Private Equity

Private equity generally works the same way throughout Wall Street, whether we’re talking about an independent private equity firm, a public firm like The Carlyle Group, or a fund that’s part of a major hedge fund or investment bank (although the Volcker Rule now requires investment banks to have no more than 3 percent of their capital invested in private equity, hedge funds, and other investment funds). Private equity companies, or divisions, have to create a fund and finance it, find potential investments, line up additional financing, make the deal, fix up the company and determine the exit strategy. Here’s a look at how it works.

Creating a Fund

Private equity firms can have multiple funds running at the same time. Some are specialized, say in distressed debt or venture capital, while others are simply giant pools of cash the firm can use for any investment it sees fit. To create a fund, of course, the firm has to find cash.

Show Me the Money

A well-established private equity firm has reasonably dependable sources of capital for its funds. Major banks, pension funds, hedge funds, and other Wall Street stalwarts are generally willing to give a fund several hundred million dollars each to get it started. Major universities and charities are also good sources of funds, since their endowments generally aren’t used for operational purposes. Finally, private wealth management organizations sometimes pool the money of some of their high-net-worth clients—and generally only those who can measure their worth in the hundreds of millions—in order to make a private equity investment.

And of course, the managing directors and ownership of the private equity firm also puts capital into any given fund. For successful private equity investors, that can be valued at several hundred million dollars.

All of these sources of capital, pooled together, create the private equity fund. Major private equity firms can have more than $10 billion in assets, though outside a handful of these top firms, such funds tend to be in the $2 billion to $5 billion range.

Why Invest?

The funds operate much like a mutual fund, in that each participant or entity receives a return on its investment commensurate with the performance of the fund and how much each institution put in. Yet there are notable differences. Private equity firms require major commitments of time for each investment—investors generally must commit their money for up to 10 years. Once a private equity firm acquires funding, they usually have a window of one to three years to deploy their capital by buying companies, and another three to five before investors begin to receive some distributions from the fund. That’s roughly the same lifespan of a major private equity investment, and the private equity firm won’t be able to execute on its strategy without assurance that the money will be there.

Depending on the kind of fund, there may be regular payouts for its investors, but in many cases, investors may have to wait the full term before getting their returns. It’s because of this wait, in part, that private equity investors start levering up their new acquisitions almost immediately upon purchase.

Finding a Target

Research

Once a fund is created, the private equity firm then needs to find appropriate investments. Depending on the market environment, the time this takes can vary between weeks and years. Private equity firms are constantly researching possible investments, even before the funds are created. These possibilities, in part, are major selling points for potential investors, who need to be reassured that the fund can put their capital into action as efficiently as possible.

Many private equity firms rely on the networks and relationships of their principles to find investment opportunities. They look for companies or parts of companies to purchase from private owners, often the original entrepreneurs who founded the company. Since these companies aren't publicly traded, less information about them is readily available. Some potential targets are easy to spot—the companies that put themselves up for sale, will attract interest, though these are by no means certain. Some companies may simply not be worth the time and money needed to turn them around, and good research should reveal that.

There are also companies that privately court private equity bidders. Generally, these contacts aren’t made via press release, but are done quietly, with the head of M&A for a major Wall Street firm making a call to a private equity firm’s managing director. Often, the company’s books are laid open to the private equity firm’s researchers, who can then determine if there are enough efficiencies to be gleaned to make an acquisition worthwhile.

The Diamond in the Rough

In still other cases, private equity firms will explore companies through their public filings and Wall Street analysts’ research, and go to them independently with the potential of a takeover. In some cases, these companies may not have given much thought to a leveraged buyout (LBO)—perhaps they had a longer-term plan to achieve the efficiencies that a private equity firm could make happen much faster, or perhaps they didn’t even see the potential for the kinds of major improvements a private equity firm might propose. Sometimes a company is the perfect adjunct to another of the private equity firm’s portfolio companies, and the firm seeks to create a private merger between the two, which would boost the value of both once they’re rolled out into the open market.

