Private Equity Explained

This article will give a detailed insight into private equity. It’ll start with a definition, then go over how they make money, some common investing strategies, and lastly career options in the industry. This will cover the work hours, salary, and skills, to help you decide if it might be a good career fit for you.

Private Equity Defined

What exactly is private equity? Private equity funds raise money from outside investors and use the money to acquire companies, taking a hands-on approach to improve their business, and then in 5 to 10 years’ time, to resell them, hopefully, at a profit.

It’s called private equity because the companies these funds invest in are not publicly traded, or sometimes they are but the fund has the goal of making them private. Essentially, a private company is usually just owned by a limited number of people like its founders and early investors, while a public company has gone through an initial public offering, known as an IPO, and anybody can become an owner by buying shares through a broker.

If you take a macro view, when looking at the different asset classes, private equity falls into the alternative investments category, so the same bucket as hedge funds, real estate etc. It isn’t an area that most people would invest their money in, it’s usually just for industry professionals. Investors typically include pension funds, insurance companies, endowments, and high net worth individuals.

High Risk Investment

In terms of risk levels, as with many alternative investments, because improving a business is not easy, it’s regarded as relatively high risk, and as consequence investors expect high returns. It’s also regarded as risky since it’s an illiquid investment. Liquidity is a measure of how easily something can be converted into cash. Among the most liquid assets are stocks of big companies, where you can just ask your broker to sell them, and you get the cash. On the other hand, an example of the most illiquid is real estate, where it can take years to sell a house, there’s a lot of legal work exchange of contract and several parties involved. Private equity is seen as illiquid as well because you’re investing in projects that last 5 to 10 years and you can’t cash out before that period.

Industry Reputation

You may be aware that private equity sometimes gets a bad reputation. This is because optimizing a business often involves cutting costs, and among the biggest costs in companies are salaries. This means that sometimes they resort to laying off a large number of employees, explaining why private equity funds are sometimes viewed negatively. Another reason is that they’re not in there for the long run, as they aim to maximize their returns in a 5-to-10-year period, and then sell. This means that private equity investors are not necessarily concerned about what happens to the company after they sell, which can sometimes result in them being overly aggressive in order to achieve a short-term profit at the expense of the long term.

How They Make Money?

Private equity funds usually make their money through a combination of a management fee and a performance fee.

The industry standard is known for using the "2+20" rule. The rule can be explain by parts below.

• 2% management fee. This is a fixed fee paid to the private equity company regardless of performance, so even if the fund is losing money, they still get 2%. This fixed fee is usually used to pay for employees, technology, office, and other administration costs.
• 20% performance fee. This fee is unlocked once the investment is sold for a profit. If the fund doesn’t make a profit from the investment, then there’s no performance fee. Hence there is a strong incentive for these funds to generate as much value as possible.

Overall, the bigger the fund, the more exaggerated this becomes. A 2% management fee doesn’t seem that much if you have $10million under management, but if you have$10billion under management that’s $200million just in management fees alone.

Depending on the reputation of the fund, the fee structure will vary. For example, top funds could have a 3+30 model, or lesser funds could follow a 1+15 structure.

Investing Strategies

Within private equity, most funds specialize in certain investing strategies. As you can imagine, investing in a small startup is not the same as a company with 500employees. In this section, we will look at 3 of the most popular private equity investing strategies with regards to the investment size, return range, control, and examples of companies.

Venture Capital – The smallest investment size, mainly because the investments are in start-ups. Basically, the goal here is to hit a homerun, so get massive returns over a long period, for example until an IPO. Ownership here is minority, so they don’t have control of the business. Examples of the big venture capitals are Sequoia and Andreessen Horowitz, and they’re primarily in California.

Growth Equity – This is larger and focused on companies that are more established than startups, but still have a high growth rate. Essentially, it’s the middle ground between venture capital and Leverage Buyouts. Transactions are in the $25-100 million range, and a homerun is not really the goal anymore, but rather returns in the 30% region. Ownership here is between minority and a controlling position, so they already have some influence on the business. Some examples of growth private companies include General Atlantic and TA Associates.

Leverage Buyouts – Also known as LBO, this involves acquiring another company using a large portion of debt to finance the acquisition. Typically, around 80% of the purchase price is done through debt. This is usually done in the context of taking a public company private, so the amounts are typically above the $100 million mark and the fund has full control of what they do with the company.

The reason LBOs are so attractive for private equity funds is because they use little equity, and a huge amount in debt, which translates to really high returns, because say over 5 to 10 years, the company is able to pay off the debt and with it the equity returns increase, and so does the overall valuation as the company is growing. Going back to the fee structure, this is how they can maximize their performance fees. This is also very risky, because the company may not be able to pay back all of the debt in time, so that’s why when looking for LBO candidates, private equity funds look for companies with stable cash flows in order to be able to pay back the debt. When it comes to companies with this kind of strategy, the largest private equity funds out there are Blackstone and KKR.

There are many other strategies, for example distressed companies or real estate, but these three are the most popular.  

Careers

When it comes to careers in private equity, the traditional approach is to work at an investment bank or a management consulting firm for 2 to 4 years, and then make the switch to private equity. A huge number of the investment banking analysts hope to make the transition into private equity because the hours are slightly better, the pay is higher, and many people see the job as more interesting since you look at a company more strategically.

Having 2 to 4 years’ experience is typical, but there are a growing number of private equity funds that have internships, as well as first year positions (so those with no experience).

Hours - In terms of hours, it’s around 60 to 70 hours work per week, which is a slight improvement on the 80 hours a week you can expect at an investment bank, or the 70 hours a week at a management consultancy.

Skills - When it comes to the skills required, financial modelling is probably the most important, as well as business strategy in order to understand how a business model can be optimized. Lastly, communication is key, especially when talking with the management team at the company you’re trying to influence.  

Pay - You can expect to earn around $130,000 in base salary in the USA. The big part here is the bonus, which can more than double your base salary depending on your performance and that of your team. In total, the salary can reach over $300,000 with the bonus. These figures are for the top private equity funds in the USA. Also keep in mind that they’re not entry level roles, people in these positions usually have about 2 to 4 years of work experience.

Additional Resources

If you want to further develop your technical skills to be a stronger candidate for private equity roles, take a look at our Excel for Business & Finance Course, our Complete Finance & Valuation Course and more using the get started button below.

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