There are four basic things private equity investors do to earn money.
- Raise money from Limited Partners (LPs) like pension and retirement funds, endowments, insurance companies, and wealthy individuals
- Source, diligence, and close deals to acquire companies
- Improve operations, cut costs, and tighten management in their portfolio companies
- Sell portfolio companies (i.e., exit them) at a profit
Let’s look at each of those things in turn.
Private equity firms raise funds by getting capital commitments from external financial institutions (LPs). They also put up some of the their own capital to contribute into the fund (commonly 1-5% but it can be higher). The partners of the firm (the GP) might go on a roadshow themselves to raise the money (as did the partners at the firm I worked at) or they might use a placement agent (an outside fundraising team) to help them do a lot of the legwork.
LPs are usually required to commit a significant amount of capital in order to be allowed to participate in the fund, since the last thing the partners want is to be fielding “support” calls and communications to a “long tail” of many little investors who only commit a small amount but require a lot of hand-holding to service. The ideal fund to a PE firm would be comprised of a handful of LPs that each commit tens or hundreds of millions of dollars, or even billions of dollars, each. Huntsman Gay, the Bain Capital spinout that I worked at, had less than 10 LPs that each committed more than $100M.
If you’re a high net worth individual, the commitment thresholds might be a little lower than a normal LP, but they will likely still be in the millions in order to comply with federal securities laws that basically say you can only sell PE investments to rich people because they are the ones who actually probably know what they are doing.
But even though LPs make a capital commitment, they don’t give all the money to the GP all upfront. Instead, the GP begins to source and close deals, and as those deals need to be funded, they “call capital” from the LPs. LPs then have a very limited window (e.g., 2 weeks) to write a check to the GP so that the GP can fund and close the deal. So committed funds are called “committed capital” while disbursed funds are called “contributed capital.”
Many PE funds have something called “first close” vs. “final close.” First close basically means that when a certain threshold of money has been raised, the PE firm can begin making investments and actually closing deals and new LPs can still join in by committing capital for a limited time (e.g., 1 year from first close). Final close means that when a second threshold has been reach, new LPs can no longer join in on that particular fund.
Sourcing, diligencing, and closing deals
When PE firms analyze companies for potential acquisition, they will consider things like what the company does (their product or service and their strategy for it), the senior management team of the company, the industry the company is in, the company’s financial performance in recent years, and the valuation and likely exit scenarios of the company.
Prospective deals come in to the firm through a combination of the partners’ reputation (in which case companies themselves may reach out to the firm), investment professionals who proactively reach out to potential investment targets through their own networks or through cold calls, or through investment banks that may be representing a company and pitching it to investors through the issuance of bank books or confidential investment memorandums. When investment banks run a process, they often do it through an auction where several private equity firms bid for the company, and firms drop out along the way as their bids are either rejected or accepted to each successive “round” of bidding.
The best way to get deals is through proprietary means because that means the PE firm has an edge against other firms in acquiring the company, either through personal relationships or special knowledge or simply a head start. At Huntsman Gay, there were a few proprietary deals we looked at and closed, and those were definitely the ones we tried to move more quickly on, that didn’t tend to get dragged out in a process, and that were more pleasant to close. To get good proprietary deal flow, the partners of the fund have to build and maintain strong relationships with key people in industry, advisers, and even bankers.
Once a potential deal has been sourced, then the investment team will conduct heavy due diligence to assess the company’s strategy, business model, management team, the industry and market, the financials, the risk factors, and the exit potential. Diligence is typically conducted in stages that correspond to phases of the bidding process, where financial and operational information is progressively revealed to PE firms based on bidders that are still in the running at each phase. If the deal looks promising and no dealbreaker red flags are found, then the investment professionals will present to the investment committee (comprised of partners) for funding approval.
Final terms of the deal with be negotiated with lawyers on both sides, and the deal will transact, with funds being released and equity being traded.
Improving operations, cutting costs, and tightening management
One thing to be very clear on is that the GP does NOT run the portfolio companies on a day to day basis. They are not installing themselves as CEOs and COOs. Instead, they take board seats, they may or may not reshuffle senior management of the company, and they provide advice, support, introductions, etc, relating to operations, strategy, and financial management.
How involved the GP is really depends on how big their stake in the company is. If they only own a small minority stake, then they won’t be very involved; rather, the lead investor owning the biggest stake will be most involved. However, if they own either a sizeable percentage of the equity or a significant portion of the entire fund is invested in the company, then they will be much more highly engaged in streamlining and improving the company for a profitable exit down the line.
The GP must also produce official reports for LPs, generally each quarter, on the progress and value of their portfolio companies, along with general financial updates, and LPs may use that information to mark their own portfolios to market when they report their results to their own investors.
Exiting portfolio companies
The end goal for PE firms is to exit their portfolio companies at a substantial profit. Typically, the exit occurs between 3-7 years after the original investment, but it could be shorter or take longer depending on the strategic circumstances. The main sources of value capture at exit include: growing revenue (and therefore EBITDA) substantially during the holding period, cutting costs and optimizing working capital (and therefore increasing EBITDA), selling the company at a higher multiple than the original acquisition multiple, and paying down debt that was initially used to fund the transaction.
Most exits happen as the result of an IPO or acquisition by another firm, with acquisitions being the more common method. Returns are then measured by the “internal rate of return” (IRR) (which is the discount rate that makes the net present value from the entry date of all cash flows between entry and exit equal zero), or its quicker proxy the “multiple of money” (MoM) which is simply the amount of money returned divided by the amount invested for that particular investment.
Note that the IRR depends on the duration of the holding period while the MoM technically does not (although you will be judged by your investors how long it took to generate that MoM). So, for instance, if a $100M investment is sold for $200M just one year later, the MoM is 2x but the IRR is 100%; if it’s sold after 3 years, the MoM is still 2x but the IRR has fallen to 26%; and it’s sold 5 years later, the MoM is still 2x, but the IRR is 15%.
While partners do a lot of the coordination to sell the firm’s portfolio companies, they may also retain investment banks to handle the execution, especially when the transactions are large or complex. That’s how investment banks earn their fees — on selling the portfolio companies into PE firms and then again on selling them out to downstream acquirers.
Be sure to check out our PDF guide “How to Nail Your Private Equity Interview (whether you have finance training or not)” for in-depth tips and strategies on how to successfully interview for jobs at top private equity firms!
Also be sure to check out our step-by-step Private Equity LBO Modeling Training Videos for walk-through tutorials on how to build an LBO model, navigate Excel with ruthless efficiency, and rapidly create an LBO PowerPoint deck to present to your PE interviewers.