Not many people understand all the hype behind private equity. So let me give you a primer…
If you’ve heard of stocks – you probably know that you can buy them off a stock exchange. This is the world of public equity, where the public can buy and sell shares in a company. If you’re familiar with IPOs, then to put it simply… before a company goes for an Initial Public Offering (IPO) it WAS a private company (duh!). Private Companies are private – the information concerning their working, their financial accounts, their processes are all ‘private and confidential’ and may not be readily available from a site like ETrade or Edgar Online, packaged in a standard format for you to digest and make an educated ‘guess’ at what its worth. And because they’re private – buying them is not so easy. Only select investors can buy enough equity (shares) in them to have decent stake.
Usually these are investors with a lot of cash – A LOT. We call them High Net Worth Individuals (HNWI). However, that shouldn’t stop you from understanding more about Private Equity, should it! There are various reasons why a private company may want to approach a Private Equity Investment Firm, but two of the strongest reasons are –
- they have grown by themselves so much that they require a fresh injection of funds from outside to grow further and reach higher economies of scale or;
- they believe in getting prepared by working alongside a professional team who will provide the equity finance, share ownership (and thereby risk and reward) and ultimately guide the company to a IPO.
As any well run organization will tell you, you must have a process. And so do we (I speak for the PE profession)…
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)
Deal Origination or as some call it ‘Deal Sourcing’ is how we get our deals, a potential deal can either come through a company owner approaching us or from an intermediary who will try to bring both parties (Company and Deal Maker) to close the deal. In some cases, we may just approach companies who are expanding fast and wish to grow further. In a year, we come across hundreds of potential deals – but only a few are selected.
Due Diligence is what you could call ‘doing your homework’. Before starting detailed negotiations, we try to make sure everything is fair and square. Although Auditors and Consultants are appointed to conduct the Financial, Tax, Legal and Technical Due Diligence – we 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.
At the Deal Negotiation phase, we 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 is probably the easiest part but also contains an element of risk. It’s 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.
- So where do those funds come from? Well, there are two routes – the Fund route or the Private Placement route. And this is where the element of risk can step in. Most private equity firms have a Fund, that calls upon its HNWI to bring up money as committed earlier to fund these acquisitions. However some firms choose to place (sell) a stake in the ownership of the acquired company to certain individuals who might wish to participate only in a specific sector – what we commonly call the private placement. We do through this Special Purpose Vehicles (SPVs) that are nothing but legal entities to hold our stake in the company.
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 company’s management or its board (where we have a seat).
As the company matures (usually after 2 – 4 years) with the presence of the Deal Team, we 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. (There’s a saying, in a deal – always leave something extra for the person buying – it makes everyone happy.) And once we’ve exited the company, we return our investors money with the profit we gained for them after taking our fees for all the effort put in the above process.
Then… we just repeat the process, albeit with a greater appetite for investments. (PS: Although this may seem like a linear process – it isn’t exactly so, primarily because we deal with a number of companies and each one is at a different stage in the private equity process.)
A New Private Equity Investment Strategy…
You hear it all the time. Buy Low, Sell High. What if I told you Sell High and Sell Higher would you listen? Maybe not… you’d think I lost a few nuts! Well, unfortunately or fortunately, I kinda follow that strategy. I’ll tell you more about this in my upcoming ebook. You’ve probably heard about using P/E (Price/Earnings) ratio to identify whether a company is expensive or not. Buy Low, Sell High logic dictates that you buy at 4x P/E and sell at 5x P/E.
Well, here’s an investment strategy I’m proposing for private equity houses… instead of spending hundreds of thousands on consultants or market research firms to tell you which industries you need to be focusing on. Just find out which industries/sectors have high P/E multiples and invest in them! Stay with me… and bear with the simplification.
Imagine you buy a private company which is earning a decent USD 1 million y-o-y in net profit and the industry which it is in has a high PE multiple, lets say 20x. Now assuming the P/E remains constant over a few years, but you manage to increase the income by another USD 1 million (which through a bit of effort could be achieve). Though this is a double in net profit… if you sell the company the following year, at the same P/E – your returns are 20 million!!!
Just to make a point, I did a quick search on Yahoo Finance (yes, despite the horrible new logo, this site still rocks!). Now if you look at the average P/E for the Publishing (Newspapers) sector it is 14x. And if you look at the average P/E for Oil & Gas Equipment & Services sector it is close to 20x. For every dollar increase in the income of an Oil & Gas Equipment Services company, you get to see an additional 42% increase over the publishing sector. How’s that for a bit of money making! So what do you think? If you think I’m still bonkers, tell me… if you think I’m a smart ass, I’d love to take you out for coffee… either way, blow your trumpet on twitter.
The Global PE Syndrome
When I used to work for a consultancy firm, I came out with the TOP 10 identifiers for consultants. Today, as an investment banker (private equity professional to put it more precisely) – we have another TOP 10 identifiers:
- Prematurely grey hair
- Inability to remember city or country in which one is awakening
- Persistent daze / jet lag / hoarse throat
- Equating sleep on an airplane with real sleep
- Inabilities to remember (or be present at) birthdays, anniversaries, or school conferences
- Contact with new friends concerned about holding charitable dinners in your honour or naming school buildings for you
- Frequent musings about the fairness of pre-nuptial agreements
- Doubling of golf handicap every 6 months
- Ability to schedule annual physical only every five years
- Frequent spousal / child discussions about the value of sound estate planning