Private Equity and Principal Investors
SECTION 1: PRIVATE EQUITY & PRINCIPAL INVESTORS - OVERVIEW
BUSINESS SENSE ABSTRACT
Private Equity firms control over $6 trillion in US assets, making it important to understand the industry. Private Equity (PE) firms take ownership in private ‘target’ companies with high growth potential and sell them years later for profit. PE firms take companies private upon purchasing them so they can make their own decisions without the influence of shareholders. During the time a PE firm owns a company, it often implements management or operational changes to increase the company’s value (for example by cutting costs). The concept of private equity is quite new relative to other financial services, with its origins beginning in 1946 and the industry taking off in the 1980s.
MECHANICS OF PRIVATE EQUITY PURCHASES
PE firms commonly take ownership and purchase target companies in two ways - Leveraged Buyouts (LBOs) and Venture Capital (VC), explained in the below sections.
There are three common ways PE firms ‘exit’ an investment (sell the target company for profit). Firstly, by taking the company public and issuing an Initial Public Offering (IPO). This involves selling ownership of the company to the public by issuing shares and listing the target firm on a stock exchange. Secondly, the PE firm can sell the target company to a much larger company in the same industry. Lastly, the PE firm can sell the company to another PE firm that may see further growth potential in the target company (known as a ‘secondary buyout’).
The PE firm can also increase profit by improving public perception of the target company. If the public thinks a company has much higher growth potential and has become much more valuable, they will be willing to pay more to own shares if the company is taken public.
LEVERAGED BUYOUT (LBO) DESCRIPTION
A leveraged buyout is a financial transaction in which a PE firm takes on a significant amount of debt to purchase ownership in a target company. The averaged LBO is currently conducted with about 50-60% debt (in the 1980s this number was closer to 90%).
In an LBO, PE firms put up the assets of the target company as collateral for this debt (assets the debt-issuer can take ownership of should the PE firm miss repayments). The goal of an LBO is to repay the debt/interest payments with the cash flows of the target company over time. At the same time, the PE firm will make changes to the target company to try to increase its value for an eventual exit from the investment. The PE firm will use the revenue from the ‘exit’ to repay the principal amount of the loan.
As the PE firm is using borrowed money, this allows them to profit more than they otherwise would. The mechanics behind this are explained in the ‘LBO hypothetical example’ section below.
HOW DO PE FIRMS ASSESS GROWTH POTENTIAL?
PE firms choose target companies by identifying firms with poor management, high costs, or the need for restructuring or consolidation. Firms that are being ‘held back’ by management, operation, or structure issues can be thought of as relatively easy fixes. If the PE firm takes ownership of the company, it can provide its expertise to facilitate restructuring or management changes. If these issues are fixed, the target company may experience high rates of growth, resulting in a large profit for the PE firm upon its exit.
Of course, there are issues with this strategy. Firstly, it’s difficult to identify management or operational problems in target companies as these don’t show up in financial statements. Secondly, the PE firm may ‘misidentify’ poor management and operational issues as the source of a company’s problems. The PE firm could take ownership and fix these issues, but there may be a separate issue slowing the company’s growth that may be much more difficult to fix. Clearly, PE firms must conduct thorough research before taking ownership of a target company.
LBO HYPOTHETICAL EXAMPLE
A private equity firm identifies a hypothetical shoe company, called Treks, with high costs. The PE firm believes Treks could increase profit and growth if these costs were cut. The PE firm purchases Treks for $100 million. It borrows $60 million at 2% interest and produces $40 million from its own equity to make the purchase.
The PE firm uses its expertise to reduce Treks’ costs. Treks experience high rates of growth and increased profit, resulting in increased cash flows. The PE firm uses these cash flows to make interest payments and repay part of the debt.
After five years, the PE firm exits the investment. It sells Treks to a much larger clothing company for $120 million. The PE firm uses this to repay the principal amount of the debt.
It may seem at first that the PE firm’s return on this investment is around 20%, but we need to remember it borrowed money to make the investment. After selling Treks, the PE firm has $120 million. It needs to pay back $40 million in the principal payment, and it has paid back $4 million in interest over five years (at 2% per year). This means the PE firm is left with $76 million, and it invested $60 million into the project. Therefore, its rate of return is just under 27%.
