An introduction to Private Equity

So what is Private Equity and how can you access it as a private investor?

In previous Advice Matters articles, we have discussed the need for diversification within portfolios to deliver a smoother investment journey for clients along the ‘pothole’ ridden investment highway to financial prosperity.

Modern Portfolio Theory taught us that the key to providing an efficient risk reward trade-off is to find alternative diversifying asset classes with a low correlation to existing investments.

We are turning our attention, in this article, to just such an asset class – Private Equity. Investing all of your money in Private Equity would be too risky for all but the most adventurous investors. But, when combined with the traditional building blocks of a portfolio, this form of investment could appeal to a much wider audience, particularly at the current, typically depressed valuations.

So what is Private Equity and how can you access it as a private investor? Let us examine each of these questions in turn.

What is Private Equity?

Private Equity can be broadly described as ownership or interest in a company that is not publicly listed or traded.

Clearly this involves more risk than investing in Listed Equity, but with that risk comes the potential to earn higher rewards. Whilst it is true that this investment space is dominated by institutional investors, there are plenty of opportunities for retail investors to benefit from fast growing businesses and attractive Venture Capital opportunities through a variety of investment vehicles.

Before considering how you could get access to the investment opportunities this form of investment provides, let us first of all examine what the term Private Equity actually means.

Private Equity is actually a collective noun and it is important to understand that there are many different strategies and market segments that are grouped under this umbrella term.

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1) Venture Capital

Have you ever seen the television programme “Dragons Den”? Budding entrepreneurs pitch to ‘angel investors’ trying to secure much needed investment in return for a share of their business? Well Venture Capital is a bit like that, and like in the television programme, this can involve investment at various different stages in a company’s development.

Start-ups – Sometimes on “Dragons Den,” someone has come up with an invention or recognises an untapped gap for a particular product in the market. The problem is that they are underfunded, and the research and development needed to get to a successful launch of their product may be beyond the means of the entrepreneur. Borrowing money from the bank may not be possible or affordable since the company is new and not cash generative and so there is a ‘Catch 22’ situation. Seed Capital in exchange for equity may be the answer, giving up a percentage of the firm for much needed cash which will not incur interest.

This form of private equity investment is very risky since start-ups face high uncertainty and many will fail! However, even the biggest companies have had to start somewhere and the few that do succeed, have provided rich rewards for the brave investors who placed their faith in them. Just imagine if you had invested in Apple Inc in the early 80’s?

Early stage – This may be the next stage in a company’s development, and this investment provides cash to set up the initial operation and primary production. The funds could also be used to market the product which has now been developed. This period in the company’s journey can often be the most lucrative since the high risk of failure in the previous stage of development has been avoided.

Later stage – These companies have proved their sustainability and have an established product. They may be cash generative by now and planning an exit strategy either by acquisition or an Initial Public Offering (IPO). As a result, here would be less risk to potential investors than in either of the other two stages of development.

2) Distressed Companies

We now wind the clock forward in the company’s journey to look at another form of Private Equity investment. When a company’s balance sheet shows high gearing in the form of debt, it is likely that both its shares and bonds will have a high yield. In order to improve the balance sheet, the company may decide to offer new bonds to a new group of buyers.

Investors in distressed companies normally seek to influence the negotiations over the restructuring of the debt pile and subsequent strategic direction of the firm.

With a renewed focus on improving the cash flow within the distressed company, asset sales of non-core businesses are likely to follow, together with a possible improvement in the distressed bond price.

3) Leveraged Buyouts

Leveraged Buyouts (LBO) normally rely on a large syndicate of banks, hedge funds and Private Equity groups to lend money to an LBO vehicle.

In turn, the LBO vehicle normally seeks to buy a controlling interest in a company’s equity using a high amount of borrowed capital. The borrowed capital is usually supplied by a syndicate of investors in exchange for LBO bonds. These bonds tend to pay a high yield given the high-risk approach of the investment vehicle.

Thereafter, there is potential for the new management team to reduce costs and improve profitability through non-core disposals.

Manchester United is a famous example (if not infamous to many supporters), of a leveraged buyout. Some people estimate that the Glazer family have taken out over ￡1bn from the company in their 18 years of ownership. Bought for ￡790m in 2005, the club is up for sale with a target price of ￡6-7bn. Some estimate the actual value of the club is nearer ￡1.6bn. but even at that price (which seems low compared to Chelsea who sold for $3.2bn last year) they will have turned in a nice profit on the deal.

