Private Equity (PE) is an investment business, where the firms get involved in collecting high-net-worth funds while searching for businesses to invest. The capital collected from outside vendors is used to buy companies, improve their operational efficiency, and then sell them for profit after the hold period. The businesses may be start-ups and well-established corporates as well. Private equity investment is a high-risk venture with heavy returns.
The investment deals in the private equity association are mainly of three kinds. They are –
• Provide funding for small and new businesses – venture capital
• Acquires a large number of shares or control – buyouts
• Invests in establishing new industrial trends or government regulations – special situations
The investment process in a private equity firm takes several months to a year or more. The processes are more structured and may vary according to the transaction process, targets, or the PE firm. Here is a quick note on the common steps involved in an investment process starting from sourcing to deal closure.
The private equity investment process
Private equity professionals are involved in raising funds, sourcing, diligence, closing of deals, improving operations, and selling portfolio companies for a profit. Let’s have a brief note on each of them.
Fundraising
PE firms are backed by various sources like Limited Partners which includes pension funds, insurance companies, endowments, government bodies, banks, and high net worth individuals. The PE firms that have raised funds would aggressively look for new investment deal opportunities.
They also invest their capital (General Partners) into the fund. Generally, it would be 1-5%. General Partners might conduct a roadshow to raise money or hire placement agents to do the groundwork.
Dealing with an investment opportunity
Sourcing for investment opportunities is difficult and is one of the primary skills required to earn a private equity job. A deal is generally sourced through internal analysis, research, cold-calling executives of target companies, meeting companies, and networking.
Further, the PE professionals may screen company databases for specific criteria, attend industry conferences, and involve in conversations with experts. A few of the PE firms may hire investment banks as intermediaries to sell businesses.
The PE professionals analyze the minimum EBTIDA, equity check, industrial vertical, and potential value creation strategy while searching for potential opportunities.
When the PE firms get interested with the prospect, they move forward by signing a Non-Disclosure Agreement (NDA). Upon signing, the PE firm receives a Confidential Information Memorandum (from intermediary or directly from the target company if sourced) which possesses an investment thesis, financials, projections, and capital structure.
Further, the investment team will conduct heavy due diligence and access to the company’s–
• Strategy
• Business model
• Management team
• Industry and market
• Financials
• Risk factors
• Exit potential
Then the investment team prepares an investment proposal and submits it to the committee. Also, they submit a bidding or non-binding letter of intent. When the deal seems to be promising without deal-breaker red flags, then the PE professionals submit for funding approval from the final investment committee. The final terms of the deal get negotiated with lawyers on both sides and they sign transaction documents and contracts. A Purchase Agreement or Merger Agreement and other related documents will get signed by the participating parties.
Improving operations of the portfolio companies
The General Partners take the board seat of their portfolio companies. They may reshuffle senior management (not always), provide advice and support for strategy, operations, and financial management. They produce quarterly official reports and financial updates to Limited partners regarding the progress and value of their portfolio companies.
Exiting from portfolio companies
The end goal for a PE firm is to exit their portfolio companies by selling them for a substantial profit. The exit occurs somewhere in between 3-7 years after the original investment. The value capture here includes growing revenue during the holding period, cutting costs, and optimizing working capital. They sell the company for higher multiples, repay debt, and divide among Limited partners and General partners. Most exits happen due to IPO or acquisition by another firm.
Final thoughts
The process from researching the potential opportunity to exiting the portfolio companies remains the same for almost all verticals while the due diligence process may vary a little. Though the process is lengthy and exhausting, it is rewarding and worth the investment.
With a trillion of funds under management, PE firms are attractive investment vehicles for investors. PE professionals are usually successful in increasing the value of their portfolio companies and deals.