INTRODUCTION TO PRIVATE EQUITY.

1 Meaning and definition

DEFINITION: Private equity is equity capital that is not quoted on a public
exchange. Private equity consists of investors and funds that make investments
directly into private companies or conduct buyouts of public companies that result
in a delisting of public equity.
Most of the time, private equity investors are institutional investors and high networth individuals who have a large amount of capital to commit to these
investments. Private equity investments often demand long holding periods to
allow for a turnaround of a distressed company or a liquidity event such as an IPO
or sale to a public company.
Private equity is a well-known industry in the financial world and it is becoming a
more familiar term for the general public as high-profile companies are purchased
and taken private by buyout firms.
Private equity firm: A private equity firm is an investment manager that makes
investments in the private equity of operating companies through a variety of
loosely affiliated investment strategies including leveraged buyout, venture capital,
and growth capital. Often described as a financial sponsor, each firm will raise
funds that will be invested in accordance with one or more specific investment
strategies.
Typically, a private equity firm will raise pools of capital, or private equity funds
that supply the equity contributions for these transactions. Private equity firms will
receive a periodic management fee as well as a share in the profits earned (carried
interest) from each private equity fund managed. Private equity firms, with their
investors, will acquire a controlling or substantial minority position in a company
and then look to maximize the value of that investment.

HISTORY
The early history of private equity relates to one of the major periods in the history
of private equity. Within the broader private equity industry, two distinct sub-

industries, leveraged buyouts and venture capital experienced growth along

parallel although interrelated tracks.
The origins of the modern private equity industry trace back to 1946 with the
formation of the first venture capital firms. The thirty-five-year period from 1946
through the end of the 1970s was characterized by relatively small volumes of
private equity investment, rudimentary firm organizations and limited awareness of
and familiarity with the private equity industry.
ORIGINS OF MODERN PRIVATE EQUITY
It was not until after World War II that what is considered today to be true private
equity investments began to emerge marked by the founding of the first two
venture capital firms in 1946: American Research and Development Corporation.
(ARDC) and J.H. Whitney & Company.
ARDC was founded by Georges Doriot, the "father of venture capitalism" (former
dean of Harvard Business School), with Ralph Flanders and Karl Compton (former
president of MIT), to encourage private sector investments in businesses run by
soldiers who were returning from World War II. ARDC's significance was
primarily that it was the first institutional private equity investment firm that raised
capital from sources other than wealthy families although it had several notable
investment successes as well.
ARDC is credited with the first major venture capital success story when its 1957
investment of $70,000 in Digital Equipment Corporation (DEC) would be valued
at over $355 million after the company's initial public offering in 1968
(representing a return of over 500 times on its investment and an annualized rate of
return of 101%). Former employees of ARDC went on to found several prominent
venture capital firms including Greylock Partners (founded in 1965 by Charlie
Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship
Ventures (founded in 1982 by James Morgan). ARDC continued investing until
1971 with the retirement of Doriot. In 1972, Doriot merged ARDC with Textron
after having invested in over 150 companies.

J.H. Whitney & Company was founded by John Hay Whitney and his partner
Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer
Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his
cousin Cornelius Vanderbilt Whitney. By far, Whitney's most famous investment
was in Florida Foods Corporation. The company, having developed an innovative
method for delivering nutrition to American soldiers, later came to be known as
Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H.
Whitney & Company continues to make investments in leveraged buyout
transactions and raised $750 million for its sixth institutional private equity fund in
2005.
PRIVATE EQUITY IN 1980S
The development of the private equity and venture capital asset classes has
occurred through a series of boom and bust cycles since the middle of the 20th
century. The 1980s saw the first major boom and bust cycle in private equity. The
cycle which is typically marked by the 1982 acquisition of Gibson Greetings and
ending just over a decade later was characterized by a dramatic surge in leveraged
buyout (LBO) activity financed by junk bonds. The period culminated in the
massive buyout of RJR Nabisco before the near collapse of the leveraged buyout
industry in the late 1980s and early 1990s marked by the collapse of Drexel
Burnham Lambert and the high-yield debt market.
BEGINNING OF THE LBO BOOM
The beginning of the first boom period in private equity would be marked by the
well-publicized success of the Gibson Greetings acquisition in 1982 and would
roar ahead through 1983 and 1984 with the soaring stock market driving profitable
exits for private equity investors.

In January 1982, former US Secretary of the Treasury William E. Simon, Ray

Chambers and a group of investors, which would later come to be known as
Wesray Capital Corporation, acquired Gibson Greetings, a producer of greeting
cards. The purchase price for Gibson was $80 million, of which only $1 million
was rumored to have been contributed by the investors. By mid-1983, just sixteen

months after the original deal, Gibson completed a $290 million IPO and Simon
made approximately $66 million.[1] Simon and Wesray would later complete the
$71.6 million acquisition of Atlas Van Lines. The success of the Gibson Greetings
investment attracted the attention of the wider media to the nascent boom in
leveraged buyouts.
LBO BUST (1990-1992)
By the end of the 1980s the excesses of the buyout market were beginning to show,
with the bankruptcy of several large buyouts including Robert Campeau's 1988
buyout of Federated Department Stores, the 1986 buyout of the Revco drug stores,
Walter Industries, FEB Trucking and Eaton Leonard. Additionally, the RJR
Nabisco deal was showing signs of strain, leading to a recapitalization in 1990 that
involved the contribution of $1.7 billion of new equity from KKR.[44]
Additionally, in response to the threat of unwelcome LBOs, certain companies
adopted a number of techniques, such as the poison pill, to protect them against
hostile takeovers by effectively self-destructing the company if it were to be taken
over.
PRIVATE EQUITY IN 1990S
Private equity emerged in the 1990s out of the ashes of the savings and loan crisis,
the insider trading scandals, the real estate market collapse and the recession of the
early 1990s which had culminated in the collapse of Drexel Burnham Lambert and
had caused the shutdown of the high-yield debt market. This period saw the
emergence of more institutionalized private equity firms, ultimately culminating in
the massive Dot-com bubble in 1999 and 2000.
THE VENTURE CAPITAL BOOM AND THE INTERNET BUBBLE (1995-200)
In the 1980s, FedEx and Apple Inc. were able to grow because of private equity or
venture funding, as were Cisco, Genentech, Microsoft and Avis.[29] However, by
the end of the 1980s, venture capital returns were relatively low, particularly in
comparison with their emerging leveraged buyout cousins, due in part to the
competition for hot startups, excess supply of IPOs and the inexperience of many
venture capital fund managers. Unlike the leveraged buyout industry, after total
capital raised increased to $3 billion in 1983, growth in the venture capital industry

