A Guide to Understanding How Private Equity Firms Work & How the Industry Operates

Introduction

Private equity firms and the private equity (PE) industry are complicated subject matter that most people do not fully understand. Some people have very negatives views of the private equity industry because of what they hear in the news with regard to employee layoffs and acquired firms failing a few years later. In 2020, the US private equity sector directly employed over 11.7 million US workers who earned over $900 billion in wages and generated over $1.4 trillion of GDP. (1) The private equity industry does play a vital role in helping fund corporate growth and expansion in different industries. Many business executives at one time or another over their careers will likely have some dealings with a private equity firm. This article is designed to explain the many aspects and topics that I feel are critical for one to truly understand how private equity firms work and how the industry operates and functions. The subject matter is quite extensive, so I have broken it out in into the following sub-topics to make it easier for you to read through:

After reading this article, the reader should have a thorough understanding of basic private equity concepts and practices. Please feel free to reach out to me if you have any questions on any subject matter in this document.

The First Private Equity Firm

The US private-equity industry started in 1946 with the founding of a firm called American Research and Development Corporation (ARDC) by Georges Doriot, Ralph Flanders, Karl Compton and Merrill Griswold. The firm raised capital raised from institutional investors and encouraged private sector investments in businesses run by former soldiers returning from World War II. The firm’s first major success story occurred with its investment Digital Equipment Corporation (DEC). In 1957, ARDC invested $70,000 for 70% of DEC and also provided a $2 Million loan to the firm. By the time of DEC’s 1968 IPO, ARDC’s initial investment was valued at over $355 million which was equivalent to return on investment of over 5,000 times or roughly an annualized return of over 100%. (2) Most modern private equity firms would love to have an investment return like ARDC achieved nearly 50 years ago.

What is a Private Equity Firm?

Private equity firms are structured as partnerships. The Financial Sponsor is composed of a General Partner (GP) making the initial investments and a Management Company that manages the investment. In addition, there are several Limited Partners (LP) investors that provide capital for the majority of the PE firms investments. A private-equity (PE) firm is an investment management company that provides financial backing and makes investments in the private equity of startups or operating companies through a variety of loosely affiliated investment strategies including growth capital, venture capital or leveraged buyout. All institutional partners of the fund agree on set terms laid out in a Limited Partnership Agreement (LPA).

A private equity firm raises money from high-net-worth individuals, accredited investor, professional investors, university endowments, insurance companies, other institutions and hedge funds and then invests that money in target companies. The target companies are either privately owned firms or publicly traded firms that are taken private. These target Investment Companies are also known as Portfolio Companies as they comprise the portfolio of companies owned by the PE firm. Usually, a private-equity firm will raise pools of capital or funds that supply the equity contributions for these transactions. Private equity firms receive a periodic Management Fee as well as a share in the profits earned (Carried Interest) from each private-equity fund managed. PE firms usually acquire a controlling or substantial minority position in a company and then look to maximize the value of that investment.

Differences Between Private Equity Firms and Hedge Funds

Private-equity firms should not be confused with hedge fund firms which typically make shorter-term investments in securities and other more liquid assets within an industry sector. Compared to private equity firms, hedge funds will have less direct influence or control over the operations of a specific company. PE firms take on operational roles to manage risks and achieve growth through long term investments in their portfolio companies. Hedge funds more frequently act as short-term traders of a company’s securities betting on both the up cycles and down cycles of a business or of an industry sector's financial health.

Strategic Success of Private Equity Industry

The private equity industry’s reputation for dramatically increasing the value of their investments has helped fuel the rapid growth of the sector. PE firm’s ability to achieve high returns is typically attributed to the following 5 key factors: (3)

The fundamental reason behind private equity industry’s growth and high rates of return is the standard practice of buying businesses and then guiding them through a transition period of rapid performance improvement before ultimately selling them.

