Private equity is a special asset class form of equity ownership, as these investments are not exchange traded.
The exam should focus on two forms of private equity: venture capital (VC) and leveraged buyouts (LBO).
Private equity typically requires investors to have a long investment time horizon; therefore institution investors, such as pension funds and endowments, are key players in this asset class.
Sources of Value
The following list represents sources of value from private equity:
- Ability to turn companies around (primarily an LBO driver).
- Ability to obtain better borrowing terms (primarily an LBO driver). Private equity firms with established track records may be able to borrow on better terms than the target company.
- Alignment of interests between the private equity firm and the target company’s management.
- The term sheet states the duties and rights of the private equity firm and the company’s management.
- Term sheet clauses include:
- Tag along, drag along rights.
- Results driven pay packages.
- Earn outs.
- Reserved matters.
- Non-compete agreements.
- Board seats.
Venture Capital (VC) vs. Leveraged Buyouts (LBO)
While both falling under the broad category of “private equity” there are some notable differences between VC and LBO.
Venture Capital (VC)
This private equity approach is associated with providing funding to new companies with high growth potential, often in new and/or high tech industries.
Some VC investment characteristics:
- Unpredictable cash flows.
- Low company asset base.
- Low leverage, primarily equity financed.
- Products and market are often new and not yet established.
- High working capital needs.
- Unseasoned management team.
- Focus on revenue growth.
- The risk/reward tradeoff can be difficult to assess, but a private equity fund typically generates most of its returns from a small number of big successes.
- The general partner typically gets carried interest.
- The exit timing can be difficult to know.
Leveraged Buyouts (LBO)
This private equity approach is associated with the use of high levels of debt financing to obtain a controlling share in an existing publicly traded company. The acquirer would have strong reasons to believe that it can unlock value trapped in the target firm.
Some LBO investment characteristics:
- Consistent cash flows.
- Large company asset base.
- Heavily leveraged.
- Products and markets are usually well established.
- Low working capital needs.
- Veteran management team.
- Focus on profit growth.
- Restructure to reduce costs.
- The risk/reward tradeoff is more easily measured than VC.
- The general partner will receive carried interest, transaction fees, and monitoring fees.
The exit is the manner in which investors recover their capital and returns. It is critical in private equity as the exit value estimate plays heavily into setting investor return expectations.
Private equity exit mechanisms that allow investors to realize value:
- Initial public offering.
- Sale of private equity stake to another investor on the secondary market.
- Management buyout of company.
- Liquidation of the company’s assets.