totalled 40% of overall assets under management or some $1 trillion, a result of high ‘fund raising’ volumes between 2006 and 2008. Funds raised fell by two-thirds in 2009 to $150 billion, the lowest annual amount raised since 2004.

The difficult ‘fund raising’ conditions have continued into 2010 with half-yearly figures showing a total of $70 billion raised in the first six months, slightly below the same period in 2009. The average time taken for funds to achieve a final close more than doubled between 2004 and 2010 to almost 20 months and in some cases the final amounts raised were below original targets.

Prior to the economic slowdown, the market saw intense competition for private equity financing. The three years leading-up to 2009 saw an unprecedented amount of activity, during which more than $1.4 trillion in funds were raised.

In the article A Primer on the Structure of Private Equity Firms” by Michael Gasparro writes: The private equity firm is typically made up of limited partners (LPs) and general partners (GPs). The LPs are the outside investors. They provide the capital and typically consist of institutional investors such as insurance companies, endowment funds (Harvard, Stanford, Princeton, Yale, and other universities invest endowment funds in private equity), foundations, banks, retirement/ pension funds, family investment offices, as well as, high net-worth individuals.

They are called limited partners in the sense that their liability extends only to the capital they contribute. Generally, the minimum commitment for an LP is $1 million. The agreement between LPs and GPs will typically include contractual provisions which specify what private equity firm can and cannot do. Broadly speaking, provisions will be placed around the management of the fund, the activities of the GPs and the types of investments the GPs can make…

In the articlePrivate Equity Insights You Need To Know” by Tom Johansmeyer writes: ‘Global private equity deal flow has witnessed a resurgence during 2010 as a whole, with deal flow globally this year representing the strongest year for private equity deals since the onset of the global financial crisis. ‘In particular, this year has been notable for a surge in both North American and European deals, with North American deal flow in 2010 more than double that witnessed during 2009, and European deal flow in 2010 almost three times the value of deals seen in the region in 2009.’ According to the Preqin’s statistics:

  • There were 265 exits in the fourth quarter of 2010, amounting to $71.8 billion – this is the highest quarterly figure on record.
  • In full-year 2010, $204.9 billion worth of buyout deals was announced, more than doubling the 2009 total value announced.
  • Deal flow in 2010 increased 130 percent from 2009 and 35 percent from 2008 in North America.
  • Deal flow reached $68.1 billion in Europe last year, almost three times the $24.2 billion in announced private equity deal flow the year before.
  • In Asia and the rest of the world, announced private equity deal flow spiked 39 percent from the third quarter to the fourth quarter, with $8.6 billion in transactions announced.

In the article Private Equity and Strategic Buyers -Distinction Without Difference?” by Peter Lehrman writes: According to the ‘Pitchbook Data’s 2011 Private Equity Breakdown’ there were 5,994 private equity-backed portfolio companies at year-end 2010.

According to a recent survey ‘AxialMarket’ conducted, interviewing its private equity customers, 57% of the respondents indicated that their portfolio companies were actively looking to grow through acquisitions, while over 80% of the respondents indicated that their portfolio companies would opportunistically review  acquisition  opportunities. Why does this information matter to business owners?

Because the most likely strategic buyer for your business ironically might well be a private equity firm instead of a Fortune 2000 corporation.  What business owners and to a lesser extent M&A Advisors appear to under-appreciate is how significant the private equity community has become as its own strategic buyer category. In addition to having over $400 billion of committed but un-deployed capital that must be deployed in the coming years, private equity firms collectively own almost 6,000 private companies.

In the articleWill Dodd-Frank Forever Change Private Equity?” by Kareem G. Nakshbendi and Averell H. Sutton write: The ‘Dodd–Frank Wall Street Reform and Consumer Protection Act’ brings ‘private equity funds’ under the auspices of the Securities and Exchange Commission. Any entity that has assets of at least $150 million is subject to record keeping and disclosure requirements pursuant to the SEC and Commodity Futures Trading Commission (CFTC).

However to work-around the provision of the bill, funds simply make smaller deals: A firm can create different fund structures to have multiple funds that have no more than $125 million each and do not have similar ownership structures in order to evade Dodd-Frank. Venture capital funds are exempt from Dodd-Frank. The bill creates a level of transparency that has not been seen before in private equity.

One of the attractive things about private equity deals is that the public is not at risk and therefore has no reason to know the details of a deal arrangement. Private equity’s real currency is its unique access to information and clients, and the opportunity to make big gains for the risks taken…

“The best-performing companies are those where the private equity investors are: Bought into the right company at the right time; Backed strong management from the outset; Focused on delivering sustained improvements”. “The key to a successful private equity is thorough preparation”.  ~ Ernst & Young

The private equity world is a very freewheeling world. It is entrepreneurial, competitive, hard-driving, and unforgiving, in part because it is both numbers-oriented and short-term. Private equity is not necessarily a confusing topic, but it can be highly complex. Private equity firms typically seek to re-energize businesses by refocusing, restructuring, reinvigorating – and then sell them on a short-term horizon, generally 3 to 5 years.

While these firms commonly take a management fee of 1.5% to 2% off the top each year, their primary goal is the eventual payoff: 15% to 20% of profits upon sale or public offering. Their business emphasis is not on operating businesses for a profit, or even building businesses over the long haul, but on buying-and-selling businesses for a profit. With the bursting of the credit bubble the private equity industry was badly affected: In research,

Boston Consulting Group estimates that at least 50% of the private equity deals done in the recent past will default on their debt. The liquidity crunch has changed the availability of cheap debt, and approximately half the firms need to raise capital for new funds.

As a result, private equity firms will shrink dramatically and only the best firms will survive the new financial environment. However, in the long-term, it is highly likely that a more vibrant industry will reemerge…

“Investors need to be aware that most of the publicly-available data on private equity returns are usually wrong – and often grossly misleading.” ~Michael Moritz