In the early years, private equity firms focused mainly on acquiring the non-core business units of large publicly traded companies that had stagnated. PE firms acquired these non-core assets and turned them into highly profitable companies. Over the last 20 years, private equity firm shifted their attention to the acquisition of entire public companies rather than focusing on only non-core assets.

PE firms excel at identifying the two or three critical strategic levers that drive improved performance at target companies. Private equity firms utilize excellent financial controls and focus on enhancing the performance basics including revenue, operating margins, and cash flow. In addition, PE firms improve corporate governance structure by eliminating several layers of management and streamlining decision making processes. Over the course of many acquisitions, PE firms’ buildup their experience with turnarounds and fine-tune their techniques for improving gross margins and maximize revenues. PE firms are especially skilled at selling businesses by either launching successful IPOs or by finding strategic buyers for the entire company.

Private Equity Deal Structures

Private equity firms utilize debt financing extensively to purchase target companies and, in the process, increase their leverage. For example, a PE firm utilize only 20% equity to buy a company and finance the remaining 80% with debt. Any small increase in a portfolio company’s value can lead to over a 100% return on equity. However, if the acquired company fails to make the target growth levels the PE firm could incur losses on its original investment.

Private equity firms usually utilize standard deal structure when acquiring new portfolio companies. Generally, a private equity firm will not purchase a 100% ownership stake in a business. Instead, they prefer to purchase only 70% to 85% of the business, with the remaining 15% to 30% owned by the existing owners or a subset of them. Many private equity firms believe it is important for existing owners re-invest some of their proceeds into the company, in a process called a Rollover Investment. When the original owners remain invested in the company it helps ensure a smoother ownership transition process. Having the prior owners involves lower operating risk and helps improve the success of the newly acquired business long-term. Some private equity groups will not acquire a target company if the existing owners do not Roll-Forward any investment amount. Sometimes after a year or two the remaining 15% to 30% equity is purchased by a second PE firms that becomes a junior PE partner to the original transaction. (4)

Most private equity firms conduct a recapitalization process of the target company utilizing some type of debt financing structures to complete the acquisition. Some private equity firms may utilize up to 70% to 80% debt to finance an acquisition which can lead to enhanced returns. This also reduces the amount of direct equity investment required to complete the acquisition. When a portfolio company performs well, then leverage can have a very positive effect on the PE Firms returns on their investment. Using debt financing allows the selling shareholders to own more equity for less cash investment than if the buyer were not debt financing.

Businesses that are sold to PE owners who finance the transaction with debt will need to service the debt interest and principal. This reduces the amount of cash available for distributions or to invest in future growth. Target company owners need to clearly understand how much debt that an acquiring PE firm intends to use and the terms of the financing to ensure that it is viable. Too often PE firms have levered up newly acquired portfolio companies up with too much debt and the firms do not have adequate cash flows to re-invest in the firm for long-term growth or to weather an economic downturn.

Private Equity Investment Life Cycle

The private equity investment life cycle consists of three main processes which are the initial acquisition, then growth and finally investment exit. The steps shown in the diagram below are general process and may vary among different PE firms.

Key Private Equity Performance Measures

The four key private equity performance measures commonly utilized include:

Private Equity Firm Income & Fees

Some PE firms do not charge their portfolio companies any fees and make their returns on exit of their initial investment. However, most private equity firms charge a performance fee called Carried Interest which typical averages 20% but can range anywhere from 15-25% of the profits generated by investments made by the firm’s portfolio companies. In addition, PE firms collect a Management Fee which is often 1-2% of the principal invested in the firm by the outside investors whose money the firm holds. For larger portfolio companies, these fees can run into the millions per year that the PE firm collects.

In addition, some PE firms will charge additional fees if they help you with specific tasks like recruiting, human resources, financial analysis, accounting functions, external consultants or other services. These fees might be hourly or in the case of an acquisition of another company, they might be a percentage of the total deal value. These fees can also run into the millions per a year for larger portfolio companies.