Occasionally, a private equity firm will spot opportunity in a previously announced deal between two public companies or an LBO by a competitor. If the research shows the company could do a better job of creating value than the existing bidder, the private equity firm might jump in with a higher offer.

And that’s the key to the entire research process—creating value. The private equity firm’s demonstrated expertise must fit well with the target company’s opportunities, and there must be a relatively quick “fix” that will bring the fund’s shareholders value within the three- to five-year time frame. Most firms have several dozen potential opportunities on their “wish list” at any given time, just waiting for the last few pieces of the puzzle to fit into the investment scheme. Sometimes it’s a question of an anticipated failure in a division, other times it’s simply waiting for the stock price to fall enough to make a deal worthwhile.

Making the Deal

The Offer

When the opportunity seems ripe, the researchers and deal makers work together to create a buyout offer. This offer doesn’t simply include a per-share price, but rather is a detailed plan for the company over the life of the buyout firm’s involvement. To a degree, it includes the areas in which the private equity firm can bring additional value to the company, as well as how much the firm plans to invest in the company’s operations. Not all the cards are laid out on the table, however. “You don’t want to just spell out exactly how they can unlock billions in value,” says one longtime private equity negotiator, who asked not to be identified for fear of giving those across the table from him an advantage. “You want to tell them the value is there, and maybe lowball it some, but you want them believing that you’re the only one who can dig it out.”

Haggling Over the Terms

All of the usual tricks and ploys used in traditional M&A deal making are on display in a leveraged buyout. Both sides can use Wall Street analysts and the broader media to bolster or hurt the target’s share price. The futures of top management at the target firm must be taken into account. Projections of cost savings are bandied back and forth. But in addition to the typical deal-making tactics and rhetoric, private equity firms have a few aces up their sleeve that a public company buyer might not.

For one, private equity buyouts, in many cases, preserve the target company’s identity; it’s not getting swallowed up by a larger rival. They also give current management an opportunity to right the ship without the scrutiny that comes from being a publicly traded company. Since the dot-com bubble burst in 2000-2002 and the Great Recession, many investors have become increasingly insistent that companies “make their numbers” each quarter, surpassing quarterly revenue and profit estimates from Wall Street analysts. If they miss estimates, the stock is punished—sometimes severely. Privately, some CEOs have complained that the drive to make their numbers has hampered their ability to make the necessary long-term investments to drive long-term growth of their businesses. Instead, they hit their numbers and store up cash on their balance sheets to use in share buyback programs and higher dividends to appease public shareholders.

The Other Side: Private Owners

To have a private owner willing to invest for even a three- to five-year time frame would seem like a vacation. And the ability to put free capital back into the company is just good business. It can be a compelling mix, even for the healthiest company.

For companies not so healthy, a buyout can be a boon in other ways. For one, the infusion of capital from private equity owners can bring about big changes in a short amount of time. Private ownership can also handle the more unpopular chores related to a turnaround, including layoffs and dealing with past creditors. The private ownership can also help top managers save face, especially if they were responsible for distressing the company in the first place. A top manager whose policies may have failed can still leave with his or her reputation intact by creating shareholder value for a buyout, usually by getting a bid with a hefty premium over the current share price. The fact that said management also leaves with a nice golden parachute is also compelling.

How Long Does a Deal Take?

Once negotiations start, agreeing to a rough framework of a deal can take months, but in reality it is a two- to four-week process—private equity firms choose their targets carefully, after all. Once an agreement in principle is reached, it’s announced to the general public and the target’s management gets to enjoy the subsequent boost in share price. From there, months of additional negotiations take place, during which time the private equity firm gets a complete accounting of the company’s operations and financial health, and the final details on layoffs, compensation, operational adjustments, and finances are all ironed out. The deal then goes to the target’s shareholders for approval. Once that happens, the private equity firm pays each shareholder the agreed-upon amount per share, and the company officially becomes a private entity owned by the takeover firm.