Let’s now imagine that Treks didn’t do well under the PE firm’s ownership, and the PE firm ended up selling it for $80 million after five years. Without leverage, its loss would be just 20%. However, as the PE firm took on debt, it still had to pay back the $44 million in principal payments and interest. This means the PE firm is left with $36 million after its exit - incurring a loss of 40% from its $60 million investment.
As can be seen, whilst LBOs increase the potential for high returns, they also can result in much larger losses.
VENTURE CAPITAL DESCRIPTION
Venture Capital (VC) is a form of private equity and a type of financing provided to small companies or startups believed to have long-term growth potential. It focuses on emerging companies seeking what may be their first large cash investment. VC can provide high returns if the target company becomes successful, but comes with high risk too.
Small companies may seek investment through venture capital as they can’t yet access the stock market and don’t have the cash flows to take on large amounts of debt. VC can be a way for these firms to raise funds. However, they then have to give up equity (ownership) in the company, meaning outsiders will get a say in the company’s future decisions. Also, acquiring firms may be looking for a fast ‘exit’ in the investment, and may pressure the target company to sell itself. VC comes with a high risk for the acquiring company as small, new businesses may not be profitable and are much more likely to fail.
However, the acquiring company can provide its management expertise allowing the target firm to potentially grow at a much faster rate, benefitting both firms, and the upside on a successful investment can result in massive returns. As well as this, as the target companies in a VC investment are small, not much funding is needed to secure ownership.
BENEFITS & DRAWBACKS OF PE FIRMS TAKING OWNERSHIP
With PE firms basing their business model on taking ownership of a target company for a period of time and then selling it for profit, controversies arise. Firstly, with LBOs, the PE firm is putting up the target company’s assets as liability for their debt. If the PE firm fails to repay this debt on time, the debt-lender can seize the target company’s assets, leading to layoffs and possibly bankruptcy.
As well as this, if after taking ownership the target company doesn’t do well and the PE firm incurs a loss upon its exit, its loss is larger due to it having to repay the debt (this is explained above in the ‘LBO hypothetical example’ section).
Also, PE firms are often focused on a company’s relatively short-term growth so they can sell the company for profit. This can lead them to make management decisions that benefit the company in the short term but may not help it in the long term.
On the other hand, PE firms must grow their target company to make a profit. They may provide technical or management expertise that the target company wouldn’t otherwise have received. These benefits can continue to help the target company long after the PE firm has sold it. Many target companies go public after Private Equity ownership, creating extra value for shareholders too.
CASE STUDY TOPIC - BLACKSTONE’S ACQUISITION OF HILTON HOTELS
In 2006, Hilton Hotels was a public company showing rising profit margins and high growth potential as it entered the international markets. Blackstone identified Hilton as a good target for an LBO as it could use its expertise in real estate to further grow the company.
In 2007, Blackstone bought Hilton and took it private at $47.50 per share, for a total of $26 billion, financed with about 78% debt, making the purchase one of the largest debt-financed acquisitions worldwide. With interest rates low at the time, Blackstone saw potential for a huge profit.
However, with the collapse of the real estate bubble and the resulting financial crisis in 2007-8, Blackstone found itself in trouble. Hilton Hotels was in large amounts of debt, but since this debt was only owed to a few banks, Blackstone used its expertise to renegotiate some of this debt down and push back its maturity by a couple of years, allowing Hilton to keep more of its cash flow.
Blackstone’s president maintained that Hilton still had a high growth potential. They invested heavily in the company building new properties internationally, and targeted the increasing middle-class abroad. Hilton doubled its number of rooms to 900,000 under Blackstone’s ownership.
Blackstone then gradually sold off Hilton, eventually holding an IPO. Blackstone ended up profiting $14 billion from the transaction, tripling its initial investment into the project.
SECTION II: FINANCIALS AND METRICS
REVENUE DRIVERS
Selling acquired companies - PE firms aim to sell their acquired companies for more than they bought them for, which is their main driver of revenue.
Leverage - as explained in section one, leverage allows PE firms to purchase companies using a portion of borrowed money, which allows them to make more revenue than if they bought the company entirely with their own equity.
Cash flows of acquired companies - after companies are bought by PE firms, they still produce cash flows each year, and if the PE firm is improving the company, these should increase year on year. These cash flows are typically used to repay interest.
Increasing perceived value of acquired companies - if PE firms increase the perceived value of a company by the public if they take this company public, this will increase its share price, increasing the revenue the PE firm receives if it holds an IPO.