Private Equity Firm Taxes

As a result of a tax loophole in the U.S. tax code, carried interest that accrues to private equity firms is treated as capital gains and is thus taxed at a lower rate than is ordinary income. Currently, the long-term US capital gains tax rate is 20% which compares to a 37% top income tax rate for individuals. This loophole has been estimated to cost the US government several hundreds of billions of dollars over the next several years in unrealized tax revenue. In addition, private equity firms often treat management fees income as capital gains through an accounting methodology called Fee Waiver. The PE industry has spent millions of dollars on corporate lobbyists and donations to political campaigns to ensure that this favorable tax treatment remains in place.

The private equity industry is nearly a $4.5 trillion dollar a year industry. The IRS conducts extensive audits of large US multinationals companies, but it rarely conducts detailed audits of private equity firms. Private equity firms are organized as complex partnerships with different types of partners. PE firm partnerships do not pay income taxes, and instead they pass those obligations on to their individual partners. PE firm profits are allocated to partners utilizing complicated profit allocation formulas for different classes of partners. (5)

Some larger private equity firms have thousands of partners spread across several different classes. The complexity of the partnership accounting, diverse allocation methodologies and numerous partners makes it very complicated if not impossible for auditors to untangle. It is estimated that each year anywhere from $75 billion to $100 billion in taxes are not paid to the IRS by partners because they either fail to report or systematically underreport their PE firm partnership earnings. Over the last 10 to 15 years the IRS has been chronically been short of manpower and many of its audit employees do not have complex partnership tax accounting backgrounds to audit PE firms correctly. (5)

PE Core Investment Criteria

Private equity firms have different investment criteria for target companies depending upon the industry that they are focusing on. However, there are a core group of investment criteria that most PE firms follow including: (6)

Portfolio Company Holding Periods

Private equity firms traditionally make investments with typical holding periods ranging?between 3 to 5 years. Sometimes private equity firms are looking to exit their investments when economic or market conditions are not ideal so they end up holding portfolio companies as long as 5 to 7 years. Over this time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.

Over the last 5 years the median holding time of private equity portfolio companies continues to decline. As of the end of 2019, it's was down to 4.9 years verses a peak holding times saw 6.2 years back in 2014. However, over the next few years there could be an increase holding times because of the growing number of long-dated PE funds entering the market and the recession like conditions developing so far in 2022. Portfolio companies aren't liquid positions like other investments classes and holdings can’t be scaled down as quickly as market conditions change. PE portfolio company exits have been a bit easier to achieve in recent years because of a rapid increase in corporate M&A activity. That has made it easier for PE firms to offload and sell portfolio companies a bit sooner than in the past years. (7)

Portfolio Company Exit Strategies

PE firms are always planning their potential exit strategies long before they even close on the purchase of many target companies. They are looking to acquire a business with a clear and executable strategy. In 2017 alone, PE firms completed over 2,500 exits by selling off portfolio companies. The exit strategy is a critical last step of the private equity investment process through which private-equity firms generally receive the bulk of their return on their investments. The three primary exist strategies include: (6)

Classifying Private Equity Firms

The five main criteria used to typically classify PE firms include the following:

Acquisition Strategies for Portfolio Companies

Private equity firm typically utilize two different acquisition strategies when acquiring companies:

PE Investment Strategies

Private equity firms utilize diverse investment strategies for acquiring portfolio companies. By the end of 2020, it was estimated that anywhere from between $500 billion and $1.5 trillion siting in private equity funds waiting to be invested. (1) The six core investment strategies utilized by private equity firms include the following:

1)?????Growth Capital

Growth Capital occurs when a private equity firm makes a minority investment in mature company that is looking for funds to finance long term growth. The companies typically generate revenue and profits but cannot generate enough capital to finance a major expansion or corporate acquisitions. This lack of additional cash flow makes it difficult for these companies to secure capital for growth. By selling part of the company to a private equity firm, the company’s owner does not have to take on the financial risk alone but can share the risk of growth with partners in exchange for some value in the company. This form of financing is sometimes referred to as expansion capital, and requires the company receiving the funds to develop a detailed, step-by-step business plan for the private equity investor showing how the funds will be used.

