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Private equity explained

Private equity is a way of owning and investing in private companies. Private equity funds can invest in companies that are already privately-owned, perhaps by a family or entrepreneur; they can acquire businesses that exist as divisions or subsidiaries of larger companies, or they can acquire publicly-listed companies and take them private.

Private Equity pros and cons

The private equity ownership model allows a professional team of fund managers to take large stakes in private companies, to ensure they are run in the best interests of the underlying investors. This avoids the 'agency' problem of a dislocation between the owners of assets and how they are managed. For instance, for stock market-listed companies to run effectively, management stewards have a large degree of control over how the company is run, with reference to widely dispersed shareholders.

In state-controlled businesses, the dislocation to the ultimate owners, the taxpayer, is even wider. Other forms of company ownership, such as family companies, do not enable outside investors to access their returns. The private equity ownership model can be applied to a wide range of company types, sizes, sectors and geographies. The common factor is that all investee companies have unrealised potential. Private equity investment will aim to unlock this potential.

Advantages of Private Equity

Private equity ownership has a number of important advantages that allow it to create value and realise capital gain in a repeatable fashion.

  • The universe of potential company investments for private equity is huge. It is a vast and unchartered land of opportunity. They can invest in unlisted companies that are at the beginning of their growth journey and in private hands; they can invest in the unloved divisions of larger corporations; or they can take private those listed companies that are unloved and under appreciated by the stock markets.
  • Private equity firms are extremely selective and spend significant resource assessing the potential of companies, to understand the risks and how to mitigate them. Managers will often drill down from thousands of potentials to the one company that has all the right characteristics to achieve growth.
  • Private equity firms invest in a company to make it more valuable, over a number of years, before selling it to a buyer who appreciates that lasting value has been created. Private equity firms are therefore patient investors, unconcerned with short-term performance targets. But assets are held for sale, so they always have their eyes on the prize.
  • The management team of companies owned by private equity are answerable to an engaged professional shareholder that has the power to act decisively to protect its shareholding.
  • The combination of this clear accountability between company managers and shareholders combined with the need for a realisation means that incentive structures can directly link tangible value with reward. There are no rewards for failure. Such clear accountability has many benefits. For instance, it gives comfort to potential lenders, allowing investments to be leveraged.

Disadvantages of Private Equity

Investing in private companies presents a number of challenges that are reflected in the traditional private equity investment experience.

  • Restricted access. The traditional way of investing in private equity is through Limited Partnerships. These are institution-only vehicles which are mainly open to institutions and other larger sophisticated investors. They cannot be accessed by many types of investor.
  • Barriers to entry. Limited Partnerships require investors to commit very large minimum amounts (normally £10m or more). 
  • Private companies are illiquid by their nature. Private equity firms expect to commit to each investment for several years. For this reason, Limited Partnerships are commonly structured as ten-year vehicles. Your money is ‘locked up’ for a decade or more.
  • Higher costs: Encompassing such a vast and unregulated opportunity set as the private company universe requires resource, infrastructure and expertise. The due diligence required can translate into higher costs.

 

As an alternative to Limited Partnerships, investors can access private equity through Listed Private Equity vehicles.

Public Companies vs Private Equity-Backed Companies

The table below summarises the typical differences between publicly traded companies and those backed by private equity.
Public companies Private Equity-backed companies
Large number of small shareholders Small number of large shareholders
Most shareholders have little or no operational input Private Equity investors often on the board and involved operationally
Shareholders may have different agendas Shareholders usually have the same agenda
Difficult for management to have a meaningful economic interest in the company Management normally very highly incentivised - and the incentives are aligned with the interests of other shareholders
Public companies often concentrate on short-term earnings figures - can make it hard to take tough decisions if it hits earnings Shareholders not concerned about taking tough decisions if that is the optimal strategy
Need to seek shareholder approval for large transactions - costly, slow and time consuming Very quick decision making process means companies can move swiftly and keep costs down
Tend not to use much leverage - suboptimal WACC? Happy to employ large amounts of leverage - probably closer to optimal capital structure
Difficult for shareholders to change management Very easy to effect management change
Increasing regulation and disclosure requirements Less regulation and little disclosure
Public companies losing the most talented managers to private companies Potential high rewards tend to attract very talented individuals to both Private Equity and Private Equity-backed companies

Table source © 2008 J.P. Morgan Cazenove Limited European Listed Private Equity Bulletin

© 2008 J.P. Morgan Cazenove Limited European Listed Private Equity Bulletin
Contact J.P. Morgan Cazenove: christopher.brown@jpmorgan.com