Getting Financing

You may have already noted that the major deals announced in recent years are far greater in value than the total value of a typical private equity fund. Welcome to the world of private equity financing, which puts the “leverage” back in leveraged buyout.

It’s rare that a private equity firm will simply buy a company outright with its own money. For one, even the biggest private equity fund could only manage to buy a company on the small end of the large-cap scale. As any fund manager will tell you, it’s never wise to put all your money into a single investment. So instead, the money that private equity firms raise is, essentially, seed money. To get the rest, private equity firms enlist banks and hedge funds.

Loans

There are plenty of different ways to raise leverage. The first is a simple bank loan—simple, of course, if you consider $10 billion a simple sum of money. But, in essence, the private equity firm promises to repay the bank the money borrowed with a certain amount of interest. This is generally backed by either the private equity firm’s own resources or, more likely, the value of the enterprise to be purchased. In theory, if the firm defaults on the loan, the bank can go after the purchased company and/or the firm itself. In reality, this rarely happens; if there’s a problem, the two sides iron out a solution that, sometimes, can even involve the bank pouring more money into the target company or private equity firm to affect a greater turnaround.

Sometimes these loans are simply that: loans from a bank. In many other cases, the private equity firm will float a corporate bond, based on the perceived value of the enterprise to be purchased. In fact, over the past few years, private equity firms have sought to lever up their new companies as much as possible. That’s not simply because they want as much capital as they can get to expand the companies. At least some of that leverage goes back to the private equity fund as a “special dividend” for the people who just bought the company. Much of that new debt stays on the target company’s books throughout the private takeover period and on through the exit strategy.

Here’s an example, admittedly somewhat extreme, of how financing works. The Ford Motor Co. sold car rental chain Hertz Inc. to Clayton, Dubilier & Rice, The Carlyle Group, and Merrill Lynch Global Private Equity for $5.6 billion in September 2005. The three private equity funds put up $2.3 billion—the rest came from debt that ended up on Hertz’ balance sheet. Indeed, shortly after the sale, the private equity firms got $1 billion back in dividends. Ten months later, Hertz Global Holdings was re-introduced to the marketplace in an initial public offering that raised roughly $5 billion. The three private equity firms logged a $4 billion paper profit on the deal through more special dividends and, it should be noted, about $100 million in fees charged by the private equity firms!

Working with Hedge Funds

Over the past decade, private equity firms have increasingly paired up with hedge funds, essentially coming together with pools of private capital to buy out a company. The hedge fund, instead of getting a fixed amount for its investment, will often go along for the ride, hoping for the same outsized returns the private equity investors will get.

Unlocking the Company’s Value

Some companies may not need to be “fixed,” per se, but the whole reason they were brought private was because the private equity investors saw ways to unlock increased value within the company that wasn’t being used. In the next one to five years, the private equity investors go to work on leaving the company, ideally, in a better state than they found it.

Leaving Their Mark

A company bought out by a private equity firm won’t notice what happened the day after the deal closes, but within a year, the firm will have left an indelible mark on the company. Inefficient processes are tossed out without a second thought, activities and supply chains are streamlined, the company’s workforce is often cut back (at least through attrition if not outright layoffs), and new initiatives and, in some cases, new products are introduced.

The firm’s role in this stage of the process is to set definitive goals for improvement and lead the company to make those goals a reality. Targets are set—often during the deal-making process—and are reached through the leadership of the private equity firm’s consultants and hand-picked managers. There are often those within the newly private company who will bemoan the changes; they’re generally the ones who will be shown the exits first. Private equity firms have neither the time nor the inclination to be sentimental about their new purchases, and thus the changes that take place can be jarring and drastic. A good private equity firm, however, will take the time to get the employees to buy into the new program, which helps everyone—the employees keep their jobs and feel good about change, while the private equity firm gets a quicker and more efficient outcome.