4) Mezzanine Finance

Imagine a hotel lobby with open access to the street outside, where the shareholders are on the ground floor vulnerable to the elements outside whilst the secured debtholders are safely tucked up in bed in the upper floors. In between is a mezzanine floor, not as comfortable as the rooms upstairs but not as vulnerable as those sitting in the lobby.

Mezzanine capital represents preference shares and unsecured debt, which, in the event of bankruptcy, ranks somewhere between ordinary shares and secured debt. Often mezzanine capital is issued in the form of sub-ordinated debt which ranks below unsecured debt but is, at least above preference shares in the event of liquidation.

To the company, this form of finance is often a more expensive way to raise money, as investors will require a risk premium when compared to secured debt. To the investor this represents the opportunity to secure a high yield, albeit with the risk of the company defaulting on some or all of their financial obligations.

In fact, mezzanine investors get their return from some or all of the following types of security.

• Cash interest – either a fixed rate of interest or a floating rate compared to benchmark rate for example LIBOR.

• Payment In Kind Interest – instead of paying interest in cash, the interest rolls up with the debt and is paid in one lump sum on maturity.

• Ownership – Often in addition to the above, an equity stake is added in the form of warrants to subscribe for shares at a fixed price in the future or the ability to convert the debt into shares at a fixed price in the future. In either case, the owner will benefit from the future success of the company.

Most private equity investors gain exposure via Private equity funds.

Within the structure of a fund there is a limited partnership consisting of two types of partner, a general partner and limited partners. The general partner is the financial entity used to control and manage the fund while the limited partners are the investors. The general partner will screen companies and carry out due diligence. This will include visiting the company, and engaging with suppliers, customers, employees, lawyers and accountants.

There are various ways that a general partner will seek to align the interests of the managers and investors and exercise control over the company:

• Board representation is often made a condition of providing finance to a company. General Partners have the necessary skills to sit on the board and can exercise significant influence on company. Even if the ownership of the company is less than 50%, the General Partner may get special voting rights to give them control.

• Access to further finance – the partnership may not give the company all its required funds at beginning so can withhold future funds if need be.

• The Partnership will have the right to inspect the company records so will be in possession of the full facts about the company’s fortunes.

The general partner will be compensated by management fees and something called carried interest. This is a performance fee paid to the general partner for enhancing performance. This is usually paid on the successful exit from an investment.

Another way of accessing the Private Equity market is through Investment Trusts specialising in Private Equity investment. Since Investment Trusts can trade at a discount to the Net Asset Value of their portfolio, astute investors constantly monitor the size of these discounts. They will hope that if they time their investment well, the discount will narrow and even if the underlying portfolio does not increase in value, they can reap rich rewards. Presently we are seeing discounts of over 40% in this space and a change in sentiment could lead to a quick reversal in the fortunes of these trusts even if the underlying companies stay at their present valuations.

Importance of due diligence

Private Equity, by definition, is not listed on a regulated market. This can lead to issues, since information about the firm may be somewhat opaque compared to listed equity where disclosure rules of the market determine that material information concerning the companies affairs is provided to the public in a timely manner.

The counter point however is that only publicly declared information is available to shareholders of listed equity whereas inside information is available to those invested in private equity.

It is however true that, before investing, the existing directors of the company know far more about the company’s fortune than potential investors. This is known as ‘information asymmetry’ and could lead to a conflict of interest in terms of those directors only wanting potential investors to know enough to attract inward investment. Buyers need to be aware and due diligence could be vital in terms of asking the right questions and analysing as much information from a variety of sources to ascertain the veracity of the data provided.

Clearly this is the work of professionals, for retail clients investing in Private Equity the fees paid to the managers of a fund or an investment trust is money well spent. As you can see, there is a great deal of choice in terms of the types of companies to invest in, the approach to be adopted and the medium of investment. Advice should be sought from industry professionals with the research capability to identify the opportunities that are likely to fit the clients risk profile, time horizon and possibly their ethical standpoint.

Source: Article “An introduction to Private Equity” was written by The ZISHI experts, and published in the?Advice Matters Magazine? | 2023 | Vol 01 | Edition 04

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