Growing, slowing, gone?

James Patterson demystifies the arcane world of Private Equity, and explains how changes in the industry could affect you

Private Equity has been at the forefront of finance for several years riding high on the bull market and generating substantial profits. To some extent these firms remain secretive as most remain private entities but, as they have realised significant profits, they have attracted greater attention.

Fundamentally the principle of Private Equity is simple: purchase companies, usually using large amounts of borrowed capital, de-list them if they are public and on the stock exchange; after that, restructure their capital, management and investment over a number of years before relisting them on the stock exchange or selling them on and making a profit.

Recently firms have raised substantial capital investment estimated to be as high as $550 billion from 2002-2007 and generated significant returns. Now, however, with the credit markets tightening, Private Equity stands at a crossroads; will it continue to rise or, as firms funding tightens and they cannot borrow, will they be forced to curtail the spending which has been the main driver of their growth?

It is undeniable that the Private Equity industry faces substantial difficulties going forward. David Rubenstein, founder of the Carlyle Group, went as far as to say that the golden era of Private Equity is gone. Funding issues aside the political climate has become increasingly hostile to Private Equity.

The industry is often accused of damaging business in the USA but is also facing a rise in Capital Gains Tax which is likely to hurt operations in the UK. Given that these are the two main markets for Private Equity firms such hostility is certainly inimical to business. But the problems facing Private Equity also extend into the banking system.

Typically Private Equity firms rely on 'leverage', high amounts of borrowed money, to fund their deals. By doing this they inject little capital of their own into deals and thus receive a substantial rate of return on capital invested when they sell high and, if plenty of credit is available, Private Equity firms can also purchase large companies in 'mega deals' which they would otherwise not have been able to. Now, with credit markets tightening, such mega deals are falling away; a UBS report indicated that the value of announced Private Equity deals was down 68% at the backend of last year.

This falling level of liquidity and supply money to Private Equity firms limits their ability to purchase whilst favouring corporate buyers, who typically have more cash and also a greater ability to borrow in the current climate. But all is not lost for Private Equity, certainly the leverage bubble may have been burst but there is now a significant opportunity for businesses to get back to basics and add value through restructuring rather than relying on the market to simply drive business price up.

The so-called 'middle markets' may provide this opportunity: deal flow in the middle markets has continued to be strong with firms still able to gain access to the finance to pursue these smaller deals. Indeed the decline in large deals has pushed many firms to consider so-called 'micro deals' valued at less than $23 million since it is possible to drive significant growth from businesses this size as well as their being a wide availability of companies at this level.

Typically Private Equity firms, at the top level at least, have not attempted to pursue integration between businesses they have purchased, keeping them separate. Now however firms might use 'add on' acquisitions; purchasing companies which complement those already on their portfolio pursuing the same synergies and strategic savings which have traditionally been the preserve of corporate mergers and acquisitions.

Indeed for some middle market firms this has already been a popular strategy, future development of the market may well revolve increasingly around this dynamic however as companies hold on to companies for longer, using their balance sheets to gain funding for vertical or horizontal integration to fill in the holes in the credit markets. The credit crunch might just signify a new strategy for Private Equity and the challenges may drive it to find ever more innovative solutions.

It is also possible that Private Equity firms will look to diversify further afield, both in their financing as well as in their target markets. Currently the UK and the USA dominate private equity with nine out of the top ten firms globally ranked according to capitalisation American and the other British. This is down to more than just economy size; it also depends on regulatory environments which in India and China are currently neither stable, nor developed enough to encourage private equity firms to invest. Moreover such countries currently do not present opportunities equivalent to those in the USA and Europe.

However there is cause for optimism: lately, Private Equity in Europe and in Japan has been growing although only time will tell whether this development will continue in light of the credit crunch. Interestingly US based Blue Ridge recently raised $1.45 billion for expansion into Asia hinting at future developments.

There is also the possibility that Sovereign Wealth Funds may become more integrated into Private Equity system acting as limited partners or financiers as firms look to secure funding. Some degree of expansion outside of the traditional markets seems inevitable, the extent to which this is pursued and is successful may well determine how large the Private Equity business can become.

A recent survey found that 75% of corporate directors would firmly consider moving to the Private Equity industry. Such confidence has largely dissipated over the past six months leading many to question what is the future for careers in this industry, both for graduates and experienced businessmen.

Fundamentally, Private Equity firms do need the debt markets to recover in order to drive growth but the forthcoming period may well weed the firms that really can drive growth and restructure from those who have merely profited from an inflated market. If firms can ride out the current crisis and improve their operations they will be ideally placed to profit in forthcoming years providing substantial opportunities.

Private Equity vs Hedge Funds

The main difference is you operate the company you invest in, as its owner. Hedge funds generally only adopt minority positions and exert a lesser influence over management.

You play a longer term role in companies and your investment horizon is longer - and hence, more strategic.

You get to work with company management.

You get to see the full life-cycle of M&A and combine all the sexy financial disciplines into a single career - M&A, financing, asset management, operations and strategy.

Possible Interview Questions

  1. What is the difference between a public and private company?

  2. Why is a company sometimes better in private, rather than public ownership?

  3. What is a leveraged buy-out?

  4. What is the financial rationale for a private equity buying out a public company?

  5. What is the difference between a financial takeover and a strategic takeover?

  6. Do private equity companies look for synergies when they buy a company?

  7. What is the difference between a private equity company and a hedge fund?

  8. Why did the years 2005 - 2007 see record levels of LBO activity?

  9. What are the inputs and outputs from a LBO model?

  10. When is a good time to buy a public company? When is a good time to sell one?

Private Equity Companies with Graduate Schemes

In general, private equity companies do not hire graduates. Some smaller private equity houses hire graduates as researchers. But the large firms - KKR, Blackstone, Texas Pacific Group, CVC, Cinven etc - hire investment bankers and strategy consultants a couple of years' into their professional careers.

However, Blackstone and 3i are known to recruit a few graduates each year straight into investment professional roles.

Further Reading

Barbarians at the Gate

by Bryan Burrough and John Helyar

Private Equity as an Asset Class

by Guy Fraser-Sampson

Beyond Wall Street: Inside the Rise of Private Equity

by David Rubenstein

Vault Private Equity Career Guide

by Mike Martinez