7 ways how private equity firms can elevate the value of their investments

Private investors are increasingly turning to private markets because they offer the potential for attractive returns, significant diversification benefits, and access to exciting investment themes.

At the same time, many investors do not yet know how private markets work in detail. This newsletter aims to bridge this knowledge gap and help to develop a solid understanding.

Learn here what private equity strategies are and how they can increase the value of their investments.

What is private equity?

Private equity (PE) refers to equity investments in companies that are not publicly traded. These investments provide investors with stock-like ownership interest and returns.

Unlike in public markets, PE firms don't just provide capital. They take a proactive stance, actively shaping the companies they invest in and playing a much more active role in the decision-making processes.

Think of PE groups and their specialists as the architects of their investments. They help build the company’s structure, appoint the CEO and the senior management team, help hire key leaders and shape a company’s strategy, grow or transform it, and create value from within.

The ultimate goal of PE is to enhance a company’s operations and financial performance, leading to a profitable sale at the end of the investment period.

PE can be further divided into sub-strategies, depending on the stage in the target company's life cycle, the amount and type of capital invested, size, and financial situation with respective risks.

This is further explained at the end of this article after the value mechanism is explained using the example of a 'Buy and Build' strategy.

Following this approach, a private equity (PE) firm acquires a well-positioned mid-sized platform company in one of its target industries. It builds on it through successive add-on acquisitions of smaller companies in the same or a related sector, often with complementary products and regional focus.

What’s the playing ground for a private equity buy-and-build strategy?

An astonishing 99,9% of all businesses are small-to-midsized companies with up to 250 employees, both in the EU and the US.

At a more granular level, the EU has 31.7 million businesses with up to 49 staff, representing 99%, and only 0.247 million in the range of 50-249 staff.

Growing a firm beyond a certain threshold seems very difficult, resulting in many fragmented industries. Why is that?

One reason is that many businesses are led by their founders and their families, who have grown them by making all key decisions themselves. This works only up to a certain size and entails a significant key man risk.

In addition, many of these leaders have never learned how to scale a business to the next level, implement structures of shared responsibility based on more diversified talent, or create processes to ensure a consistent quality of outcomes without getting personally involved. ????

To achieve this scalability, you must transform the leaders from aeroplane pilot style to an orchestra conductor. If that evolutionary transformation hits a roadblock, Private Equity Firms can help in various ways.

7 ways how private equity firms can elevate the value of their investments

Buy-and-build (BaB) PE strategies can continuously increase the value of their investments over many years following using these levers:

1. Growth Themes: Many BaB strategies focus exclusively on industries that ride structural growth trends like digitalisation and automation, the use of AI, healthcare, or decarbonisation and sustainability. This provides a strong basis for above-average returns.
2. Elevated Valuation: Larger companies enjoy higher valuations than smaller firms. PE firms typically buy one medium-sized player as a platform investment and add smaller competitors afterwards. The value of these ‘building blocks’ is rising just because they are now part of a bigger, more diversified group.
3. Cross-Selling: Merging companies with complementary products and geographical focus enables cross-selling, leading to higher sales, a more diversified business and a stronger market position. Imagine one firm's geographic focus in Asia and another in Europe. After they merge, they can offer complementary products in both regions.
4. Realize synergies: Company integration allows for the exploiting of synergies in areas such as sales, marketing, production, and administration. Shared processes, IT platforms, and resources lead to efficiency gains and lower costs.
5. Talent upgrade: The acquisition of companies in private equity often brings with it a valuable asset: talented managers and employees. This is a strategic priority for private equity firms, which aim to hire and leverage the expertise of industry veterans and experts in crucial business disciplines. These experienced professionals are instrumental in driving accelerated growth, taking the acquired companies to the next level in size, efficiency, and scale.
6. Strategic investments: The Private Equity firm and platform company can use their industry knowledge and expanded capital pool to strategically invest in and position the acquired companies to grow them.
7. Exit strategy: A successful sale of the combined and optimised firm to a peer or another private equity firm or via an IPO can lead to a high return for the PE firm, as it has specialists for finding a strategic buyer for their investments.

What are the main private equity segments?

Private equity firms typically invest along the guardrails of the below segments:

1. Venture Capital (VC): VC funds invest in small, early-stage companies with high growth potential to provide them with the capital they need to grow and develop their products or services. These companies are often in the technology or healthcare sectors and may not yet be profitable.
2. Growth Equity (GE): GE funds invest in more mature companies that have a proven track record of success. These companies are typically looking to expand their operations or enter new markets. GE firms provide these companies with the capital they need to continue growing.
3. Buyouts: Buyout funds invest in mature, profitable companies. There are two main types of buyouts: leveraged buyouts (LBOs) and non-leveraged buyouts. LBOs use a significant amount of debt to finance the purchase of a company. The buyout firm then works to improve the company's operations and sell it for a profit, using the 'Buy and Build' levers.
4. Distressed Private Equity (DPE) funds invest in companies in financial trouble. These funds may try to turn around the company, merge it with others, or sell it for parts.
5. Fund of Funds: Funds of funds invest in other private equity funds, allowing investors to gain exposure to a variety of private equity strategies.

In conclusion, private equity investing offers a wide range of opportunities for investors. However, it’s important also to understand the complexities and risks involved. This new educational series aims to cover both opportunities and risks.

The next edition will explain private debt in more detail.

Don’t miss future learning opportunities, subscribe to get a note when the next editions are released!