Republican frontrunner Mitt Romney has been under a lot of pressure recently because of his private equity experience. Much of this negative media attention stems from certain assumptions about the nature of the private equity industry — assumptions that reflect preconceptions rather than reality.
In order to elevate the current debate to a more rational and balanced discourse, I decided to pen a very simple primer on private equity based on my previous experience investing in both venture capital and buyout firms. Like any industry, private equity has both positive and negative aspects. It can be a source of value creation or destruction, depending on the actions of a private equity firm’s general partners, the price these partners pay for an asset, the success or failure of the management teams these general partners put in place to run their companies, and broader market conditions beyond the general partners’ control.
To make many of these descriptions easier for readers to understand, it sometimes helps to use examples. As such, my primer will leverage the fictional companies of Meritocratus and Egalitarius.
What Is Private Equity?
Private equity is exactly what it is called — private equity. Investors can either make money by trading stocks on public markets by owning shares of publicly traded companies, or they can invest in privately held companies via private equity investments.
Anyone can gain access to the public equity markets, but only those with a high net worth or annual income can invest in private equity transactions. The American people can thank the United States government for these restrictions, which set criteria for “accredited investors”. In other words, the government has erected barriers to entry for people to invest in this asset class based entirely on net worth and/or income. However, that is a topic for another day.
By definition, private equity transactions tend to be riskier. Because there is no central clearing house like the stock market for private equity transactions, investors can either spend millions of dollars investing in a single company, or they can jointly pool their money together and invest in several companies to diversify their risk. If the investors do not have the transaction or operational expertise to purchase and then operate these companies, they can hire a private equity firm to accomplish these tasks for them. In return, investors pay the private equity firm an annual management fee. The investors then share a percentage of the firm’s profits on successful transactions (I will explain more detail on the mechanics of how private equity firms make money later in this article).
Types of Private Equity
While there is a wide variety of different types of private equity, one can broadly segment the industry into two areas – venture capital and buyouts. Critics often seem to confuse the two. For instance, they often refer to the buyout business as “vulture capital”, in an effort to play on the term “venture capital”. However, venture capital has little to do with buyouts.
Venture capital is a segment of private equity in which investors inject money into new companies and/or business ideas. Investors tend to purchase minority stakes in these start-ups.
In contrast, buyout investing is a segment of private equity in which investors acquire established businesses that are either struggling or simply mismanaged, and attempt to turn them around. They usually purchase controlling stakes in these businesses, and fund much of these transactions with debt. That is, they borrow up to 80% of a company’s purchase price from banks or by raising money for bonds from public bond markets.
Venture capital tends to have a much higher risk profile than buyout investing because start-ups frequently have new technologies, inexperienced management teams, and/or markets that do not yet exist. Both venture capital and buyout firms have an exit orientation. In other words, they can only truly make money for their investors by selling the companies they help fund or turnaround. They can either sell these companies to other private equity firms or public companies, or to public market investors by floating shares in an IPO. If the company turns out to be a dud, they can liquidate that company’s assets, often for pennies on the dollar.
How Do Private Equity Firms Make Money?
To form a private equity partnership, a group of general partners (GPs) get together and raise a venture or buyout fund. Investors who wish to diversify their risk typically invest in these private equity partnerships for a period of roughly ten years as limited partners (LPs). In exchange for running the fund, the limited partners pay the general partners a management fee each year. Additionally, the LPs also share a small percentage of all the partnership’s profits with the GPs.
A buyout partnership profits by buying, restructuring, and/or growing the acquired business, and then selling it for a profit several years later. It can create value in roughly four ways:
- Cutting costs
- Growing sales
- Paying down debt
- Selling the company at a higher multiple of earnings than the multiple for which it originally purchase the asset
In the next section, we will look at two fictitious buyout firms, Demon Capital and Angel Capital.
Demon Capital and Angel Capital
Several general partners form two buyout firms, Demon Capital and Angel Capital. Both firms decide to raise $10 billion buyout funds. They will each invest in ten buyouts over the next five to ten years. The GPs will charge a 2% annual management fee on $10 billion, or $200 million each year. Additionally, the GPs will also earn a 20% carry on every dollar of profit the fund earns over its life.
Demon Capital’s strategy is to restructure businesses aggressively by cutting costs and reducing inefficient business practices. Angel Capital’s strategy is to target the acquired companies’ most profitable and high growth markets to achieve better overall profitability via higher sales growth.
Both buyout funds began to make investments in 2012 at the advent of a recession. They both are interested in the company Egalitarius because it is much cheaper relative to its industry peer, Meritocratus, and there is a lot of room for a buyout firm to improve operations at the company.
The following section provides a brief background on Meritocratus and Egalitarius:
Meritocratus and Egalitarius
Once upon a time, there were two firms, Meritocratus and Egalitarius. Both firms operated in the $10 billion widget industry, and each had 50% market share. Widgets were not a commodity. Purchasers were sometimes willing to pay a premium for a superior product.
By the end of 2011, both Meritocratus and Egalitarius had identical products. The only thing separating them were their operating philosophies.