COST DRIVERS
Purchasing companies - the majority of a PE firm’s costs is purchasing target companies. Although PE firms usually borrow a portion to make the purchase, they still have to use a large amount of their own money.
Interest payments - the PE firm must repay interest on its borrowed money each year until the principal amount is repaid in full.
Improving acquired companies - after a PE firm acquires a target company, it grows it by improving its operations and financial performance. This incurs a cost as the PE firm may have to bring in outsiders (e.g. consultants) to help.
Employee expenses - private equity firms recruit very competitive talent across the world, and the work can often be highly stressful. Employees therefore demand extremely high salaries.
KEY METRICS
Internal Rate of Return (IRR) - the annual rate of growth that an investment is expected to make.
Multiple of Invested Capital (MOIC) - the ratio of the total amount made from an investment to the total amount invested.
Net Asset Value (NAV) - the firm’s total assets minus liabilities at a given moment.
Distribution to Paid-In Capital (DPI) - the ratio of capital received by investors to capital returned to investors.
SECTION III: PORTFOLIO ANALYSIS
Now we’ve gone over the mechanics of how PE firms operate, let’s have a look at a PE firm’s portfolio. Warburg Pincus is a PE firm founded in 1966 and headquartered in New York City. The firm currently has around $80 billion in assets under management. Its current portfolio has over 245 companies in different global regions, industries, and stages of development1.
Firstly, let’s have a look at its active portfolio. These are firms that Warburg Pincus currently has ownership of.
Interestingly, four out of five of its largest portfolio companies last received financing from Warburg Pincus in the form of ‘Later Stage VC’. This is a form of venture capital that occurs after a VC-backed company has already developed its product and has strong revenue.
Warburg Pincus may have invested in these companies as they have good track records for producing revenue, but there may still be growth potential before they exit. The track records make these investments less risky than early-stage VC, but the possible returns are also likely much lower.
You’ve possibly heard of ‘Nord Security’ (the parent company behind NordVPN). You may know this company’s VPN has been extremely successful, and understand why this investment is much less risky than investing in a new start-up.
Now let’s have a look at part of the firm’s former portfolio - these are investments that the firm has previously exited. They no longer hold ownership in these firms.
Looking at Warburg’s five most valuable companies in its former portfolio, a few more questions arise. Looking at the current ownership status of these firms, three are now publicly held, and two are privately held with financial backing (likely by another PE firm). Do you think Warburg Pincus would prefer to exit their most valuable investments by taking the company public, or by a secondary buyout to another PE firm?
The advantage of taking the company public is that they likely sell their ownership of it for more money - public valuations of companies are typically higher than private, especially as public perception plays a role in this type of valuation.
However, during times of recession, the public is likely willing to pay much less for shares in the company. Interest rates also fall during a recession, meaning another PE firm would find it easier to conduct an LBO to buy the company. But in a recession, the other PE firm is less likely to want to buy the company. They also suffer from the economic conditions in a recession (they will struggle to produce high valuations when taking their portfolio companies public, so may have less money to purchase new companies with).
Also, these five companies are all in different industries. Do you think this is typical for a PE firm? What are the advantages and disadvantages of this?
On the upside, if one industry has a huge disruption but the PE firm’s portfolio is industry-diversified, then its entire portfolio won’t be massively harmed (for example if oil prices went up, this would hugely harm the PE firm if it mainly held airlines, but if it held only one airline and had a diverse portfolio, they would fair better). This is the same logic behind diversifying a portfolio of stocks - essentially, don’t put all your eggs in one basket.
However, a PE firm won’t have expertise in an acquired company’s industry if its portfolio is highly diverse. They will likely hire outside consultants to give the acquired company its expertise, incurring an extra cost. This cost is probably worth it though for protection from industry-specific risks.
Finally, let’s have a look at some of the firm’s analytics for the last few years.
What’s immediately obvious is how its active investments, PE deals, and VC deals all fell by large amounts from 2021-2023. Why may this be? Well, the median deal size climbed from $138.02M to $224.50M, and the median valuation climbed from $650M to $920M. So, it may be that Warburg Pincus is completing fewer deals, but each one is worth a lot more.
Also, it may be harder for the firm to finance deals in recent years. In September 2021, interest rates in the US were 0.08%, in September 2022 they were 2.56%, and in September 2023 the rate reached 5.33%2. With interest rates climbing an unprecedented 5% in just two years, this makes conducting LBOs much more difficult for PE firms as their interest payments are much higher.
