Private equity is a form of financing where capital is invested in a company that is seen to have the potential for growth. Private equity firms typically invest in privately-held companies and/or assets which aren't traded on public markets. Founders will look to private equity firms for assistance typically when they are looking for both capital as well as expertise in how to manage and grow their business. The funds raised from private equity are used either to grow the business, or to liquidate founders who may be interested in cashing out.
Venture Capital ("VC") is often seen as a subset of Private Equity ("PE") and will usually involve investing in earlier stage companies whose business models and/or businesses are not yet established. Private Equity firms typically invest in more mature companies. Whereas Venture firms usually take a minority stake in a company, Private Equity shops will often take a majority share of the company giving them more control over how the business operates. Both PE and VCs are sometimes referred to as "sponsors".
"Late stage Private Equity" are firms that look to make much bigger size investments in later stage private companies. Sometimes these firms bleed over with LBO or "Leverage Buyout" shops which will make bigger bets on later stage companies, sometimes which are publicly traded companies. LBOs typically use debt as part of their investment whereas late stage Private Equity mostly use cash to buy the equity in their investments.
Private equity firms usually acquire entire companies using equity and debt whereas hedge funds acquire small stakes in companies or other financial assets like bonds, currencies, and derivatives. PE firms have more of a long-term focus on the companies they acquire and spend time on management and growth of the companies in their portfolios, while hedge funds focus on benefiting from quick gains in the short term.
Hedge funds also invest in publicly traded companies and will sometimes use a "short" instrument to bet against publicly traded businesses. Hedge funds invest in a wider array of assets than Private Equity shops.
Private Equity firms are accredited investors that have registered with the Security and Equities Commission. They are required to follow the rules and regulations of the SEC. PE Firms have General Partners (GPs) who usually spend 100% of their time and energy finding, executing and helping run companies.
PE firms raise funds which are the vehicles they use to invest in new companies. Firms buy and sell companies out of a given fund and returns are measured for each fund. PEs sometimes have multiple funds working at any given time. Funds are created by raising capital from Limited Partners or "LPs". LPs can be any accredited investor and are often institutional investors such as pension funds, endowments or money management firms.
PE firms hire a variety of people to help raise funds as well find promising companies and operate those companies. A given set of companies that a firm has invested in is referred to as their "portfolio". PEs charge their LPs a "management expense" to cover their base costs. There can also be "fund fees" which are attributed to a given fund. Ultimately, however, PEs make money by investing in companies helping them grow and ultimately find a buyer. Most PEs will have a target return for each company measuring their return in multiples of their initial investment. A "3X return" means you return $3 for ever $1 invested.
Private equity firms also make money through two types of fees:
The management fee is usually a small % of "committed capital" or the size of their fund. These fees are meant to cover operating expenses like their overhead, some of their employee costs and other G&A costs.
The performance fee, also called their carried interest, or just "carry" for short, is how PEs will make the majority of their money. The Carry is also a % of the fund but is more like 10-30% of the upside returns that they are able to drive. The performance fee is meant to align interest of GPs and LPs. PEs that are successful in buying, growing and selling companies drive a return for both the LPs and the GPs. Firms measure their return as an IRR or "Internal Rate of Return". Each GP will measure their individual performance in terms of IRR as well and PEs see this as a yardstick of their success.
There are over 6,000 PE firms in the world. This number has increased each year over the last 20 or so years. While PE is seen by many to be an easy way to make money, it's quite competitive and difficult to consistently outperform the market.
PEs will typically use a mix of strategic and opportunistic approach to investing. Strategic investing means that firms come up with a strategy or thesis on which they will invest. These strategies are sometimes called "themes". Investing strategies will evolve with time and are often hotly debated. An example strategy would be investing only in companies that help with remote work given a global pandemic is spreading. While this strategy may seem smart with given conditions, other firms may have similar strategies that increase the demand (and thus price of investing) in these companies and soon the potential of getting a return greater than the market is rendered futile.
Opportunistic investing is when opportunities come across a firm's radar given connections GPs or LPs have with privately held companies. Some firms try to adhere to strategic investing only, while others rely more on opportunistic investing.
