Private Equity investors usually acquire established companies in order to help accelerate their growth, for example by expanding into international markets or by acquiring competitors in order to consolidate their position. Transactions can include management buy-outs, management buy-ins and refinancings that allow owner-managers to stay in place while realising a portion of their equity value. PE funds usually aim to hold their shares for anything between three years and seven years.
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The Informed Funding two-minute guide: Private Equity
- What is Private Equity?
Private Equity firms generally invest in established, privately-owned companies that have a record of profitability and that need to raise equity capital for a variety of reasons including expansion, to carry out acquisitions or to enable the founder or current owner to exit perhaps via an MBO or management buy-out. Private Equity is usually seen as distinct from Venture Capital – VCs specialise in backing early-stage companies that are still developing, whereas Private Equity investors tend to target later-stage companies that are established but still have significant growth potential.
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- What sorts of companies are suitable for Private Equity investment?
Private Equity investors aim to make substantial returns on their investments and therefore target companies that are capable of significant growth, either organically or via a “buy and build” strategy in which competitors are acquired and integrated into the group. Many PE firms have a particular interest in companies that are capable of international expansion, since establishing foreign operations is one of the main ways in which PE investors seek to add value to the firms in their portfolio. In general, PE investors will back firms across a wide variety of sectors but will be most interested in companies with strong growth potential and a very experienced, proven and ambitious management team. In recent years, when stock market listings have at times been harder to achieve due to difficult conditions, PE deals have become a favoured way for founders to sell their businesses and realise their gains.
- How much can I raise this way?
PE investments, as distinct from earlier-stage VC investments, will tend to be quite large. They may start at a few million pounds but the largest deals can be well into the hundreds of millions. A PE investment will often take the form of an equity investment coupled with a package of debt that may be provided by a bank or debt fund and that the business must be able to service from its cash flow. In general, the cost and complexity of carrying out PE transactions means that they are uneconomic when relatively small sums are involved, due to the professional fees associated with the due diligence process.
- What are the advantages of securing PE funding?
Raising money from a PE investor can provide significant funds for expansion as well as access to experienced investors that can advise on the best way for the management to achieve its ambitions. This may well include help in expanding the business overseas, access to talented outside managers that can be brought in to strengthen the team, and new contacts with other companies, advisers, finance providers etc. PE investment can also lend credibility to the business and its management due to the extensive due diligence that any company that receives funding from this source will have to undergo. A PE investment is often taken to indicate that the company has attractive growth potential and a strong management team. A PE investment will usually grant the management team a significant minority stake in the company that may increase if agreed growth targets are met. Since PE funds always seek an eventual sale of the companies they invest in, this often leads to large financial gains for the key managers.
- What kind of due diligence is involved?
Deals involving PE investors include extensive professional due diligence that can be expected to last for months and will take up a very significant amount of the management’s time, over and above the need to run the company successfully day to day. The PE fund will carry out legal, and financial due diligence to ensure the company and its business plan are financially sound and that the ownership and legal structure of the business are fully understood. It will scrutinise all the company’s major existing contracts as well as examining the backgrounds of the key managers, the market in which the firm is operating and its position against its main competitors.
- Do I need professional advice?
Yes, you will need both a corporate finance adviser and a firm of lawyers. Many PE firms are reluctant to deal with owners and managements who have not appointed professional advisers. This is partly because the adviser can act as a buffer between the PE investor and the current owners if negotiations become difficult; partly so that the owner and managers can be coached through the process by an experienced team of advisers who are paid to put their interests first; and partly because different parties may have conflicting interests, eg an owner that wishes to exit at the highest possible price and a management team that wishes to stay with the business and buy it at the most advantageous price. Each party should consider hiring advisers to represent their particular interests.
- Need to know:
- Private Equity firms typically have a time horizon in mind for any investment, which is often between five and seven years. This is because each fund they raise has a limited life, often 10 years, after which the investors who put money into that fund expect to be repaid and to receive their profits. Having raised a fund, the PE firm will spend a period investing the money, will work intensively with its portfolio companies to achieve their growth plans, and will then start seeking exits in order to repay their investors.
- PE firms seek high rates of return - 20% a year is often quoted as a baseline expectation – so companies that want to seek finance from this source will have to make a very strong case that they are capable of providing outstanding returns.
- An investment from this source will generally involve the PE firm acquiring a majority stake in the company, although this will ultimately depend on the particular circumstances of each deal.
- PE firms will take at least one seat on the board of each investee company.
- They can exit their investments in a variety of ways. This may involve a sale to another company, also known as a ‘strategic buyer’, a sale via the stock market by way of an Initial Public Offering, or a sale to another PE firm, which is usually termed a ‘secondary buy-out’.
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