Demystifying the Private World: How does Private Equity Work?

Private Equity (PE) has been a 'world behind the curtains' for working professionals and public at large for many decades. Whether you realize it or not, many of the goods, services and products that you use in your everyday lives are from private equity backed companies. From picking your short-term home rentals on Airbnb to have a relaxing vacation in a new place, to booking tickets for a nice movie night on BookMyShow, or consuming high-speed internet through Reliance Jio network or enjoying a refreshing drink from Hector Beverages (Paper Boat), private equity backed companies are all around us - All the time!

Waiting for your package to be "delhivered" by the logistics unicorn Delhivery? Its PE-backed. Looking for a source code for your project on Github??Again, PE- backed. Cars 24, Cred, Ixigo, Groww, Meesho, Razorpay, Unacademy and the list goes on....

But before we delve deeper into Private Equity, lets talk a bit about 'Private Markets' in general. Private market investments are capital investments that are not publicly traded on a stock exchange. These investments can be broadly categorized into the following:

• Private Equity - Acquiring ownership in a privately held company
• Private Debt - Providing debt capital to a privately held company
• Investments in Real Estate and Infrastructure projects

Private markets have three features that distinguish them from public markets:

• First, there is limited liquidity transformation because investors in private markets commit capital for extended periods.
• Second, investors in private markets tend to be large and sophisticated entities, whose focus on long-term returns enables the target companies to confront significant earnings volatility.
• Third, the regulation of private market investments is relatively light as compared to their public counterparts, partly reflecting the lesser degree of liquidity mismatches and also the limited presence of retail investors.

"The last two decades have seen the growth and consolidation of private markets across the world. These revolve around funds gathered from institutional investors by alternative asset managers, typically private equity and venture capital firms that have expanded substantially. In an environment of light regulations, long investor horizons and low interest rates, the involvement of private market funds in firms' investment financing and restructuring has grown over time, boosting global economic growth through new companies which are delivering attractive rate of return across markets" ~ Bain & Company

What is Private Equity?

Simply put, private equity refers to a financing approach where privately held companies acquire funding from private equity firms or accredited investors instead of stock markets, in exchange for providing ownership stake in their companies.

The pool of capital that is invested in these companies, which represent an opportunity for a higher rate of return to the capital providers is known as a Private equity fund. The amount of capital committed to the PE fund but not yet allocated is frequently referred to in the industry as 'Dry Powder'.

Institutional investors and high net worth individuals (HNIs) usually make up the primary sources of private equity funds, as they can provide substantial amount of capital for extended periods of time. Typically, PE investments are made into mature businesses in traditional industries in exchange for equity (or ownership stake).

"Private equity is a major subset of a larger piece of the financial landscape known as Private Markets, and has been growing in the digital age, as innovative ideas continue to disrupt traditional industries" ~ Mckinsey & Company

The ultimate goal of private equity investments is to boost a company’s growth to the extent that it can go public (get listed in stock exchange) or get acquired by a bigger entity. In exchange, investors of the PE fund earn fees and a substantial share of the improved profits. Many times, they also become the company’s shareholders after it goes public.

A team of highly skilled and qualified investment professionals from the PE firm are given the responsibility to raise and manage the PE funds.

What is a Private Equity Firm?

A PE firm is a type of an investment firm. They invest in businesses with a goal of increasing their value over time before eventually selling the company at a profit. Raising capital to form a private equity fund requires two groups of people:

1. Financial Sponsor and
2. Investors?

A Financial Sponsor includes a team of individuals that identify, execute and manage investments in privately-held businesses. Financial sponsor can be further divided into:

• General Partners (GPs):?The entity (usually the PE firm) with the 'legal authority' to make decisions for the fund and also assume all 'legal liabilities'.
• Management Company:?The operating entity that employs investment professionals responsible for allocating capital and managing investments.

Investors include large entities and HNIs that provide the capital to form the fund. Because PE funds are generally formed as 'Limited Partnerships', investors are often referred to as Limited partners (LPs) in the industry.

So, similar to venture capital (VC) firms, PE firms use capital raised from limited partners?(LPs) to invest in promising private companies. However, unlike VC firms, PE firms often take a majority stake (50% ownership or more) when they invest in companies. PE firms usually have majority ownership of multiple companies at once. A firm's array of companies is called its 'Portfolio', and the businesses themselves are known as 'Portfolio Companies'.

PE firms perform very detailed and stringent due diligence in order to ensure that they are making a sound investment. This process of due diligence is crucial for the success of the investment. Financial sponsor looks at all critical aspects of the target company such as:

• Commercial
• Financial and
• Legal

Vast majority of the time is spent on commercial due diligence while the financial and legal areas are more confirmatory in nature.

PE firms rely on consultants for their expertise and advice for portions of the due diligence process, but ultimately the investment decision is the firm’s responsibility.