Another way that firms compete is by focusing on either specific verticals of the market, or on specific stage of companies. Vertical focus is a fairly standard way to build strategy and many firms feel the more they invest in a given sector, the more knowledge and intuition they build on where and how to invest.
Picking a specific stage of company can also help firms compete. Many firms talk about both stage of company they will invest in and "check sizes" they will write. These two aspects also relate to how much risk they want to take with each investment. Some strategies have PEs, in particular, write bigger checks and take bigger stakes in companies. Others wish to write smaller checks and/or take a smaller % ownership of their portfolio investments. Many Partners and Directors think about their check sizes and % ownership in terms of how much time they have to help portfolio companies. This too feeds into strategy.
General Partners ("GPs") are generally full time employees of the firm and manage the day to day operations of the firm. Many times they will invest their own money in the funds they are raising. Limited Partners ("LPs") are those who invest in the fund of the PE or VC. LPs have influence on where and how funds are invested, but their rights are much less than General Partners.
Analysts and Associates are the entry level position of PE firms and their role is to help across a number of different work streams at the firm. Typically they will help most with deal sourcing and deal execution (whether it be buying new companies or selling portfolios). They may also help with portfolio management.
Vice Presidents are often the next level role at PEs, and typically they will have their MBA. VPs help deal sourcing and deal execution but will have more responsibilities than Associates in terms of driving and closing deals. VPs work closely with Associates and Analysts often reporting into them. VPs are expected to own new deal flow and are evaluated on their ability to source and close new investments.
The Principle role would be the next more senior role in an organization and typically has several years experience as a Vice President. Principles are evaluated mostly on their ability to find and close promising companies. They typically also start playing a role on the management and execution of the portfolio companies (which they source). They are often times closely involved in any sale of a portfolio. Principles may or may not have compensation tied to the carry of the firm. Oftentimes they are compensated based on the success of their companies.
Partners are senior professionals at the firm and have responsibilities across deal flow, portfolio management as well as fund raising and operating the firm. Partners sometimes specialize in different areas. For example you can have Investing Partners who focus on investment activities, and you could have Operating Partners, who focus on the operations either of the portfolio, or of the firm itself. The CFO or COOs of a PE may be considered Operating Partners.
Managing Partners are the most senior partners of the firm, and are often the founders of the firm. They hold ultimate responsibility for the operations and returns of the firm. Managing Partners will play the point in terms of fund raising as well as investor relations with LPs. They will also have more responsibilities on the operations and administrations of the firm including personnel management.
The fund within a private equity firm is a pooled investment vehicle that is used for raising and distribution of funds. Funds are established with specific operating documents which specify both the economics and the administration of the fund. Funds are sometimes focused on specific strategies, whether it be by vertical, or by "size of check", or by stage of company. Many VC firms, for example, have "venture funds" - investing in earlier stage companies, as well as "growth funds" - investing in later stage companies.
Funds typically have a life cycle and often times funds must be fully invested by a specific date, or any left-over money is returned to investors. PEs can have multiple funds operating at any given time and typically when a given fund is near the end of it's lifecycle a new fund will be raised. PE firms find it more or less easy to raise new funds based on the performance of its older funds.
Private equity raises funds through investors called limited partners which can be pension funds, institutional accounts, and wealthy individuals.
Management fees are fees paid by limited partners on their committed capital, usually this fee falls at around 2%.
Private companies, public companies, and start-ups.
Private equity firms can find companies to invest in by hiring an in-house team with dedicated deal sourcers and by using an online platform such as Sourcescrub to enhance or build deals via an optimized sourcing process, garner information on both private and public companies, and to better understand their target market by getting alerts in real time on changes of companies within the market.
Private Equity firms add value to their owned companies through a "buy and build" strategy, where they acquire add-on companies that add value to an existing platform company to gain synergies.
IPOs, where companies offer shares of stock to the public, corporate acquisitions, which is when the company invested in is bought by another company, or secondary sales, where the company is bought by another private equity firm, are some of the ways a private equity firm exits a company.