remained limited through the 1980s and the first half of the 1990s increasing to just
over $4 billion more than a decade later in 1994.

After a shakeout of venture capital managers, the more successful firms retrenched,
focusing increasingly on improving operations at their portfolio companies rather
than continuously making new investments. Results would begin to turn very
attractive, successful and would ultimately generate the venture capital boom of
the 1990s. Former Wharton Professor Andrew Metrick refers to these first 15 years
of the modern venture capital industry beginning in 1980 as the "pre-boom period"
in anticipation of the boom that would begin in 1995 and last through the bursting
of the Internet bubble in 2000.[30]
THE BURSTING OF THE INTERNET BUBBLE AND THE PRIVATE EQUITY
CRASH (2000-2003)
The Nasdaq crash and technology slump that started in March 2000 shook virtually
the entire venture capital industry as valuations for startup technology companies
collapsed. Over the next two years, many venture firms had been forced to writeoff their large proportions of their investments and many funds were significantly
"under water" (the values of the fund's investments were below the amount of
capital invested). Venture capital investors sought to reduce size of commitments
they had made to venture capital funds and in numerous instances, investors sought
to unload existing commitments for cents on the dollar in the secondary market. By
mid-2003, the venture capital industry had shriveled to about half its 2001
capacity. Nevertheless, PricewaterhouseCoopers' MoneyTree Survey shows that
total venture capital investments held steady at 2003 levels through the second
quarter of 2005.

Although the post-boom years represent just a small fraction of the peak levels of
venture investment reached in 2000, they still represent an increase over the levels
of investment from 1980 through 1995. As a percentage of GDP, venture
investment was 0.058% percent in 1994, peaked at 1.087% (nearly 19 times the
1994 level) in 2000 and ranged from 0.164% to 0.182% in 2003 and 2004. The

revival of an Internet-driven environment (thanks to deals such as eBay's purchase

of Skype, the News Corporation's purchase of MySpace.com, and the very
successful Google.com and Salesforce.com IPOs) have helped to revive the
venture capital environment. However, as a percentage of the overall private equity
market, venture capital has still not reached its mid-1990s level, let alone its peak
in 2000.
CHARACTERISTICS OF PRIVATE EQUITY FUNDING
Most of the private equity firms are formed by limited partnership. The
company has some main partners who run the company and provide the
initial investment with a minimum period commitment.
General Partners (GP) : Responsible to raise capital from the high net worth
investors like pension funds, endowment funds, insurance funds, corporate
funds, different trusts, high net worth individuals etc. they hold the legal
position as partners in the firm.
Limited Partners (LP): They are responsible for the respective debt or money
raised by them. They have the limited liability and the extent lies only on the
investment raised by them. They have no management authority and they
receive a return on their invested capital.
High Risk-Return: Private equity funds investment follows high risk and
high return objective. Investing in privately held startup companies are very
much risky and at the same time offer very high return potential.
Carried interests: This is the share of profits the fund management team
receives as a performance reward for running the fund. The rest of the profit
is shared among all the investors based on their invested amount.
Hurdle rate: A hurdle rate is the minimum rate of return on a project or
investment required by a manager or investor. In order to compensate for
risk, the riskier the project, the higher the hurdle rate. If the return falls
below the hurdle rate, then the management will get only the base payment
without any carried interest. This is to protect the investors and provide them
a minimum return on their investment.
Initial investment: As the private equity fund intend to invest a significant
part of a privately held company to control their business operation and
drive their growth, it requires a huge initial investment by the partners of the
private equity firm.

Limited liquidity and investment term: Private equity investments have very
low liquidity as these investments are made with the long term intention to
gain profit. The investment term for private equity is typically 3 to 7 years.
HOW PRIVATE EQUITY FUNDS WORK?
Private equity funds are set up as a limited partnership by a private equity firm.
The firm then reaches out to large investors like university endowments, union
pension plans, charities, insurance companies, and extremely wealthy individuals
to raise capital. Once invested, the limited partners capital is locked up for a
predetermined number of years before the fund is liquidated and the principle (and
hopefully profits) are returned to shareholders.
The investors are limited partners in the newly established fund. The private equity
firm managing the fund is the general partner enabled to make all investment
decisions after raising capital.
The name private equity explains much of what these funds do. Private equity
firms use their raised funds to take companies private from public stock markets,
or to invest in companies that are already private.
Investing in a private equity fund is different from investing in a mutual fund or
exchange-traded fund. PE funds are typically closed-end funds that operate for a
limited term, typically lasting ten years. They start by raising money from investors
and generally spend anywhere from 1-10 years investing in a portfolio of
companies, which is known as the investment period. The next chapter is known
as the harvesting period, which is when funds reap the rewards of their
investments. Ultimately, harvesting means selling the fund's stakes in companies
and liquidating the fund, but these transactions can happen gradually, one portfolio
company at a time. You can expect to receive cash proceeds as these events occur
as well as smaller interim cash flows if and when special dividends are declared.
Assuming the fund has met its objectives, over the course of the harvesting period
you receive your money back, plus profits.
The way your investment is initiated is also very different from what you may be
used to with open-ended funds like mutual funds. Instead of paying money directly
into the fund, you make a commitment of a certain amount of capital, and the fund

gradually draws on that money by issuing capital calls each time it finds a
suitable company to invest in. If the fund cant find enough good opportunities,
you may end up investing less money than you had committed.
Also, its generally not possible to redeem your money until the end of the funds
specified term. Investing in a private equity fund is a long-term commitment, and
although it is possible to sell your stake on the secondary market, its more
complicated than selling publicly-listed securities, and you may have to sell at a
discount.