Commercial due diligence (CDD)

It includes understanding the company’s value proposition, market position, historical performance, and industry trends in order to assess the target’s ability to achieve its forecasted projections. Broadly speaking, private equity firms look for the following while carrying out CDD on their target:

1. Competitive Landscape and Market Position: A strong PE target should hold a competitive position within its industry and have the potential for sustainable growth. PE firms look for answers, for the following questions (not-exhaustive):

• What is the target's competitive advantage (e.g. product offerings, technology, price, premium brand, distribution capabilities, geographic presence, etc.)? Is this a disruptive business model? What are the barriers to entry into the business? What are the costs of switching to a competitor’s product?
• Where does the target company fit in the industry value chain? How has the industry changed over the last 5-10 years? How do we expect that to change over the next 5-10 years? Who are the main competitors of the target? From whom has the target company been gaining/losing market share? Which firm is the biggest threat to the target company?
• What is the market landscape (e.g. oligopoly, fragmented market, first-mover, etc.)? How saturated is the market?

2. Industry Growth and Addressable Market:?When evaluating the industry, it is crucial to understand the market environment and the external factors affecting the business. Over here, PE firms look for answers, for the following questions (not-exhaustive):

• What has been the historical growth of the market? What is the projected growth of the market over the next 5-10 years? How mature is the industry? What is the total addressable market (TAM)? What segments of the industry are growing faster than others?
• Have there been any significant changes to the industry landscape (e.g. disruptive new entrants, consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)?
• What are the regulatory concerns and how can it adversely affect the target company's business?

3. Customer Base and Suppliers:?This entails understanding the loyalty of customers and the target company’s reliance on its suppliers. Here, PE firms look for answers, for the following questions (not-exhaustive):

• How many customers does the target company have? What is the typical contract length of a customer relationship? What is the typical renewal rate? What are the buying dynamics? And how long is the entire sales process?
• How many suppliers does the target have? What is the concentration of its top suppliers? How large of a customer is the target company to its suppliers? How often are the target company's supply contracts renegotiated?
• If the target receives price increases from its suppliers, is it able to pass it through to its customers?

4. Capital Requirements of the Business:?A good understanding of the total capital needed to run the operations of a business is needed, especially during difficult times. Here, PE firms look for answers, for the following questions (not-exhaustive):

• How capital intensive is the target company's business? What percentage of capital expenditures is growth capital v/s replacement/maintenance capital? How has that trended over the last 5 years? What kind of lead-time is needed (i.e. time from purchase order to delivery) when making a purchase order?
• How cyclical is the target company's business? Are there any severe seasonal changes in demand? What are the factors? How much visibility does the target have in expected sales?
• What percentage of the Cost of Goods Sold (COGS) cost structure is fixed v/s variable? What is the breakdown of the operating expenses of the target company? What is the normal working level of cash to run the business for a year? Has the target company experienced crunched working capital funding gap in last 5 years?

5. Financial Performance (Historical & Projected):?Analysis of the financial performance of the target company provides a deeper insight into its historical performance in order to understand how realistic are the company’s forecasted projections. Here, PE firms look for answers, for the following questions (not-exhaustive):

• What is the comparative historical performance of the financials with the management budgets for the last 5 years (aka Planned v/s Actuals)? What is methodology behind the budgeting and the key reasons for beating/missing the budget.
• What are the key performance indicators (KPIs) the management uses to monitor the business of the target company? What is the trend in these indicators? How does the financial KPIs of the target company compare to the industry average and to its main competitors?
• What is the break down of the organic growth of the target company over the last 5 years? (Excluding the impact from any acquisitions the target might have done). How does the growth projections of the target company compare to expected market growth? Where will the growth in financial metrics come from (increase in price, increase in volume, increase in market share, new products, acquisitions, etc.)?
• Where will increase in margins of the target company come from (operating leverage, cost efficiencies, higher margins on products, revenue/cost mix, etc.)?

Financial due diligence (FDD)?

FDD helps PE firms to understand the dynamics of the company from a financial reporting perspective. Beyond their in-house teams, PE firms typically hire professionals to review the financials, operations, customers, markets, and tax issues of the target company in detail. This is usually referred to as "Transaction Advisory Services" offered by many professional services firms (such as Big4s).

Main areas of financial due diligence include:

1. Quality of Earnings:?PE firms need to confirm the historical earnings of the target company (excluding any non-recurring costs/expenses) as this affects the valuation of the target. Consequently, PE firms hire accountants/auditors to ensure that the information provided by the target is accurate.

Strictly speaking, a PE-backed portfolio company needs to have steady and reliable cash flows, or the PE firm would not be able to meet its interest payments.

