What Is Private Equity? - African Business Magazine
What Is Private Equity?

What Is Private Equity?

At its simplest form, ‘private equity’ is investing in shares in companies that are not ‘public’, which means they are not listed for trading on a stock exchange. Typically this could be smaller and faster-growing companies than the more mature listed companies, and private equity firms are hunting for better returns than they could get on stock markets.

Since the beginning of taking stakes in business ventures, most investors have been private equity investors, who would initially have been wealthy individuals, families and merchant banks. The origins of institutional private equity can be traced to the first venture capital firms founded in the US in 1946. Private equity soared to prominence in the US as a major arm of professional finance in the last 30–40 years. Leading private equity firms now control global empires as big as the largest listed companies. US firms such as Blackstone and KKR would rank in the top 20 of giant companies listed by Fortune magazine, and UK firm CVC was recently was described as having a global portfolio of 53 companies with more than 400,000 employees and revenues of more than €80bn.

Giant global private equity is driven by borrowing money and buying companies in ‘leveraged buyouts’, of which the first in the US were probably two deals in 1955.

In the 1960s and 1970s, several firms, including Kohlberg Kravis Roberts and Thomas H. Lee Partners, started buying portfolios of equity assets. Morgan Stanley launched two ‘Leveraged Equity’ funds in 1985 and 1987, although modern labels such as ‘private equity’ and ‘alternative assets’ usually do not mention debt. The peak of the boom came in 2006 and 2007, before the global financial crisis; in 2006 private equity firms bought 654 US companies for $375bn. In 2007 investor commitments to 415 funds totalled $302bn, but in 2010 the total value of funds raised (closed) was $225bn, a six-year low.

Private equity investors typically invest in a huge range of opportunities. ‘Angel’ investors might back start-up companies and businesses still in the development stages. ‘Venture capitalists’ look for adventure in high-growth new business and ‘technology ventures’ and are credited with much of the innovation and growth of recent decades.

Private equity could also include buying and taking control of companies in distress and aiming to turn them around or buying companies listed on a stock exchange and delisting them (making them ‘private’) and restructuring. This pressure may push performance among managers even of giant companies, as a private equity firm would swoop in and try to take over as soon as it thought it could do a better job. ‘Management buyouts’ or ‘leveraged buyouts’ involve debt involve taking control from existing shareholders and radical restructuring backed with debt or other leverage.

Growth capital model

In Africa, much private equity usually follows a ‘growth capital’ model. The investor buys shares in a company with a good track record and opportunities for growth and then helps it through the next growth stage.

The company may be already relatively mature and its next stage of growth could be expanding or restructuring its operations, entering new markets, for instance, into another African country or developing new lines of business, or acquiring another business.

The private equity investor might back existing management with a shareholding of some 20%–30%, rather than taking control. However, they may link their investment to a range of ‘restrictive covenants’ – depending on how desperate the investee company was for the money – and these could include the right to fire management if they do not meet agreed annual business growth targets.

Profits for private equity investors come primarily from the difference between the price at which they buy the investment and the price at which they exit or sell, as well as returns in dividends, asset disposals or other revenues.

For substantial growth in the value of an investment, a private equity investor may have to wait three to five years. Typical exits could involve selling the shares to a rival company or strategic buyer (merger or acquisition) or to another investor looking for investments with a different size or risk profile. Private equity investors could sell the shares back to the management or other shareholders. Where there is a developed capital market, the exit could include through a listing or initial public offer, followed by selling equity via the stock exchange. In order to see growth in the investment, private equity investors might take a stronger role in the management of the investee companies than an investor in listed companies. The private equity firm could take board seats, and make its investment conditional on achieving some strategic change and bring strategic partnerships.

One of the strengths of private equity in Africa, where many companies are expanding and skilled management with relevant experience is in short supply, is that private equity investors should bring ‘money and management’, including new strategic thinking, introductions to new markets or partners and more effective ways of operating.

The institutional industry largely works on a model developed in the US in the 1960s. A specialist private equity fund manager, known as a General Partner (GP) or alternatively ‘private equity firm’ or ‘financial sponsor’ puts together a proposed fund (often a limited partnership) which it hopes to manage. Institutional and wealthy investors who are persuaded to become passive investors in the fund are often termed Limited Partners (LPs) and it can take up to two years to raise a fund. The GPs may invest a portion of their own capital alongside the LPs, and their revenues include an annual management fee (2% or so) and a ‘carry’, a disproportionate share (say 20%) of the extra annual return over an agreed hurdle rate.

Typically private equity investments are illiquid, and an LP may expect to sit in a fund investment for up to 10 years until the fund managers have sold or exited the fund’s equity investments and the fund is closed and proceeds given to investors. 

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Written by African Business Magazine

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