ADVANTAGES OF PRIVATE EQUITY

Private equity funds always invest with the intention of very high returns
over a long term. They are always considered as long term money enhancer.
They have a very low and positive correlation with stock market which
enables them to provide some diversification benefit.
Over the long term, the private equity fund gives better returns than other
market indexes. The historical data also supports the same.
From the invested companys point of view, private equity funds help them
to raise the cash and meet the short term obligations. Also the experienced
private equity fund managers and professionals help the company to take
good business decisions and grow properly.
Private equity can provide the largest amounts of money. The deals are
measured in hundreds of millions of dollars.
Private equity funding provides finance to new project which have high
growth potential accompanied with high risk. Thus private equity funds help
in promoting entrepreneurship among the young and talented entrepreneurs.
DISADVANTAGES OF PRIVATE EQUITY
Private equity fund investments have very low liquidity and hence the fund
investors cant sell their investments whenever they want.
It requires a very high amount of initial investment which only the very high
net worth investors can afford.

It requires a very high long term commitment by the investors. Investors

who can invest high amount of capital for long term can only invest in
private equity funds. It actually rules out all the small investors from the list.
The private equity firms invest in only startup companies and privately held
small companies, the risk of losing money is very high.
Private equity funds often demand a major stake, this results in loss of
ownership, also the private equity fund managers interfere in the normal
business operations.
The management cost and the transaction cost are very high because of the
complexity involved in analyzing the company and managing the company
as well as the fund.
Private equity firms are looking for particular companies to invest in, they
have to offer potential for large profits in a relatively short time frame. A
business that cant offer the investors a lucrative exit within about five years
will struggle to attract any interest from private equity firms.

DIFFERENCE BETWEEN PRIVATE EQUITY AND HEDGE FUNDS

MEANING:
Hedge funds are alternative investments using pooled funds that may use a
number of different strategies in order to earn active return, or alpha, for
their investors. Hedge funds may be aggressively managed or make use of
derivatives and leverage in both domestic and international markets with the
goal of generating high returns.
A private equity fund is a collective investment scheme used for making
investments in various equity (and to a lesser extent debt) securities
according to one of the investment strategies associated with private equity.
Private equity funds are typically limited partnerships with a fixed term of
10 years (often with annual extensions)
INVESTMENT STRATEGY:
Most hedge funds invest in securities like stocks, bonds, derivatives and
commodities that are tradeable on the open market and can be bought or sold
on short notice. Positions in the portfolios of these funds change often,
sometimes even on an intraday basis.
Private equity funds, in contrast, invest in companies or properties with the
intent to operationally manage, grow and eventually sell these assets. These
investments generally take 5-7 years, and sometimes much longer, to
become fully realized.

LIQUIDITY
Hedge funds have higher liquidity as compared to private equity.
Private equity is less liquid as the funds have to be committed for a specific
period that is usually more than 3 years and around 5-7 years.

RISK MANAGEMENT
Hedge funds minimize risk by hedging high risk investments with safe
ones.

Private equity funds meanwhile may control risk by utilizing secondary

investments.

DIFFERENCE BETWEEN PRIVATE EQUITY AND VENTURE CAPITAL.

Private equity is sometimes confused with venture capital because they both refer
to firms that invest in companies and exit through selling their investments in
equity financing, such as initial public offerings (IPOs). However, there are major
differences in the way firms involved in the two types of funding do things. They
buy different types and sizes of companies, they invest different amounts of money
and they claim different percentages of equity in the companies in which they
invest.
MEANING:
Technically, the term private equity refers to money invested in private
companies, or companies that become private through the investment.
Startup companies with a high growth potential need a certain amount of
investment. Wealthy investors like to invest their capital in such businesses
with a long term growth perspective. This capital is known as venture
capital.

COMPANY TYPE:
Private equity firms mostly buy mature companies that are already
established. The companies may be deteriorating or not making the profits
they should be due to inefficiency. Private equity firms buy these companies
and streamline operations to increase revenues.
Venture capital firms, on the other hand, mostly invest in start-ups with high
growth potential.

% ACQUIRED:

Private equity firms mostly buy 100% ownership of the companies in which
they invest. As a result, the companies are in total control of the firm after
the buyout.
Venture capital firms invest in 50% or less of the equity of the companies.
Most venture capital firms prefer to spread out their risk and invest in many
different companies. If one start-up fails, the entire fund in the venture
capital firm is not affected substantially.

INVESTMENT SIZE:
Private equity firms invest $100 million and up in a single company. These
firms prefer to concentrate all their effort in a single company, since they
invest in already established and mature companies. The chances of absolute
losses from such an investment are minimal.
Venture capitalists spend $10 million or less in each company, since they
mostly deal with start-ups with unpredictable chances of failure or success.

STRUCTURE:
PE firms use a combination of equity and debt.
VC firms use only equity.

STAGE:
PE firms buy mature companies
VCs invest in early stage companies.

