Private equity (PE) is invested across a wide range of businesses and sectors. As a result, it has a significant influence on growing businesses, however, it can often be misunderstood.
What is private equity?
The British Venture Capital Association describes private equity as “medium to long-term finance provided in return for an equity stake in potentially high growth private companies”.
Another way of looking at it would be “an investor who invests in private companies backing the management teams of those companies to deliver a growth strategy where management and private equity interests are aligned through equity ownership”.
Regardless of how you define them, PE houses are professional investors and buyers of businesses. Theory suggests that trade buyers should be able to pay more for businesses because of potential synergies from combining their business with the target business (not available to private equity). However, PE has to compete with trade buyers on pricing and PE’s professional approach to transactions results in them winning in competitive processes against trade and investing in a significant number of transactions each year.
Private equity firms raise finance from pension funds, insurance companies, family offices and high-net-worth individuals into a fund for PE to invest principally in private companies to support growth across a range of transactions for a range of reasons. The key factor is that private equity ‘back credible management teams’. They support management’s strategy and growth plans; they do not impose strategies on management teams, and they do not parachute their management in to run the business.
Why use private equity?
There are a range of different reasons for seeking PE investment with growth and equity value enhancement at their core. PE might be considered to support:
Management buy-out – helping management acquire or grow their equity stake in the business they run
Cash out/equity release for an existing owner
Succession planning
M&A – to support and fund an acquisition or a buy and build strategy
Growth/development funding - to accelerate organic growth, to access overseas expansion, new markets, new products, or new service lines
A combination of the above.
How does private equity invest?
PE invests in businesses to deliver equity growth as that is the main driver of their returns, however, the structure of their investment might be comprised of different elements including:
Loan notes or preference shares – to which a coupon or interest rate return will be applied
Equity/ordinary shares – with the objective of enhancing the equity value through growth
In most transactions, a PE investment will be a combination of both loan notes/preference shares and ordinary shares, although sometimes an investment might be made purely in ordinary shares. It is important that management and PE interests are aligned where possible, so management should be investing in similar funding instruments in the same proportions as PE.
At the same time as PE money is being invested, it is also likely that debt funding will be raised as part of the overall funding package for the transaction. Debt should always be considered as it is a cheaper form of funding than equity. However, the availability of debt will vary from business to business and will depend upon a number of factors including serviceability, the risk profile of the business and the reason the funding is required. Some funding risks will be considered as ‘equity risks’ and therefore to be funded by an equity investor such as PE.
What does private equity look for?
PE is backing the management team of a business, hence a strong management team + growth strategy + a track record of delivering growth = a combination for PE success.
As a rule of thumb, PE will look to double their money over the life of the investment across circa 3-5 years. Management needs to be able to clearly and succinctly explain their growth strategy and why they need PE investment to help support them. PE wants to see a management team committed to the future of the business, a team focused on growing the business and the equity value.
What should you look for from private equity?
This depends upon what is important to you. There are a wide range of PE houses to choose from. You will need to consider some of the following:
Size of investment - how much are you looking to raise (in total including debt and level of equity)? Somewhat counterintuitively, there are fewer PE houses looking to invest in smaller (sub £10m) transactions than larger deals
A PE house focused on your sector or a more general approach
A minority or majority investment – too many businesses become engrossed with 'control' when the range of documents that sit behind an investment apply more elements to day-to-day control than the equity percentage even in a minority equity transaction
Hands-on v hands-off investor – all PE houses will take a seat on the business’ board and the vast majority will agree on the appointment of a non-executive director/ chairman with management as well. These appointments should be embraced, they are there to test and challenge management but also to share their experiences and knowledge. Non-executives and Chairmen should bring value to the boardroom, if they don’t, they are the wrong appointment.
How does private equity generate its returns?
Private equity looks to double their money from a return. They might talk about a money multiple (of their original investment) or an IRR (internal rate of return) to measure success.
Their return is a combination of the growth and percentage applicable to the different elements of capital in which they invest:
Loan notes/preference shares – these will have an interest rate/coupon applicable to them. This is likely to be 'rolled up' on an ongoing basis and only paid out upon an exit/sale of the business
Equity/ordinary shares – this is the largest element of the return and will be generated upon an exit/sale of the business. This could be to a trade buyer, or it could be to a different PE house coming in to support the management team. As a professional investor, and with the majority of value being generated on an exit, PE will help to align strategic decisions to the impact they might have on the exit value and timing
Value can also be generated through deleveraging or paying down some or all of any debt funding raised for the transaction that would increase the equity value.
The next step
If you are considering private equity and would like an initial, confidential discussion around your options, please contact Nick Carr or one of our corporate finance specialists at UHY.
Prosper issue nine
This article is taken from our latest issue of Prosper aimed at businesses and business owners. You can access Prosper on this page.
