Private equity is a way of owning and investing in private companies with the intention of growing them and/or improving their business performance. Private equity funds typically invest in businesses that are held in the following ways:
- Privately-held unlisted companies that are on a growth trajectory;
- "Corporate orphans", or under-developed divisions of larger corporations;
- Listed companies that are under-valued by the stock market, or whose growth potential would be more optimally developed under private ownership.
In the private equity model, a team of professional fund managers takes large stakes in private companies, usually with a specific investment thesis and a detailed value creation plan. Ideally, private equity investors are able to ensure that the interests of all stakeholders in a deal are aligned, thus ensuring that the companies they invest in are managed in the best interests of the company's management team, the limited partners who invest in the private equity funds, and the private equity fund managers themselves.
The private equity ownership model can be applied to a wide range of company types, sizes, sectors and geographies. The changes that benefit from private equity ownership are also manifold: a change in the scale of a business, a required change in ownership, a change in strategic direction, or a change in the structure and operations of a business. The common factor is that all investee companies have unrealized potential. Private equity investment aims to unlock this potential through specific value creation plans.
Private equity performance is generally measured and evaluated in terms of multiples of the amounts invested, and the internal rate of return (IRR).
The structure of private equity ownership has a number of distinctive characteristics:
- Large universe of target companies;
- Time and resources to study and assess opportunities within industries, and analyze and value the target companies best-positioned to grow and capitalize on the secular trends within those industries, as well as the risks of potential investments and how best to mitigate them;
- Patient and engaged ownership, less concerned with short term performance targets, but vigilant on achieving broader and longer-term value creation in line with an investment thesis and with detailed value creation objectives;
- Ability to modify business plans or change management teams as required in order to achieve objectives;
- Clear accountability between company managers and shareholders, combined with the ultimate objective of a realization, and incentive structures directly linked to tangible value-creation;
- Ability to tap debt markets and include substantial proportions of debt to finance the acquisition of the investee companies.
- Exhaustive pre-investment due diligence process which can translate into higher costs. Encompassing such a vast and unregulated opportunity set as the private company universe requires resources, infrastructure and expertise.
- Longer term results: The average private equity investment cycle leads a significant part of performance to be skewed toward the last years of the life of a fund. Accordingly, fund performance must be assessed over the long term.
- The majority of private equity capital is administered through institutional limited partnership funds, which are highly illiquid, privately negotiated vehicles with very high minimum investment sizes.