PRIVATE EQUITY STRATEGIES

Private equity funds typically employ a transformational, value-added, active
investment strategy. However, diverse investment strategies can be used depending

on where the company is in its life cycle. Each stage of a companys life cycle
exhibits a certain risk profile and requires a specific set of skills from the general
partner

Leveraged Buyouts (LBO)

Leveraged buyouts are conducted when a company borrows a significant amount
of capital (from loans and bonds) to acquire another company. Private equity firms
make buyout investments when they believe that they can extract value by holding
and managing a company for a period of time and exiting the company after
significant value has been created.
Leveraged buyouts typically utilize debt to finance the buyout, and the firm
performing the LBO has to provide a small amount of the financing (typically
around 90% of the cost is financed through debt).
The goal of a leveraged buyout is to generate returns on the acquisition that will
outweigh the interest paid on the debt. For the firm thats performing the LBO, this
is a way to generate high returns while only risking a small amount of capital.
Oftentimes a financial sponsor is involved and the assets of the company being
acquired are used as collateral for the debt. Private equity firms will then either (1)
sell off parts of the acquired company or (2) use the acquired companys future
cash flows to pay off the debt and then exit at a profit.

Growth capital
Growth Capital refers to equity investments, most often minority investments, in
relatively mature companies that are looking for capital to expand or restructure
operations, enter new markets or finance a major acquisition without a change of
control of the business.

Companies that seek growth capital will often do so in order to finance a

transformational event in their life cycle. These companies are likely to be more

mature than venture capital funded companies, able to generate revenue and
operating profits but unable to generate sufficient cash to fund major expansions,
acquisitions or other investments. Because of this lack of scale these companies
generally can find few alternative conduits to secure capital for growth, so access
to growth equity can be critical to pursue necessary facility expansion, sales and
marketing initiatives, equipment purchases, and new product development. The
primary owner of the company may not be willing to take the financial risk alone.
By selling part of the company to private equity, the owner can take out some
value and share the risk of growth with partners. Capital can also be used to effect
a restructuring of a company's balance sheet, particularly to reduce the amount of
leverage (or debt) the company has on its balance sheet.

Mezzanine Financing

While some companies might take on growth capital to finance their expansions,
mezzanine financing is an alternate way. Mezzanine financing consists of both debt
and equity financing used to finance a companys expansion. With mezzanine
financing, companies take on debt capital that gives the lender the right to convert
to an ownership or equity interest in the company if the loan isnt repaid in a timely
manner and in full. Companies that take on mezzanine financing must have an
established product and reputation in the industry, a history of profitability, and a
viable expansion plan.
A key reason why a company may prefer mezzanine financing is that it allows it to
receive the capital injection needed for business without having to give up a lot of
equity ownership (as long as its able to pay back its debt on time and in full).
Another advantage of taking on mezzanine financing is that it may be easier to
receive traditional bank financing since its treated like equity on a companys
balance sheet.
On the flip side, there are some disadvantages to companies that take on mezzanine
financing. Since mezzanine financing is not collateralized, the lender takes on
greater risk. Therefore, mezzanine financing is typically conducted by

unconventional lending institutions versus standard lending institutions. As a

result, interest rates and terms can be much higher than traditional debt financing.

Venture capital
Venture capital is a broad subcategory of private equity that refers to equity
investments made, typically in less mature companies, for the launch of a
seed or start-up company, early stage development, or expansion of a
business. Venture investment is most often found in the application of new
technology, new marketing concepts and new products that do not have a
proven track record or stable revenue streams.
Venture capital is often sub-divided by the stage of development of the
company ranging from early stage capital used for the launch of start-up
companies to late stage and growth capital that is often used to fund
expansion of existing business that are generating revenue but may not yet
be profitable or generating cash flow to fund future growth.
Entrepreneurs often develop products and ideas that require substantial
capital during the formative stages of their companies' life cycles. Many
entrepreneurs do not have sufficient funds to finance projects themselves,
and they must therefore seek outside financing. The venture capitalist's need
to deliver high returns to compensate for the risk of these investments makes
venture funding an expensive capital source for companies. Being able to
secure financing is critical to any business, whether it is a start-up seeking
venture capital or a mid-sized firm that needs more cash to grow. Venture
capital is most suitable for businesses with large up-front capital
requirements which cannot be financed by cheaper alternatives such as debt.
Although venture capital is often most closely associated with fast-growing
technology, healthcare and biotechnology fields, venture funding has been
used for other more traditional businesses.
Investors generally commit to venture capital funds as part of a wider
diversied private equity portfolio, but also to pursue the larger returns the
strategy has the potential to offer. However, venture capital funds have
produced lower returns for investors over recent years compared to other
private equity fund types, particularly buyout.

Special situations or distressed PE

Special situations funds specifically target companies that need restructuring,
turnaround, or are in any other unusual circumstances. Investments typically profit
from a change in the companys valuation as a result of the special situation.
Examples of special situations include: a large public company spinning off one of
its smaller business units into its own public company, tender offers, mergers and
acquisitions, and bankruptcy proceedings. Besides private equity funds, hedge
funds also implement this type of investment.
Secondaries
Secondary investments refer to investments made in existing private equity assets.
These transactions can involve the sale of private equity fund interests or portfolios
of direct investments in privately held companies through the purchase of these
investments from existing institutional investors. By its nature, the private equity
asset class is illiquid, intended to be a long-term investment for buy and hold
investors. Secondary investments provide institutional investors with the ability to
improve vintage diversification, particularly for investors that are new to the asset
class. Secondaries also typically experience a different cash flow profile,
diminishing the j-curve effect of investing in new private equity funds. Often
investments in secondaries are made through third party fund vehicle, structured
similar to a fund of funds although many large institutional investors have
purchased private equity fund interests through secondary transactions. Sellers of
private equity fund investments sell not only the investments in the fund but also
their remaining unfunded commitments to the funds.
Real Estate

Private equity real estate involves pooling together investor capital to invest in
ownership of various real estate properties. Four common strategies used by
private equity real estate funds are:

Core: Investments are made in low-risk / low-return strategies with

predictable cash flows.
Core Plus: Moderate-risk / moderate-return investments in core properties
that require some form of value added element.
Value Added: A medium-to-high-risk / medium-to-high-return strategy
which involves the purchasing of property to improve and sell at a gain.
Value added strategies typically apply to properties that have operational or
management issues, require physical improvements, or suffer from capital
constraints.
Opportunistic: A high-risk / high-return strategy, opportunistic investments
in properties require massive amounts of enhancements. Examples include
investments in development, raw land, and mortgage notes.

