Overview of Value Creation in Private Equity

What is private equity?

Private equity is an alternative investment vehicle that provides money to companies in need of capital. It typically invests for a longer time frame and may take a majority stake in the company's equity. In general, the private equity firm seeks to make significant value creation for its investors by transforming a company's business model and operations.

The Value Creation Process

Value creation is not a static process, but one that evolves and changes over time as the company matures. There are four key phases to value creation:

* Pre-investment

* Initial investment

* Exiting the investment

* Ongoing Value Creation

Pre-investment: The first phase begins before an investor has invested in a company. This phase is typically where the private equity firm conducts due diligence on a potential target company. They will then do more extensive analysis of the data collected during their pre-investment period. This detailed analysis of the potential target's past performance, management and prospects for growth, determines whether or not to invest in the company. After an investor decides to invest in a company, they must also complete their due diligence process. This process will involve identifying any legal issues or environmental factors (like pending lawsuits) that could impact the business moving forward.

Initial Investment: Once an investor invests in a company, they must now identify ways to create value for their investors through restructuring and improving operations within the target company. An important aspect of this restructuring includes developing strategies to increase profitability and reduce costs. These initial strategies often include reducing excess inventory, improving factory efficiency, negotiating better terms with vendors and suppliers and enhancing customer service capabilities. On top of restructuring strategies, private equity firms will typically have a list of operational goals that need to be met by managers and executives - including increasing revenues from existing products or services while decreasing cost structures - in order to generate significant

Exiting the Investment: After a company has started moving towards a path of growth and realization of identified value generation milestones, the overall valuation of the business in appreciates. This may also attract other companies who may seek to buy the company out or the business can become a good prospect for an IPO. This is where private equity investment creates its returns to its principals and its investors. They are paid back for the value that has been created through their investment of capital, experience and expertise.

Ongoing Value Creation:

Value creation does not stop at an exit. Private equity investors look back at what they did right and what could have gone better. Investment strategy and prospect search is aligned with the lessons learned and experienced gained to be used in future deals. Furthermore, if a business is listed and the firms stays invested, they may take an activist role in guiding a business towards better performance for fruition of returns on their investment.

Value Creation for the Private Equity Firm

One way to create value with private equity is by acquiring a company, turning it around, and then selling the resulting company. This is done by implementing operational reforms such as retooling the business model or developing a new product line. For example, Bain Capital invested in the toy retailer Toys "R" Us in 2005 and maintained majority ownership of the company until 2015. Bain implemented many changes to Toys "R" Us' business strategy that helped it rebound from near bankruptcy. Toys "R" Us was eventually sold for $6.6 billion in 2018 - more than 10 times what Bain Capital originally invested.

Conclusion

Private equity investments are an attractive way for individuals to invest in the private sector, enjoy the potential liquidity of their investment, and diversify their portfolios. To ensure that investors receive the best possible return on their investment, private equity firms have a vast array of tools at their disposal to improve the asset values of the businesses they invest in. These include full-scale management replacements, cost cutting, and portfolio restructuring. However, each intervention has its own set of trade-offs, and it is important for investors to understand the risks and rewards of value creation before they commit to any private equity investment.