What REALLY is Private Equity? What do Private Equity Firms ACTUALLY do?

Summary

This video script delves into the world of private equity (PE) firms, explaining their primary focus on acquiring non-public companies and their specialization in various types of equity investments. It highlights how PE firms often target specific life cycle stages of companies, from young, high-growth firms to established businesses or even distressed companies. The script contrasts PE firms with hedge funds, emphasizing the longer investment horizon of PE and their active involvement in improving the financial performance of their investments. The typical structure of PE firms is also outlined, with a focus on limited partnerships and closed-end funds, and how they operate through a management fee and carried interest model. The life cycle of a PE fund is described, from the investment collection period to the investment, management, and eventual divestiture phases, culminating in the distribution of proceeds among partners or investors. The summary provides a clear and concise insight into the operations and strategies of private equity firms, piquing the interest of viewers for further exploration in upcoming videos on related topics such as hedge funds.

Takeaways

• 🏢 **Private Equity Focus**: Private equity (PE) firms primarily invest in private companies that are not listed on a stock exchange, focusing on equity investments.
• 💹 **Specialization**: PE firms often specialize in specific types of target companies based on their life cycle stage, such as young high-growth firms or established companies with stable cash flows.
• 🔄 **Distressed Investments**: There is an overlap between PE and hedge funds in investing in distressed companies, but PE typically has a longer investment horizon.
• 📈 **Investment Strategy**: PE firms aim to acquire a significant stake in businesses, often aiming for full or majority control, and then actively engage in improving their financial performance over several years.
• 🤝 **Active Involvement**: PE firms often take a hands-on approach, providing advice, and sometimes replacing management to position the business for growth.
• 💼 **Fund Structure**: PE firms are commonly structured as limited partnerships in the US or closed-end funds in Europe, with general partners managing the fund and limited partners providing capital.
• 💰 **Compensation**: General partners charge a management fee and may receive carried interest, typically structured as '2 and 20' (2% management fee, 20% of profits after a hurdle rate).
• 📊 **Lifecycle of a Fund**: The typical PE fund lifecycle includes a capital collection period, an investment period of up to five years, active management, and a divestiture phase that can last several years.
• 🌐 **Market Factors**: The timing of exiting an investment is influenced by factors such as the economy, market volatility, and finding a suitable buyer.
• ⏳ **Patience and Growth**: PE firms are known for their patience, aiming to grow and improve profitability of the businesses they invest in over a five to ten-year period.
• 📉 **Hedge Fund Differences**: Unlike hedge funds, which may engage in short-term investments in distressed companies, PE firms focus on long-term growth and active management of their investments.

Q & A

What is the primary reason private equity firms are interested in private companies?

Private equity firms are primarily interested in private companies because they are not listed on a stock exchange, allowing the firms to acquire a significant equity stake and engage in active management to improve the company's performance.

How do private equity firms specialize in their investments?

Private equity firms specialize by focusing on specific types of target companies based on their life cycle stage. Some may invest in young, high-growth firms, while others may target established companies with stable cash flows or even distressed companies.

What is the main difference between private equity and hedge funds when investing in distressed companies?

The main difference is the investment horizon. Private equity typically aims for long-term investments, acquiring the entire company, improving its performance, and then exiting after several years. Hedge funds, on the other hand, usually have a short-term investment horizon, looking to profit from the immediate trading of securities.

What is the typical structure of a private equity firm?

Private equity firms are typically structured as either a limited partnership or a closed-end fund. Limited partnerships are more popular in the US, while closed-end funds are more prevalent in Europe.

What are the roles of general partners and limited partners in a limited partnership structure?

General partners are involved in the management of the fund, including target company selection and post-investment advisory. Limited partners provide the investment capital and do not participate in the day-to-day management of the fund.

What is the '2 and 20' compensation structure often used by private equity firms?

The '2 and 20' structure refers to a management fee of 2% and a carried interest of 20%. The management fee is paid regardless of the fund's success, while the carried interest is a percentage of the profits after the fund has reached a break-even point.

What is a hurdle rate in a private equity partnership agreement?

A hurdle rate is a minimum rate of return that must be achieved before the general partners can start accruing carried interest. It is used to ensure that the fund's performance meets a certain threshold before the partners can receive additional compensation.

How does the lifecycle of a private equity fund typically progress?

The lifecycle of a private equity fund typically includes a period for collecting investments, an investment period that can last up to five years, an active involvement phase where the fund managers work to optimize the performance of the businesses they've invested in, and finally a divestiture phase where the investments are sold or listed on a stock exchange.

What factors determine the best moment for a private equity firm to exit an investment?

Factors that determine the best moment to exit an investment include the general state of the economy, market volatility, and finding the right buyer willing to pay the appropriate price.

How do private equity firms position businesses for growth?

Private equity firms position businesses for growth through active involvement, which may include providing advisory services, management rotations, and substitutions to improve the company's financial performance and increase its value.

What is the typical duration of a private equity firm's investment in a company?

The typical duration of a private equity firm's investment in a company is between five to ten years, allowing for sufficient time to implement changes, grow the business, and then exit the investment.

How do established players in the private equity industry benefit during the investment collection period?

Established players in the private equity industry benefit from a shorter investment collection period due to their reputation and the demand for their services within the investment community, which gives them a significant edge over newer or less established firms.