WHAT DO PRIVATE EQUITY INVESTORS ACTUALLY DO?

There are four basic things private equity investors do to earn money.
Raise money from Limited Partners (LPs) like pension and retirement funds,
endowments, insurance companies, and wealthy individuals
Source, diligence, and close deals to acquire companies
Improve operations, cut costs, and tighten management in their portfolio
companies
Sell portfolio companies (i.e., exit them) at a profit
Raising Money
Private equity firms raise funds by getting capital commitments from external
financial institutions (LPs). They also put up some of the their own capital to
contribute into the fund (commonly 1-5% but it can be higher). The partners of the
firm (the GP) might go on a roadshow themselves to raise the money (as did the
partners at the firm I worked at) or they might use a placement agent (an outside
fundraising team) to help them do a lot of the legwork.
LPs are usually required to commit a significant amount of capital in order to be
allowed to participate in the fund, since the last thing the partners want is to be
fielding support calls and communications to a long tail of many little
investors who only commit a small amount but require a lot of hand-holding to
service. The ideal fund to a PE firm would be comprised of a handful of LPs that
each commit tens or hundreds of millions of dollars, or even billions of dollars,
each. Huntsman Gay, the Bain Capital spinout that I worked at, had less than 10
LPs that each committed more than $100M.
If youre a high net worth individual, the commitment thresholds might be a little
lower than a normal LP, but they will likely still be in the millions in order to
comply with federal securities laws that basically say you can only sell PE
investments to rich people because they are the ones who actually probably know
what they are doing.

But even though LPs make a capital commitment, they dont give all the money to
the GP all upfront. Instead, the GP begins to source and close deals, and as those
deals need to be funded, they call capital from the LPs. LPs then have a very
limited window (e.g., 2 weeks) to write a check to the GP so that the GP can fund
and close the deal. So committed funds are called committed capital while
disbursed funds are called contributed capital.
Many PE funds have something called first close vs. final close. First close
basically means that when a certain threshold of money has been raised, the PE
firm can begin making investments and actually closing deals and new LPs can
still join in by committing capital for a limited time (e.g., 1 year from first close).
Final close means that when a second threshold has been reach, new LPs can no
longer join in on that particular fund.

Sourcing, diligencing, and closing deals

When PE firms analyze companies for potential acquisition, they will consider
things like what the company does (their product or service and their strategy for
it), the senior management team of the company, the industry the company is in,
the companys financial performance in recent years, and the valuation and likely
exit scenarios of the company.
Prospective deals come in to the firm through a combination of the partners
reputation (in which case companies themselves may reach out to the firm),
investment professionals who proactively reach out to potential investment targets
through their own networks or through cold calls, or through investment banks that
may be representing a company and pitching it to investors through the issuance of
bank books or confidential investment memorandums. When investment banks run
a process, they often do it through an auction where several private equity firms
bid for the company, and firms drop out along the way as their bids are either
rejected or accepted to each successive round of bidding.
The best way to get deals is through proprietary means because that means the PE
firm has an edge against other firms in acquiring the company, either through
personal relationships or special knowledge or simply a head start. At Huntsman

Gay, there were a few proprietary deals we looked at and closed, and those were
definitely the ones we tried to move more quickly on, that didnt tend to get
dragged out in a process, and that were more pleasant to close. To get good
proprietary deal flow, the partners of the fund have to build and maintain strong
relationships with key people in industry, advisers, and even bankers.
Once a potential deal has been sourced, then the investment team will conduct
heavy due diligence to assess the companys strategy, business model, management
team, the industry and market, the financials, the risk factors, and the exit potential.
Diligence is typically conducted in stages that correspond to phases of the bidding
process, where financial and operational information is progressively revealed to
PE firms based on bidders that are still in the running at each phase. If the deal
looks promising and no dealbreaker red flags are found, then the investment
professionals will present to the investment committee (comprised of partners) for
funding approval.
Final terms of the deal with be negotiated with lawyers on both sides, and the deal
will transact, with funds being released and equity being traded.

Improving operations, cutting costs, and tightening management

One thing to be very clear on is that the GP does NOT run the portfolio companies
on a day to day basis. They are not installing themselves as CEOs and COOs.
Instead, they take board seats, they may or may not reshuffle senior management
of the company, and they provide advice, support, introductions, etc, relating to
operations, strategy, and financial management.
How involved the GP is really depends on how big their stake in the company is. If
they only own a small minority stake, then they wont be very involved; rather, the
lead investor owning the biggest stake will be most involved. However, if they
own either a sizeable percentage of the equity or a significant portion of the entire
fund is invested in the company, then they will be much more highly engaged in
streamlining and improving the company for a profitable exit down the line.
The GP must also produce official reports for LPs, generally each quarter, on the
progress and value of their portfolio companies, along with general financial

updates, and LPs may use that information to mark their own portfolios to market
when they report their results to their own investors.

