Private Equity Introductory Series: Investment Strategies

I first learned the concept of investing on my fifth birthday from my older brother, Jason. My wise brother told me that I could turn my birthday money, a singular $5 bill, into a money tree by planting it. He was even so kind as to offer to water it for me, as long as I told him where I had planted it.

Of course it didn't take long for my loving family to ruin our plan with reality. But the idea had taken root, and I ultimately opened a banking account to save my money and earn interest (which I later learned wasn't very much).

And that's today's topic - investing. More specifically, what strategies private equity firms pursue to add value to their investments (their operating companies).

The Private Equity Investment Playbooks

1. Buyout Strategy: The favorite (most common)

In this strategy, a private equity firm will acquire controlling stakes in mature companies, often using a mix of equity and debt. They aim to optimize operations, cut costs, and add new revenue streams.

• Typical Timeline: 5-10 years.
• Example: Blackstone acquired the publicly traded Hilton, and took it private, in 2007 for $27 billion (using a LBO model of $20.5 billion debt/$5.6 billion equity). By the time Blackstone had fully exited their investment in 2018, they netted $14 billion in profit.
• Strengths: Control.
• Weaknesses: Utilizing a disproportional amount of debt, as is the case in a Leveraged Buyout (LBO), can put a strain on the company's cash flow.

2. Growth Equity

Rather than taking full control, PE firms invest in minority stakes of promising companies. The goal is to infuse capital to fuel expansion, such as product launches, or expanding operations.

• Typical Timeline: 3-7 years.
• Example: Shopify raised $100 million in Series C funding from Insight Venture Partners, and other investors, in 2013. This fueled their growth and two years later, went public, raising $131 million. Not a bad return for a two year investment.
• Strengths: Existing leadership is largely retained increasing collaboration.
• Weaknesses: Less influence over decision-making compared to buyouts.

3. Venture Capital

This strategy focuses on funding early-stage startups with significant growth potential. Venture investments work similarly to growth equity but cater to riskier, less-proven business models.

• Typical Timeline: 5-12 years.
• Example: Sequoia Capital’s early investment of $585 thousand in Airbnb in 2009 helped the company transform into a global hospitality leader. Sequoia continued their financial support and invested a total of $280 million that was worth nearly $12 billion at the time of Airbnb's IPO in December 2020.
• Strengths: Potential for high returns.
• Weaknesses: High failure rates.

4. Distressed Investing

Private equity firms buy undervalued and struggling companies or assets and attempt to rehabilitate them. The focus is on operational turnaround or balance sheet restructuring.

• Typical Timeline: 2-5 years.
• Example: Apollo Global (along with Ares and Len Blavatnik) organized an $8 billion debtor-in-possession (DIP) loan to restructure LyondellBasell in 2009. Apollo acquired the debt stakes at low prices and converted their position into equity, and realized a $9.6 billion return in 2013 when they fully exited their investment.
• Strengths: Opportunity to buy assets at deep discounts.
• Weaknesses: High unpredictability and risk if the turnaround isn’t successful.

Show me the money! Let's talk returns.

Private equity has become an increasingly popular investment strategy, in part due to the returns they generate. Each fund and strategy will have their own target return, but generally speaking, they range between 15% to 20% IRR (internal rate of return). This figure is meant to estimate the profitability of potential investments.

Here's a mathematical illustration:

• $1,000 at 15% IRR after one year is = $1,150
• If you kept that money in the investment for 10 years, and if it maintained that 15% IRR, you'd pocket $4,045.56

Since our friends in private equity are playing with much larger sums of money, it can get exciting pretty fast. But don't forget, the examples referenced above and the target IRR is not guaranteed.

Remember CalPERS from yesterday's newsletter on fundraising? The largest public pension system in the United States? Well, they provided data on all of their PE partnership investments as of June 30, 2024. The column on Net IRR is fascinating and will give you a more realistic illustration of returns (remember this is a specific snapshot in time). On the first page alone I saw -29.1% from one fund to 42.7% on another. Quite the swing.

Four Strategies. A lot of individual stories.

These are not the only investment strategies, just the most popular ones. And the examples I referenced are the really fun ones that make for click-bait, splashy headlines. Most of these headlines are for larger enterprises (like Hilton, worth Billions), which overshadow the thousands of lower middle-market businesses that have meaningful stories to share. It is my goal to give a voice to some of these players in time, since the work these business owners (whether the founders or private equity owners) are doing is, in my opinion, admirable.

Thanks for reading. Stay tuned for tomorrow's segment on Portfolio Management - magic in the making.

Best,

Teresa

References:

CalPERS

Private Equity Program (PEP) Fund Performance Review. June 30, 2024. Website: https://www.calpers.ca.gov

Buyout reference: Blackstone & Hilton

Hospitality Investor. Blackstone made a fortune on Hilton. Is it the last of the hotel mega deals? Author: David Eisen. Published: June 26,2022.

Growth Equity reference: Insight Venture Partners & Shopify

Insight Partners. Shopify Raises $100M To Drop The 'E' And Become The Commerce Company That Spans On-And Offline. Author: TechCrunch. Published: December 12, 2013.

Yahoo! Finance. Here Is How Much Money You'd Have Today If You'd Invested $100 In Shopify In 2015. Author: Eric McConnell. Published: September 20, 2024.

Venture Capital reference: Sequoia Capital & AirBnB

Markets Insider. A legendary venture-capital firm bought Airbnb shares for $0.01 each in 2009. Author: Theron Mohamed. Published: December 11, 2020.

Distressed Debt reference: Apollo Global & LyondellBasell

Forbes. How One Billionaire's Bet On LyondellBasell Turned Into The Greatest Deal In Wall St. History. Author: Nathan Vardi. Published: July 30, 2014.