Growth capital can be used for: (9)

Growth equity may sound similar to venture capital and buyouts strategies but there are some key differences. In growth equity, PE firms invest minority stakes in companies with proven markets and business models that need the capital to fund a specific expansion strategy. Unlike venture capital, there’s minimal risk that a company will outright fail in growth equity.

Large growth strategy firms include: Warburg Growth, General Atlantic, TPG Growth, Insight Partners, JMI, Providence Strategic Growth, Summit Partners, Accel-KKR, , Sequoia Growth, Spectrum & TA Associates

2)?????Venture Capital

Venture capital (VC) is a form of private equity that focuses on start-ups and high-risk businesses. Many people think of start-ups as Silicon Valley based software or technology companies, but high-risk and high growth start-up can be in any industry. In 2020, total global VC investments were around $300B. (1) Venture capital typically involves less mature companies, start-up companies, or companies in early-stage development. Venture capital is provided for investment in companies that have a proven record of accomplishment or steady revenue streams but their high costs structures mean they are no profitable. These companies utilize the funds to develop new software, technology, biotechnology, marketing concepts, or products that do not yet.

Venture capital is characterized by a higher risk and high failure rate but those that succeed provide outstanding returns. PE firms utilizing a venture capital strategy need to deliver high returns to compensate for the risk of these investments makes venture funding an expensive capital source for companies. Venture capital firms typically expect 40-50% of their portfolio companies to fail, but if they succeed then they could still earn high returns and enough to cover their losses in portfolio companies that fail

The three major venture capital phases include: (9)

Large VC firms include: Kleiner Perkins Andreesen Horowitz (a16z), Benchmark, IDG Capital, Index Ventures, Sequoia, and New Enterprise Associates

3)?????Fund of Funds (FoF)

PE firms utilizing the Fund und of Funds strategy do not invest directly in target companies’ debt or equity. Instead, FoF invests in other private equity firms who then invest in portfolio companies utilizing various private equity strategies. Investment professionals at funds of funds conduct extensive due diligence on other PE firms by investigating their teams, track records and portfolio companies returns.

By investing in a fund of funds, investors obtain greater portfolio diversification and the ability to hedge their risk by investing in various private equity fund strategies. Unfortunately, funds of funds can be rather expensive because investors are subject to an additional layer of fees from the FOF vs. if they invest directly in the private equity firms themselves.

Large FOFs firms include: HarbourVest Partners, Access Capital Partners, Portfolio Advisors, Horsley Bridge Partners, ATP Private Equity Partners, A LGT Capital Partners, Axiom Asia Private Capital, SwanCap Partners, and Oriza Holdings

4)?????Leveraged Buyout (LBO)

The Leveraged Buyout strategy is one of the most common private equity strategies. Unlike VC or growth equity, which both involve minority stake investments LBO firms acquire majority control, usually 100% ownership of mature public traded or privately held companies. When executing an LBO transaction, a portion of equity provided by the private equity fund covers a portion of the purchase price of the company being acquired, and the remaining financing is covered by a bank loan for which the acquired firm serves as collateral.

An LBO effects a significant portion or majority control of a business. This can result in the delisting of a public traded company or the carve-out of an operating unit from a larger parent company. The private equity firm completing the LBO retains significant control and becomes highly involved in managing the newly acquired company. In LBO a PE firm called the Financial Sponsor will agree to an acquisition without committing itself to all the capital required for the acquisition. The PE firm will raise acquisition debt, which looks to the cash flows of the acquisition target firm to make interest and principal payments. Since there is high utilization of debt, it can result in substantial interest payments for the target company. The idea of a leveraged buyout is to make enough returns on the acquisition to offset the interest cost.