Exiting portfolio companies

The end goal for PE firms is to exit their portfolio companies at a substantial profit.
Typically, the exit occurs between 3-7 years after the original investment, but it
could be shorter or take longer depending on the strategic circumstances. The main
sources of value capture at exit include: growing revenue (and therefore EBITDA)
substantially during the holding period, cutting costs and optimizing working
capital (and therefore increasing EBITDA), selling the company at a higher
multiple than the original acquisition multiple, and paying down debt that was
initially used to fund the transaction.
Most exits happen as the result of an IPO or acquisition by another firm, with
acquisitions being the more common method. Returns are then measured by the
internal rate of return (IRR) (which is the discount rate that makes the net
present value from the entry date of all cash flows between entry and exit equal
zero), or its quicker proxy the multiple of money (MoM) which is simply the
amount of money returned divided by the amount invested for that particular
investment.
Note that the IRR depends on the duration of the holding period while the MoM
technically does not (although you will be judged by your investors how long it
took to generate that MoM). So, for instance, if a $100M investment is sold for
$200M just one year later, the MoM is 2x but the IRR is 100%; if its sold after 3
years, the MoM is still 2x but the IRR has fallen to 26%; and its sold 5 years later,
the MoM is still 2x, but the IRR is 15%.
While partners do a lot of the coordination to sell the firms portfolio companies,
they may also retain investment banks to handle the execution, especially when the
transactions are large or complex. Thats how investment banks earn their fees
on selling the portfolio companies into PE firms and then again on selling them out
to downstream acquirers.

THE PRIVATE EQUITY PROCESS

The Private Equity Process in 7 Steps:

Deal Origination (Deal Sourcing)
Due Diligence
Deal Negotiation
Deal Closing (Acquisition)
Post Acquisition Monitoring
Exit (IPO, Trade Sale or Buy back)
Repeat.

Deal Origination: Deal Origination or as some call it Deal Sourcing is how

they get their deals, a potential deal can either come through a company
owner approaching them or from an intermediary who will try to bring both
parties (Company and Deal Maker) to close the deal. In some cases, they
may just approach companies who are expanding fast and wish to grow
further. In a year, the private equity firm comes across hundreds of potential
deals but only a few are selected.
Due Diligence: Due Diligence is what you could call doing your
homework. Before starting detailed negotiations, the PE Firm tries to make
sure everything is fair and square. Although Auditors and Consultants are
appointed to conduct the Financial, Tax, Legal and Technical Due Diligence
They also work side by side to understand the target company and its
industry better. All the information collected at this time, is then used during
negotiation.
Deal Negotiation: At the Deal Negotiation phase, they set out the terms and
conditions (covenants, representations and warranties) and other deal terms
that define or make the deal. Contracts such as Investment Agreement, Share
Purchase Agreement, Management Agreement, Advisory Agreement etc are
drafted to include all items that put the deal together.
Deal Closing: Deal Closing is probably the easiest part but also contains an
element of risk. Its the conclusion of the deal, the signing of all Agreements
and transferring funds* from the buyer to seller, conducting other

administrative functions (usually done by a separate entity) like updating

any articles of association etc.
Post Acquisition Monitoring: Post Acquisition Monitoring requires the Deal
Team (those who have worked on putting the deal together) to closely
monitor the company, both from an operational and financial point of view
against the expansion plan and budgets that were setup earlier by the
company. Improvements to business, from Corporate Governance, Financial
Reporting, Information Flow to Strategy are made at each level through
either the companys management or its board.
Exit: As the company matures (usually after 2 4 years) with the presence
of the Deal Team, they prepare it for an Exit - either an IPO or a Trade Sale
(sale to a larger party, multi-national or conglomerate) or in rare cases a Buy
Back by the owners. By this time, the company will have grown quite a bit
with still plenty of room to grow further.
Repeat: And once they have exited the company, they return their investors
money with the profit they gained for them after taking the fees for all the
effort put in the above process. Then, they just repeat the process, albeit with
a greater appetite for investments.
Although this may seem like a linear process - it isnt exactly so, primarily
because the private equity firm deals with a number of companies and each
one is at a different stage in the private equity process.

EXIT ROUTES IN PRIVATE EQUITY

It is the ultimate objective of all private equity investors to realize the return
on their investment after a certain amount of time, typically between three to
seven years after the original transaction took place. Performing an exit is
the process by which private equity firms achieve such goal, which is
therefore a natural part of the life-cycle of every private equity transaction.
Also, the number of successful exits achieved by a certain private equity
house has a strong influence on its ability to attract investors and raise funds.
Accordingly, the potential exit opportunities from an investment play a
highly important role in an investors decision about whether or not to invest
in a company. This is the reason why exits receive such special attention
from the earliest stages of the deal.
There are many exit strategies that private equity investors can use to offload
their investment. The main options are discussed below:
Initial public offering:
Initial public offering (IPO) or as sometimes referred to flotation or listing
is the method whereby the companys shares get listed on the stock market
for the first time, so the investor will be able to sell its shares to the public.
This is one of the most popular exit strategies used by private equity
providers, due to the fact that when the proper market conditions are
available, this method is likely to enable the investor to realize the highest
return on its investment.
Notwithstanding the higher outcome that can be obtained, IPOs also have
serious disadvantages compared to other exit methods that need to be taken
into consideration. First of all, the public offering of shares in itself does not
mean an exit. The private equity provider will only be able to exit its
investment when its shares are actually sold on the stock market, which is
very unlikely to happen simultaneously with the IPO. Therefore, the investor
seeking to perform an exit will be exposed to fluctuations and other market
risks for a certain amount of time after the IPO is carried out. Also, the
listing of the shares of a company is typically subject to strict regulatory
requirements and restrictions, which make the IPO a lengthy and expensive
process.

