Private Equity: An Industry Under Siege

First, what is private equity and how big is this sector in the overall financial industry?

Private equity and venture capital firms have been around for decades now. First venture capital funds were created in the 1960s in the US while leveraged buyout firms came around during the 1980s and Kohlberg Kravis Roberts & Co. (KKR) with its leader Henry Kravis were the creators of this type of investing.

Venture capital (VC) and private equity (PE) is about investing in privately owned companies. Both VCs and PE firms are similar and the only difference is that firms that tend to invest in early stage companies are known as VCs while private equity investing tends to be focused on larger, more established businesses. PE firms tend to use more varied financial structures because unlike VC funds, they do not necessarily focus on investing in growth. They can easily buyout out some small shareholders if the company is well-managed and wait until the business goes public for example.

VCs on the other hand tend to focus on innovation and the best example is in Silicon Valley in California which has been a breeding ground for technology companies. Intel, Google, Apple and Oracle. You name the tech giant and its there, in Silicon Valley. There are at least several reasons why there has been so much success.

US is the leader in research and development (R&D) in the world in many areas. Protection of intellectual property rights has been one important reason why there has been success in this area, but while this is all well and good there are many other countries in the world that have invested millions in R&D, few have been as successful in uniting the VCs and engineers/scientists as Silicon Valley and a few other areas.

Silicon Valley has been such an awesome breeding ground due to talent in the science and engineering area, and proliferation of entrepreneurship, management skill and venture capital funding for monetization of technologies. The scientist, the manager and the VC came together and decided that they can't live without each other so the best thing to do is to join forces and make a company out of the resources that each one can contribute. They were lucky to have these elements as each one is rare in many other parts of the world.

Venture capitalists and PE funds are sophisticated investors. They are professional investors that look at hundreds and even thousands of investment opportunities per year and invest in just a few companies where they believe they can make money. Typically the PE fund will look for an exit after a period of time (normally 3-5 years) in order to return the money back to his investors, the Limited Partners.

The exit is normally carried out via an IPO or a sale of the company to a strategic buyer but other options exist. If the company goes bust, investors may have a preference to get their money first before the other shareholders do while small investors who have a difficulty in exiting alone may be able to sell their shares back to the company or to another existing shareholder in the business.

So what is the business model? Who pays the VC or PE team to do all the work?

The model is relatively simple. Investors called the Limited Partners put up money which is invested by the investment team at the fund. The PE fund is normally lead by prominent investors or businessmen who put up their own money alongside the LPs. LPs however pay typically a 2% commission on the funds they put up per year to the PE fund that basically helps support ongoing expenses related to management, salaries, office expenses etc. The other part known as carry, is a percentage (normally 20%) that is paid from the profit above a hurdle rate (normally 8%) to the PE firm by LPs.

So basically if you have a fund with $100 million that you raised from LPs, your fund gets $2M per year and 20% of any profits from investments you make. A good business model if you can raise the funds and find the good deals. Typically LPs are either high net worth individuals or they are institutional investors like pension funds and insurance companies. If the PE fund performs badly, LPs will not want to invest in the next fund of course.

The industry has been growing enormously over the past decades. Many industries have been growing and privately owned companies have allowed PE investors to make returns over and above what they could have made in the public equity markets or in other asset classes.

To give you a sense how big the industry really is, just take a look at the US figures. In 2007, in US alone, $475 billion was invested by PE firms. That is half a trillion dollars, a truly enormous figure by any means. To name a few big deals done in 2007-2008, private equity firms have been involved in deals to buyout Chrysler LLC, utility TXU Corp., Equity Office Properties, radio station owner Clear Channel Communications Inc. and eye-care products maker Bausch & Lomb Inc. 2000 PE firms are operating today, again only in the US and with another $450 billion ready to invest.¹

Despite the growth and previous successes however PE firms have faced troubles as many other companies in the US. Bigger firms used a lot of leverage or debt to finance deals which has now become much more expensive. Other private equity firms have struggled due to financial difficulties of their investors. Entire institutions have collapsed like Lehman Brothers and this has made raising new money extremely difficult. Without new money, PE funds cannot survive and this has lead to many disappearing from the private equity landscape. Those that did manage to raise substantial funds before the crisis, like Warburg Pincus for example have done well. They have the ability to invest at lower valuations and wait until the crisis is over to do some exits and raise the next fund.

So what we have at the end of the day is the fact that private equity funds have been affected differently. Those that managed to raise large funds just before the crisis did best while others had to tighten their belts and survive. Permira for example let its investors reduce their commitments, understanding that it is difficult to fund new investments during these hard times.

There is no doubt that when the crisis is over, new private equity and VC businesses will emerge with new money to invest in well-managed businesses.

^{1 - The Associated Press http://www.google.com/hostednews/ap/article/ALeqM5hwfKBjiDN5OH6-upSoy-zUI70VoQD9AAB8B80}