Acquisition debt in an LBO is often non-recourse to the PE firm and it has no claim on other investments managed by the financial sponsor. Therefore, an LBO financial structure is very attractive to a fund's limited partners, allowing them the benefits of leverage, but limiting the degree of recourse of that leverage. Historically the debt portion of an LBO will range from 60% to 90% of the purchase price. The buyout is leveraged with as much as 90% debt and only 10% being contributed by their own funds. The goal of an LBO is to generate returns on the acquisition that will outweigh the interest paid on the debt. For the firm that’s performing the LBO, this is a way to generate high returns while only risking a small amount of capital. PE firms will then either sell off parts of the acquired company or use the acquired company’s future cash flows to pay off the debt and then exit at a profit.

Large LBO PE firms include: Silver Lake, Apax Partners, Bain Capital, Brookfield, Apollo, TPG, Warburg Pincus, KKR, EQT Partners, Carlyle, and Blackston

5)?????Mezzanine Financing

Mezzanine Financing strategies consists of both debt and equity financing used to finance a portfolio company’s expansion. Companies’ utilizing mezzanine financing provide the lender with the option of converting to an equity interest or full ownership in the company if the funds are not repaid in a timely manner and in full. Companies that utilize mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan. Mezzanine capital allows such companies to borrow additional capital beyond the levels that traditional lenders are willing to provide through bank loans. This form of financing is often used by private-equity investors to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. (9)

Mezzanine financing is not collateralized and thus the lender takes on greater risk. As a result,?interest rates and terms can be much higher and more costly with mezzanine financing as compared to other more traditional debt financing. Mezzanine debt tends to have a relatively high fixed coupon rate ranging from 10% to 15%, incurrence covenants, bullet maturity, call protections, commitment fees, and an equity-kickers such as option or warrants.

Large mezzanine strategy PE firms: MSCP, Blackstone GS), Bain Capital Credit, Oaktree, Carlyle, HPS Partners, BlackRock Capital, KAMP Apollo Credit Funds and Crescent

6)?????Real Estate

Real Estate Private Equity (REPE) involves a group of investors pooling funds to invest in real estate assets usually in a particular asset class. Some REPE firms focus on specific segments within commercial real estate, such as multifamily, retail, industrial, office, or hotel properties. More recently some REPE firms have focused exclusively on residential real estate which has helped drive up prices dramatically in 2020 and 2021 during the Covid Crisis. The targeted rates of returns on these deals tend to be lower than those in traditional LBOs because there’s less room for growth.

The four different real estate strategies utilized include: (9)

Large real estate strategy PE firms include: AEW, GLP, Brookfield, Starwood Capital, Blackstone, Lone Star Funds, Carlyle and Rockpoint

7)?????Distressed and Special Situations

Distressed and Special Situations is a broad category referring to investments in equity or debt securities of financially stressed companies. This PE strategy is relatively small and highly specialized. Firms that utilize this strategy have very strong experience in credit risk and leveraged finance and distressed debt trading

The category encompasses two broad sub-strategies including:

Large distressed and special situation PE Firms include: Bain Capital, PIMCO, TPG, Oaktree, Fortress, Brookfield, Ares, Blackstone GSO, Apollo and Cerberus

Portfolio Company Reporting Requirements

Publicly traded companies are required by SEC regulations to produce Generally Accepted Accounting Principal (GAAP) compliant quarterly and annual financial reports. When publicly traded companies are taken private by PE firms then they no longer are required to produce the SEC required GAAP complaint financial reports but many of them continue to do so, they just are not filed or released. Private company owners and their senior executive teams are used to seeing monthly operating reports and quarterly and annual financial statements which may or may not be GAAP compliant.

Both publicly traded companies and privately held firms are used to producing monthly, quarterly and annual operating and financial metric reports and financial statements. However, when these firms are sold to private equity firms, they need to get used to a whole new level of reporting requirements. When a private equity firm owns your business, the partner responsible for overseeing the firm’s investment in your business must report to the firm’s investment committee and must also generate financial reports for lenders on a monthly, quarterly and annual basis. Often these PE firms require portfolio company management teams to generate significantly more and diverse reports on a more frequent basis than they did in the past when they were publicly traded or privately owned. Often it takes time for new acquired portfolio company management teams to get used this more in-depth level of reporting requirements.