Trade sale:
Another commonly used exit route is the trade sale in which the private
equity investor sells all of its shares held in a company to a trade buyer, i.e. a
third party often operating in the same industry as the company itself. This
method is preferred by private equity providers mainly because it provides a
complete and immediate exit from the investment. Another advantage of the
trade sale is that in this case, the negotiations take place with a single buyer
which allows for a quicker and more efficient process which is not subject to
the regulatory restrictions applicable to IPO transactions. In a trade sale
transaction, the investor can also exercise more control over the whole
process, and in certain cases might even end up obtaining a higher value for
the company compared to other exit methods. On the other hand, trade sale
is not free from potential problems and risks either. The management of the
company may be resistant such a transaction as the change of control often
results in the replacement of the companys management as well. A trade
sale might also entail serious business risks as the buyer is oftentimes a
competitor of the company, which will inevitably obtain confidential
business information during the negotiation process.
Secondary buyout:
In the case of a secondary buyout, the company is sold by a private equity
investor to another private equity firm. In other words, the particular nature
of a secondary buyout lies in that private equity houses appear on both sides
of the deal, while in the average transaction private equity investors would
only be involved either as seller or purchaser. There are a number of possible
reasons why an investor may choose this method as the exit route. It can be a
means of shortening the life-time of a transaction which has become a
priority for private equity houses in the recent economic climate, and
therefore secondary buyouts have become increasingly popular. Sometimes,
the investor which carried out the original acquisition is not willing to (or
cannot) finance a business anymore, even though the company might not yet
be ready for a trade sale or IPO. In that case, selling the company to another
private equity firm which sees potential in further developing the company

might be a reasonable solution. This method can also be used by the

management when they wish to replace the private equity investor backing
the company. A secondary buyout offers the advantages of an immediate and
complete exit and it can be carried out even faster than a trade sale or an
IPO. This plays a significant role in its increasing popularity.
Leverage recapitalization:
Leveraged recapitalization is a partial exit method, whereby the private
equity investor is able to extract cash from a business without actually
selling the company. This is achieved by re-leveraging the company i.e.
substituting some of the companys equity with additional debt. It is usually
done by the company raising money by borrowing from a bank or issuing
bonds, which amount is then used to repurchase the companys own shares
from the investor. The most important advantages generally associated with
leveraged recapitalizations are that investors can remain in control whilst
still receiving payment and the possible tax benefits compared to other types
of exits. On the other hand there are significant disadvantages to this method
too. A leveraged recapitalization may result in over-leverage that can
eventually lead to financial difficulties and even bankruptcy. Also, increased
leverage limits the flexibility of the companys operations.

Liquidation:
This is the least favorable option but sometimes will have to be used if the
promoters of the company and the investors have not been able to
successfully run the business.

TYPES OF RISK AND RISK MANAGEMENT IN PRIVATE EQUITY

First, private equity is an equity investment into non-quoted companies. As the

companies are not traded on a secondary market like the shares of publicly listed
companies, there is no market price available on a regular basis. Only if the
company is sold to another investor can true market values be observed, but this
typically only happens after a number of years. Due to the lack of regular market
prices, the typical and well-known risk measures of public markets, such as
volatility, value-at-risk or shortfall-risk, cannot be used in private equity. Because
of this lack of availability of market prices, fund managers derive a value for each
company using one of the industrys standard valuation methods; e.g. market
comparables, discounted cash flow methods or others. These net asset values
(NAV) are not market prices. Rather, they are similar to accounting values and are
reported to investors on a quarterly basis to provide them with an indicative price
for their investment based on valuations of the unrealized investments held. Even if
these NAVs are sometimes used to calculate a risk measure, it is important to
understand that they are not based on actual market transactions. Consequently,
they can differ from true fair market values.
Second, a typical pension fund, insurance company, bank or family office does not
invest directly into a company. In the large majority of cases, a fund is used as the
investment vehicle because the professional fund manager has both the experience
and knowledge to source and select the investments, manage them actively, adjust
the strategy of the company in order to create more value, monitor the company,
and sell it after an average holding period of five years. The typical investment is
done through a closed end Limited Partnership structure. Here, investors are the
Limited Partners (LP) who commit an amount of capital at the beginning of the life
of the partnership with the legal obligation to pay this capital into the fund
whenever the fund manager (General Partner; GP) calls for it. When the fund
manager has identified an attractive investment opportunity in a company, they
will draw down the capital from the investor; usually this will be done during an
investment period of five years. Thereafter the investment will be held and exited.
In total, LP structures tend to be set-up for a long-term horizon of 10 years with no
redemption rights for investors. They can only try to liquidate their stake at the
secondary market for depending on the market situation and external factors a
potentially large discount, due to the illiquidity and inefficiency of this market. In
addition, sales negotiations can typically take several weeks to complete. As such,

an investor in private equity can run a liquidity risk. Lastly, an investor does not
pay in all of their capital on the first day; rather, the money is drawn from the fund
over time. This represents a specific risk for investors, which is of course a result
of the typical fund structure discussed in the previous paragraph; i.e. funding risk.
If the investor is not able to pay the capital call in accordance with the terms of the
partnership agreement, they default on their payment. In such a case, the investor
might lose the entire investment and all the capital which they already paid into the
fund. Many fund managers have strict rules in their Limited Partnership
Agreements in the case of a defaulting investor. Typically, the investor will lose
their entire investment; in some cases they still hold the liabilities. This strict
mechanism is important for the fund manager as they need to have the highest
possible security to fund the investments they would like to acquire. In addition to
the risk of not being able to fulfill their own undrawn commitment; each investor
can be adversely impacted as a result of other investors defaulting. Hence, liquidity
and funding risks arising through unfunded commitments are an important element
and need to be reflected in sophisticated risk management systems.
Following risks can be identified in private equity:

1. Funding risk: The unpredictable timing of cash flows poses funding risks to
investors. Commitments are contractually binding and defaulting on
payments results in the loss of private equity partnership interests. This risk
is also commonly referred to as default risk.
If this risk materialises, an investor can lose their full investment including
all paid-in capital, which is why it is of paramount importance for investors
to manage their cash flows to meet their funding obligations effectively.
The financial crisis in 2008 highlighted the importance of managing funding
risk. Since then, regulators have focused more on funding risk and have
issued principles for sound funding & liquidity risk management. But how
does funding risk occur when managing a private equity portfolio? In
general, there are two reasons: (i) over-commitment and (ii) market
distortion in capital calls and distributions.
How can funding risk be measured and which solutions are possible?