Pulling It Off

There are, of course, an infinite number of ways to unlock value in a given company. Retail chains have traditionally been popular targets of private equity firms because underperforming outlets can be closed and the real estate sold, or the PE firms may decide to expand the portfolio company’s product and/or service lines and expand into new geographic sales areas. “Following a private equity deal, target firms increase retail sales of their products 50 percent more than matched control firms,” according to “Barbarians at the Store? Private Equity, Products, and Consumers,” an article in the Journal of Finance. “Price increases—roughly 1 percent on existing products—do not drive this growth; the launch of new products and geographic expansion do.”

Private equity firms also have their sights set on manufacturing companies. Industrial companies can be improved with new machinery and tighter supply chains. Payrolls can be reduced, debt can be restructured, and a variety of expenses can be cut through using different vendors or items. New customers and contracts are pursued.

Alternatively, the “fix” may involve disbanding the company, either in part or altogether. Smaller conglomerates tend to be unwieldy—so why not focus on the core business and sell off the other divisions? Perhaps there just aren’t enough synergies within the company, so the divisions can be sold off to rivals. So long as it generates capital or the potential of higher profit down the road, the private equity firm will do whatever it takes.

The Exit Strategy: Return on Investment

Private equity firms aren’t in the business of actually owning companies. They buy and sell companies like one would buy an old house, fix it up, and resell it for a handsome profit. At some point, the private equity firm will want to close out the investment and reap the returns. In general, it has plenty of options.

The most common way to reap the benefits is to reintroduce the company to the public market via an “initial” public offering—a somewhat misleading name since this is likely the second time the company has floated stock. Nonetheless, the company is new in the eyes of regulators, and thus is a new offering.

IPOs

The IPO route is quite similar to that of any other company seeking to go public. The private equity firm hires an investment bank (or walks across the hall, in the case of a private equity division of an investment bank) to underwrite the offering. The investment bank assesses what it thinks the enterprise is now worth; ideally, the private equity firm has brought enough value to the company to make it worth more than the initial purchase price. The private equity owners and investment bank come to a consensus of value, and then the company goes on a junket with the investment bank, giving institutional investors and Wall Street analysts a “road show” to discuss how much the company has improved and what it’s worth now—and, of course, what it will be worth in the years to come.

Ultimately, the company sets an offering price and a date, and stock is floated. Generally, the private equity firms will retain large chunks of equity in the company, floating anywhere from 20 to 90 percent of the stock on the open market. The proceeds of the IPO generally go to the private equity firms. Sometimes, the firms will float only a minority of the outstanding shares, leaving them with effective control of the company. The private equity firm may unwind its position in time, of course. Other times, the firm is simply interested in getting out with as much money as possible. It may hold on to a stake to see how much it appreciates, however, building even more value for its own stakeholders.

Private equity firms are partial to IPOs because they bring about returns in several stages. When the firm releases stock to the public, it receives the returns. It then gets to see its remaining stake appreciate, and can participate in dividend and stock buyback programs as well. And, as we saw from the Hertz example previously, it can find whatever additional fees it wants to end the relationship between it and the newly public company.

Other Reselling Tactics

The other exit strategies are fairly straightforward—outright sale and disbanding the company. In an outright sale, the “fixed-up” company is sold to someone else, generally a larger public or private company. This can be somewhat less lucrative, but the company also doesn’t have to be in pristine shape, either. If a private equity firm has come across some recalcitrant problems within its target company, selling to another company effectively passes off the problem while still generating returns for the firm’s investors.

Alternatively, the private equity firm may opt for a sum-of-its-parts strategy, selling off the company piecemeal. This is particularly popular when a private equity firm purchases a distressed or even bankrupt company that has more than one operating unit. The units can be broken apart and sold to rivals, who are likely to pay a premium to buy up market share at the expense of a one-time rival. Some private equity firms will even purchase a company solely for the purpose of merging part of it with another portfolio company to strengthen the latter, and then sell off the rest of the former company.

This is, of course, a necessarily broad overview of how private equity deals work. There are many private equity funds that specialize in distressed debt, early-stage venture capital investing, and other wrinkles. But ultimately, the roles and the process are generally the same.