Accountants review the target's historical performance to understand its actual EBITDA* (adjusted for non-recurring costs). Adjusted EBITDA is critical because that is what will drive the target company’s valuation (Adjusted EBITDA × EBITDA multiple = Purchase Price). The type of adjustments done include:

• Management Adjustments: These adjustments are done where compensation of the management is flexible. Adjustments include one-time or excess executive compensation, transactional costs, legal settlements, and personal expenses (like a private jet of owner, accounting fees, etc.).
• Business-related Adjustments: These adjustments include accounting-related issues, such as inventory valuation, revenue recognition, accrual/reserve reversals, etc. These adjustments also include lost customers and unsustainable margins or cost cuts.
• Pro forma Adjustments: Pro-forma adjustments occur when the target company has made recent acquisitions or divestitures. Note that the focus of PE firm is to determine the organic growth of the target company (excluding the impact from any acquisitions the target might have done). This kind of adjustment includes synergies (eliminated positions & facilities, scaled pricing, audit/tax related fees, known cost increases, etc.).

2. Debt and Debt-like items:?During FDD, PE firms calculate the target company’s total debt-like items outstanding, because it impacts the total amount given to the sellers of the business (Total purchase price - Debt = Cash given to sellers of the business). All liabilities of the target are categorized as either working capital or debt, not both. Sellers of the target have an incentive to have lower debt & debt-like items, but financial buyers (PE firms) need to ensure that the amount of debt owed isn’t misrepresented.

For example: There could be a possibility of capital expenditures which may not be accurate because the target company could have ordered a lot of equipment but have yet to pay for the purchase, which could result in a payment post-acquisition, thus affecting the total cash available after the deal.

3. Tax structure:?Reviewing the tax structure of the target company and delving deeper into a detailed analysis of the federal, state, local, and international tax situation (both historical and anticipated) is critical for PE firms.

Federal taxation occurs at the national level and includes review of tax assets, tax related compliance procedures, and identification of the potential tax liabilities. State and local taxation are based on the location of the target company and its assets. International taxation deals with a concept called Transfer Pricing* as the company conducts business globally. By looking closely at a target company’s tax structure, PE firms get insights into the best methods and locations for tax compliance so that the target may maximize its net profit and minimize its tax liabilities post acquisition.

Legal due diligence (LDD)?

Just like FDD, LDD is mainly confirmatory. It is focused on confirming that the target company is not subject to any future contingent liabilities including regulatory issues, threatened or ongoing lawsuits, and unusual or onerous contract provisions. PE firms usually hire legal advisors and experts from law firms to review the target company in detail.

Main areas of legal due diligence include:

1. Review of Corporate Filings:?This review is done to check whether the corporate filings have been filed correctly or not and to understand the legal organization of the target company (such as whether there are any strange corporate structures).

2. Review of Material Contracts:?Prior to acquiring a target, PE firms look at past and current material contracts of the company. This includes the debt structure and other liabilities, and it may also include key customer, partner or supplier agreements.

3. Review of Human Resources:?HR due diligence is another important area under legal due diligence process done by PE firms and it refers to the target company’s management team and employees. Here, PE firms look at employment terms/agreements, individual contracts, collectively bargained agreements, and retention/severance agreements. Compensation structure of executives of the target company is also crucial for the PE firm in their analysis, to understand the operational structure of the company along with possible severance required if they are to be terminated post acquisition. This also includes other salary and stock option plans to senior executives of the target company.

4. Review of Lawsuits/Litigation/Patents:?Here, PE firms take a close look on any pending litigation or history of past litigations, (including environmental, employment, customer or worker compensation related issues) which may pose a risk to the target company's business.

Similarly, a careful review of the intellectual property (IP) of the target company is done by the financial buyer, as its proprietary information will help raise the value of the business. Valuable IP such as patents, trademarks, domain names, trade secrets, and design rights that are exclusive to the target company are taken into consideration during legal due diligence.

So, by now, you would have gotten a fair idea on how, so many players come together and are involved in a single deal and why private equity industry is considered to be so complicated. But if I were to give my opinion - Private equity is just highly detailed, and transactions operate on 'tight timelines', so the professionals in this industry rarely have as much time as they would like, to close a deal. PE firms face a unique mandate to produce substantial returns quickly. This is what makes it chaotic (with a very steep learning curve), because you are required to know your stuff, extremely well and in advance. To be honest, we have just scratched the surface of this 'critical industry' which has kept organizations like Byju's, Zomato, FirstCry and many more, buoyant in the market through their funding. There is a lot more to this that meets the eye and I will be covering more in this space as time goes. Hope this article was informative and insightful for you all and I hope you have a productive weekend ahead.

*EBITDA = Earnings before interest tax depreciation and amortization

*Transfer Pricing = ?According to the Income Tax Department, Government of India - "Commercial transactions between different independently operating units (under different tax authorities) of multinational groups may not be subject to the same market forces shaping relations between the two independent firms. Hence when, one party transfers goods or services to another for a price, that price is known as 'Transfer Price'. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest?their claims.