Portfolio Company Financial and Operational Targets

When portfolio companies meet their PE firm owner’ financial targets and metrics then everyone is content and happy. If a portfolio company doesn’t hit its financial targets or operating metrics almost all private equity firms will immediately jump in to help. The PE firm’s help and advice is usually very constructive as often the firm has owned other portfolio companies in the same industry. Sometimes in newly acquired portfolio companies there if a little bit of friction between management teams and PE partners because the existing management teams are not used to getting very structured advice, but this quickly passes as they learn to work together. Many PE firms will bring in on a temporary basis financial or operational consultants or industry experts to work directly with portfolio company management teams to improve performance to meet PE targets. (4)

PE Firms Provide General and Administrative Services

Some PE firms after they acquire new portfolio companies remove human resources, recruiting, accounting, finance, treasury, legal and other general and administrative functions out of the portfolio companies and into the PE firm directly. The PE firm then provides these services back to the portfolio companies in the form of additional services fees. The thought process behind this arrangement is that by centralizing the G&A function or services at the PE firm can help achieve better economies of scale and reduce overall costs across the board for all portfolio companies.

The downside to this process is that it removes all of the imbedded expertise such as finance and accounting employees directly ?from the portfolio companies. When the PE firm wishes to exit its portfolio company investment then this presents a major problem. Often once the G&A employees move to the PE firm which pay quite well, they do not want to go back to the portfolio company before it is sold. Then the PE firm is tasked with hiring new ?core staff to populate the G&A departments such as finance and accounting. These new employees do not often have as much company specific knowledge and experience as the former G&A department employees that now work for the PE Firm.

Reasons to Sell to a PE Firm

Private equity firms offer a wide variety of growth opportunities, but many company founders and owners have only heard negative stories of PE firms. Many corporate owners fear that PE firms will purchase their companies under distressed economic conditions, in highly leveraged transactions and will systematically dismantle their firms over time. But this is far from the truth. Very few PE firms dismantle the companies that they acquire. If anything, they utilize these newly acquired portfolio companies as a platform to merge with other potential acquisitions and scale the business.

Three common scenarios that are good reasons for a company owner or founder to consider doing a private equity backed deal include: (6)

Benefits of Selling to a Private Equity Firm

Selling a company to a private equity firm can be a great experience and they can make good partners. PE firms have management teams that?can serve a great sounding board with significant experience growing companies. Some owners that sell out to PE firms make more money on the second sale of the business with their private equity partner than they made in the original sale. Some company owners learn more in a few years operating with a private equity partner than they learned in all their previous years running the company on their own. Below are five of the more common benefits of selling to a private equity firm: (10)

Key Deal Terms in Private Equity Transaction

The key to success for any company owner or founder who is thinking of selling a company is finding a private equity firm that can implement the right strategy to allow the business to flourish. Private equity firms commonly seek the following key deal terms when making new investments: (10)

Things A PE Firm Will Do After They Buy a Company

Immediately, after a company is sold to a private equity firm, they start making changes. Some of the more common changes include the following: (11)

Private Equity Transaction Failures

Many people believe that PE firms purchase companies under distressed economic conditions and squeeze as much cash out of them as possible and then left them fail. Some people believe that acquiring PE firms make huge profits from private equity deals, often destroying the companies they invest in to make money.