Meritocratus was ruthlessly focused on the bottom line. Its overriding goal was to return value for its shareholders. It would pursue anything that would increase profits, provided its actions were legal.
Egalitarius’ management wanted to balance its corporate goals with a broader focus on the social well-being of the communities it served.
In a prior seven-part series, Egalitarius’ management encouraged its workers to unionize, and then instituted several aggressive cost-cutting measures to offset the cost of more expensive unionized labor.
In another scenario, Egalitarius’ unionized workforce went on strike. In the last two scenarios, Meritocratus’ management moved its production facilities offshore, and both companies struggled through a crippling recession.
Throughout these examples, Egalitarius’ concern for society’s well-being resulted in its bankruptcy, while Meritocratus’ ruthless pursuit of the bottom line left a trail of human wreckage in its wake.
Both companies represent caricatures of the left’s and right’s idealized worldviews carried to their natural and extreme conclusions.
Both Demon Capital and Angel Capital decide to bid for Egalitarius in the depths of a recession. Therefore, the state of the company is as follows:
The current market valuation of Egalitarius is about $1.8 billion. The company currently has no debt and minimal cash, therefore its asset value (company equity + company debt – company cash) is roughly equal to its market capitalization.
Both firms submit a bid for Egalitarius at a 20% premium to Egalitarius’ current asset value. To purchase the asset, both partnerships plan to raise $1.7 billion of debt or 80% of Egalitarius’ ~$2.2 billion price to fund the transaction. In other words, the partners only need invest $431 million in the transaction to purchase a $2.2 billion asset.
The figure below lists the mechanics of the transaction, and, for simplicity, assumes that transaction, legal, and accounting fees are embedded in the purchase premium:
Demon Capital’s Plan
Demon Capital plans to decrease Egalitarius’ costs by ~1.25% per year over the next five years by renegotiating its union contract, offshoring jobs, and downsizing the workforce. It also plans to grow company revenue by ~2.5% per year by improving factory utilization rates. Additionally, the firm anticipates that it will sell the company in a bull market where the company’s multiple will rise from its current levels. Demon Capital also anticipates that Egalitarius will have fully paid off all the debt the company incurred when Demon Capital purchased it by the time it sells the company.
The figure above assumes that Demon Capital is able to sell the company for $5.5 billion in five years, pay off all debt, and that company’s earnings grow from $212 million to $461 million. As the chart above shows, Demon Capital created most of the transaction’s value through cost reductions (34%) and paying down debt (34%).
Angel Capital’s Plan
Angel Capital plans to increase Egalitarius’ revenue by 5% per year over the next five years without reducing the size of the workforce. The firm also makes some minor efficiency improvements that reduce production costs by 2% of sales. Additionally, the firm anticipates that it will sell the company in a bull market where the company’s multiple will rise from its current levels. Angel Capital also anticipates that Egalitarius will have fully paid off all the debt the company incurred when Angel Capital purchased it by the time it sells the company.
The figure above assumes that Angel Capital is able to sell the company for $5.5 billion in five years, pay off all the debt the company incurred when Angel Capital purchased it, and that company’s earnings grow from $212 million to $461 million. As the chart above shows, Angel Capital created most of the transaction’s value through revenue growth (36%) and paying down debt (34%).
How Demon Capital and Angel Capital Make Money
Over their five-year investment horizon, both Demon Capital and Angel Capital make the same amount of money, only they do so in very different ways. Demon Capital did it by ruthlessly cutting costs and downsizing the union work force. Angel Capital accomplished it by finding new markets and making Egalitarius’ products more valuable. In the real world, buyout firms typically pursue a mix of all four value creation strategies, but tend to put relatively more emphasis on one in particular.
The figure below shows how two very different strategies can achieve the same results. For instance, Angel Capital’s projected revenue for Egalitarius is ~13% higher than Demon Capital’s projections. That said, Demon Capital’s strategy results in operating costs that are ~13% lower for Egalitarius.
Either strategy results in a more profitable enterprise that is worth a greater market value. Nevertheless, Demon Capital had to pursue a more ruthless strategy with more cost cutting and layoffs to get there.
As buyouts go, this investment was a home run, returning 11.8x invested capital. In addition to pocketing $1 billion in management fees over the five-year period, either firm would earn an additional ~$1 billion of profit before taxes from the 20% carry incentive fee. LPs would keep the remaining ~$4.1 billion of profit before taxes. However, since this profit is akin to a capital gain or dividend, the government would only tax it at 15% versus 35% for ordinary income. This tax treatment allows the GPs to pocket an additional ~$200 million on the ~$1 billion of profit than they otherwise would if government taxed these gains at the ordinary income tax rate.
In the real world, Demon Capital’s strategy works better for certain industries than others. Angel Capital’s strategy is more achievable in technology buyouts and other growing industries.
In most cases, buyouts still likely save more jobs than they destroy for the simple reason that many mismanaged companies would have gone out of business in the absence of a buyout firm’s rescue. Of course, there will always be exceptions, but in the end, the buyout side of private equity can be either a force for good or evil, depending on how one uses its tools.