Funding risk can be measured through a funding test or through

cash flow models which take extreme cases into account. The funding
test places the undrawn commitments in relation to the resources
available for commitments. Alternatively, a cash flow model provides
the investor with a simulation of the expected capital calls and
distributions in the future. It is very important that extreme scenarios
are also considered in which capital calls are much higher than
distributions and, hence, large amounts of outside capital are
necessary.
How can funding risk be reduced?
Investors can reduce the risk by assessing their future commitment
plan with cash flow simulations and cautious planning. Investors who
have limited external capital available or large allocations to illiquid
assets should be more cautious on the over-commitment and selffunding strategy. However, when deciding on such a strategy,
investors should be aware of possible extreme scenarios and how
much cash would be necessary and how this could be obtained from
other sources. A strategic plan for these extreme cases as well as the
portfolio construction plan is the key element.
2. Liquidity risk: Liquidity Risk is the risk that an investor is unable to redeem
their investment at the time of their choosing. We have already noted that
private equity fund structures are designed so that the investor remains in the
fund for its full term without an opportunity to redeem their commitment. As
a result of these structures, however, a secondary market for LP
commitments (participations) has evolved. Consequently, liquidity risk may
also be regarded as the risk that an investor wants to sell their private equity
investment (in the form of a fund commitment) on the secondary market, but
the market does not offer enough volume or efficiency for a fair trade.
How can liquidity risk be measured and which solutions are possible?
Liquidity risk in private equity is difficult to measure. While the
secondary market can be very active in a normal market environment
and during boom phases, this level of activity is far from what one

would see in even the most illiquid of listed markets. Moreover, the
secondary market was shut down during the financial crisis in 2009
with very low trading volumes. As such, the liquidity risk for
investors in private equity seems to be high due to inefficient
secondary markets.
How can liquidity risk be reduced?
Liquidity risk in private equity is difficult to reduce, although it is
simpler to handle for investors in an overall asset allocation model. If
an investor is solely focused on private equity assets and they need to
sell in difficult market times, they cannot circumvent the liquidity
risk. However, if private equity is only a small part of a welldiversified asset allocation, as is the case for many insurance
companies, pension funds and banks, many other assets are more
liquid and can be traded. In reality, the experience is that banks or
insurance companies use the secondary market in years of high prices
to sell their assets and do not use it frequently in distressed markets.
3. Market risk: The fluctuation of the market has an impact on the value of the
investments held in the portfolio.
How can market risk be measured and which solutions are possible?
As the NAVs are available on a quarterly basis, statistics that are
applied to continuously traded securities can also be used for private
equity investments, such as the volatility of the NAV-based return
time series on a quarterly basis. However, as mentioned above, such
unadjusted time series would unfairly favour private equity
investments over the stock market and therefore should not be used.
To still allow for a simple comparison with other asset classes, there
are approaches to de-smooth those NAVs before running risk
analyses. Other analyses focus on the time-lag of reporting.18
However, it is debatable how well such adjustments work for private
equity returns. Furthermore, results based on such market risk
measures are centered on the implicit assumption that the quarterly
NAVs are actual market values which an investor could buy and sell.

This is not true for private equity investments and as such the results
can give an investor a misleading view on their investment. Rather,
they should focus on the long-term properties of private equity as it is
inherently a long-term asset class.
How can market risk be reduced?
Market risk as the quarterly change of the net asset value is a shortterm risk measure and, therefore, also depends on the short-term
movement of public and FX risks. As such, if the portfolio is largely
diversified over various geographies, markets and industries, this
volatility can be minimised.
4. Capital risk: Closely related to market risk is capital risk for the investor.
Capital risk for the investor is defined as the probability of losing capital
with a private equity portfolio over its entire lifetime.19 As a consequence,
the investor would have a realised loss in their portfolio, while market risk is
based on unrealised values. Similarly to market risk, capital risk is driven
both by internal and external factors.
In the long-term, the development of the underlying companies in a fund
portfolio affects the performance and the capital risk of the investments. The
positive operational development of the companies and their financial
situation is a substantial source of value creation for investors. As such, the
fund manager spends a significant amount of time working with the
management analysing and improving the companies strategies during their
holding periods in order to exit the company to a value above the investment
cost. The conditions of the exit market, method and timing of the exit can
also be a route through which the fund manager can create value for
investors.
How can capital risk be measured and which solutions are possible?
For liquidated or mature funds, the ratio between distributions and
paid-in capital can be used as a measure for capital risk (DPI). If this
ratio is below one for a specific investment, an investor has lost
money. This measure can be calculated on the portfolio level of the
investor, on the fund level and on the portfolio company level. For
funds that are still active, the residual NAV should be added to the

numerator to measure total value to paid-in capital (TVPI). This

measure is then dependent on the quality of the reported NAV.
How can capital risk be reduced?
Studies have shown that, over the long-term, internal factors are
critical when building a successful private equity portfolio. Investors
are able to minimise their capital risk significantly when diversifying
over a large number of funds in many geographies, industries, and
over many years and with different fund managers. In general, the best
results have been achieved when funds have equal weighting with the
same investment strategy. Apart from investing in direct funds, doing
so in co-investments and secondary funds further increases
diversification.