Private equity firms have been connected to several retail store chain bankruptcies in recent years including the following: (2)

Private equity firm need to carefully research target companies and industries before they make investment. The financial structure of the proposed PE transaction needs to be carefully vetted to make sure that it is viable. Over the last 20 years several extremely large private equity deals have gone bad including the following four transactions: (12)

Private equity firm need to carefully research target companies and industries before they make investment. The financial structure of the proposed PE transaction needs to be carefully vetted to make sure that it is viable. Over the last 20 years several extremely large private equity deals have gone bad including the following four transactions: (12)

A Private Equity Story

One of my former neighbors in NJ family had a metal fabrication business that was in the family for over 60 years with annual revenues around $20M a year. The firm employed over 100 people and had a very low employee turnover rate with some employees working at the firm for over 25 years. The firm produced highly complex metal components for the aerospace, defense, shipping and industrial sectors. The firm utilized delicate and precise metal fabrication and milling equipment some of which dated back to before WWII. The employees were very skilled in operating this older equipment that produce high quality precision milled products with low rejection rates. The firm had tried utilizing new CNC milling machines but finding and retaining skilled technicians was a constant challenge. The new equipment productions rejection rate were much higher and customers preferred the quality of older equipment because of better precision tolerances.

The company owners were approached by a PE firm in 2006 to see if they would be interested in selling the company. This PE firm’s focused on small to medium size industrial firms. The PE firm was looking to use my neighbor’s family firm as a platform firm to acquire other metal fabrication shops and help consolidate and modernize industry. My neighbor’s father had run the firm for the past 30 years. The father who owned the business wanted to retire and was looking to exist the business because his son (my neighbor) wasn’t really interested in running the business as wanted to focus on growing his legal practice. My neighbors two sons had recently graduated college had grown up with the business but were too inexperienced to run it. The grandfather sold the business to the PE firm with a non-compete that he could not personally start a competing business for 3 years. He stayed on for one year to help the PE firm during a transition period.

Over the next two years the PE firm had started to fundamentally change the metal fabrication firm it had acquired. The firm purchased several new CNC milling machines and robotic metal fabrication equipment. The firm had hoped that this more modern equipment would streamline production, improve quality, increase production volume, reduce the number of workers and thus labor costs. The PE firm laid off 50% of the firm’s workforce and hired new technicians to run the modern equipment. The company had problems retaining CNC technicians who would often resign to go work at another firm for higher pay. Product quality issues rose very quickly and customers were rejecting parts at ever higher rates. The plant manager and his team slowly resigned over time as things got progressively worse. Things were not looking good for this PE firms’ metal fabrication investment.

The two grandsons tried their hand at several things but decided they really enjoyed the metal fabrication business and started their own company with advice from their grandfather. They hired some of the laid off employees from their grandfather’s former company. Over the next year or so the grandsons were able to build a nice customer base including former customers of their grandfather’s old firm who left because of qualify control issues.

The PE firm struggled for two more years to revitalize the metal fabrication firm that it had purchased much to no success. The PE firm had levered the company with so much debt that there was not enough cash flow available to stabilize the firm. The firm also tried unsuccessfully to hire back many of the workers it had laid off initially. Most of them were now working for the grandson’s new metal fabrication firm. The PE firm eventually let the metal fabrication firm go into bankruptcy. The funny part of the story is that the grandsons purchased their grandfather’s old plant out of bankruptcy with all of the old equipment for 20% of what the PE firm had originally purchased it for. Their grandfather had actually provided the financing for the acquisition as his 3 year non-compete was now over.

So now the family had its original plant back plus the new plant. The grandsons were able to embrace the newer CNC milling machines and robotic fabrication equipment more effectively by utilizing them in conjunction with the older manual equipment and keeping the higher product tolerances and quality. This was done by training some of their older workers with a unique knowledge of metal fabrication on how to utilize the newer CNC equipment. So, in this case the PE firm’s initial investment did not work out as planned, but the firm did have a good intent at the start.

Conclusion

Private equity firms and the private equity industry are complicated subject matter that most people do not fully understand. Many business executives at one time or another over their careers will likely have some dealings with a private equity firm. This article was designed to explain the many aspects and topics that I feel are critical for one to truly understand how private equity firms work and how the industry operates and functions. The private equity industry does play a vital role in helping fund corporate growth and expansion in different industries. Please reach out to me if you have any questions of would like to discuss any topics.

References