Introduction to Private Equity

welcome back in this video we will focus on the two major types of private equity strategies these are the leveraged buyout or LBO and venture capital or VC LBOs are the most common strategy in private equity they use a lot of debt financing to acquire companies the leverage may come from bank loans high-yield bonds or mezzanine financing essentially mezzanine is debt or preferred equity securities that are subordinate to high-yield bonds it typically has warrants or conversion rights that give investors an additional upside LBOs can be divided into two sub groups in management buyouts or MBOs the existing management team acquires a company with the help of a financial sponsor usually a private equity firm thus they gain even more control over the strategic direction of the business for instance management can implement major corporate actions in order to create value which might be difficult if they don't have full control over the company or the support of the majority of the shareholders in management by N's or MB is a private equity firm buys a target company and brings in a new management team to replace the existing one this is done when an external management team is expected to implement new strategies that will increase the value of the business as the target company's cash flows are used to repay buyout debt companies with high stable and visible cash flow generation are considered suitable for LBOs to create more value private equity firms put in place management incentives like partial ownership in the business they can also implement strategy initiatives for cost reduction and revenue enhancement and what about venture capital it provides funds to young companies with high growth potential also known as startups or scale ups Vesey allows investments in equity convertible shares or convertible debt as you can guess the investment risk associated with venture capital is very high as most startups fail before reaching maturity the ones that succeed however usually deliver very big returns VC funds are closely involved in the development of their portfolio companies usually fund managers take board seats in these firms depending on the growth phase of companies invested in venture capital investing can be divided into angel investing seed stage early stage later stage and mezzanine stage angel investing refers to the very first funding rounds of a business when it may be only at the idea phase usually financial from angel investors also known as business angels is used for preparing business plans and market potential assessment investors are mostly high net worth individuals rather than funds seed stage investments are typically used for market research product development and marketing not only business angels but also VC funds invest in seed funding rounds then we have early-stage investments which finance initial commercial production and sales while later stage BC funds invest in companies that already have production and sells and are trying to expand through increasing marketing activities finally we have the mezzanine stage financing this refers to the timing of the financing rather than its type as it is used when a company is preparing for an IPO it's called mezzanine because it enters the firm's capital structure during its transition from being a private organization to becoming a public company well done this is how leveraged buyout and venture capital work in a nutshell however there are also two smaller categories of private equity strategies the first one is development capital which is also known as minority equity investing it provides capital for business growth or restructuring when it's done in public companies it's called pipes or private investing in public equities finally we have distressed investing this involves investing in the debt of mature companies in financial difficulties such as default or bankruptcy these investors are sometimes called vulture funds they work closely with the management of their portfolio companies to come up with a turnaround strategy and reorganization okay great we've covered the main types of private equity strategies what else do we need to know that's right we have to discuss the common structure and fees of private equity funds similarly to hedge funds private equity funds are usually set up as limited partnerships the capital provided by investors is called committed capital in general it isn't all drawn down or invested immediately but gradually as various investment opportunities are identified the drawdown period is discretionary however it typically lasts from three to five years and how about fees as we mentioned earlier alternative investment funds usually have management and incentive fees management fees of private equity funds are between one and three percent of committed capital as opposed to invested capital incentive fees are typically 20% of profits so on average we have the famous two and twenty fee structure meaning 2% management fee and 20% incentive fee however before paying any incentive fees the fund must return the investors initial capital in some cases at the end of the fund life the total incentive fee may turn out to be higher than 20% this situation may occur when returns on portfolio companies are higher in the early stages of the fun life and decrease later on the solution for this pitfall is called a clawback provision it requires the fund manager to return to investors any surplus received in incentive fees above the agreed fee level okay good another key point we need to cover our exit strategies private equity funds hold their portfolio companies for five years on average then they sell them to realize returns the main exit strategies are a trade sell a secondary sell an IPO recapitalisation or liquidation let's quickly discuss each of them a trade sell is when a portfolio company is sold to a strategic buyer in a private deal a secondary sell is a variant of the strategy where a portfolio company is sold in a private deal to another private equity fund or a financial investor consortium initial public offering or IPO for short is another common type of exit strategy as you know this is the process of listing a company's shares on a stock exchange where they are sold to the public and traded an IPO makes the company public which comes inevitably with many regulatory and disclosure requirements next we have recapitalisation in this type of strategy a given portfolio company takes on more debt to fund a dividend distribution to the private equity fund in this way the fund can cash out partially and still retain control of the portfolio company thus it is not a real exit but an alternative to realizing returns and often they step towards an exit finally there is the option of a write-off or liquidation in such cases a private equity owner would close down a portfolio company and take a loss on that investment perfect now we know how private equity funds exit their investments what's next let's discuss key benefits risks and due diligence as with other types of alternative investments over the last 20 years private equity has recorded higher returns than the public stock market it has also exhibited a lower correlation suggesting diversification benefits private equity returns have a higher standard deviation in the public stock market that implies higher risk as private equity strategies such as LBO use high leverage investors should also consider the impact of interest rates and capital availability similarly to hedge funds private equity is often affected by survivorship and backfill bias when doing due diligence selecting the right fund manager or general partner is of key importance investors should consider his or her track record operating and financial experience and expertise this is reflected in the performance of top quartile funds which have significantly and consistently outperformed bottom quartile funds over time other factors to pay attention to during due diligence include the valuation methods used fee structures and drawdown procedures okay great this is the end of today's video if you are into educational investment and Finance videos make sure you subscribe to our channel and hit the like button thanks so much for sticking till the end I'll see you in our next episode

Channel: 365 Financial Analyst

Views: 47,110

Keywords: private equity, introduction, cfa, alternative investments, finance

Id: Vb8c84qtkZU

Length: 9min 15sec (555 seconds)

Published: Wed Feb 19 2020