Guide to Private Equity

Private equity is a well-established source of medium- to long-term finance provided in return for an equity stake. Private equity firms mainly invest in private businesses but will sometimes acquire stock exchange-listed companies in ‘public to private’ buyouts. For some companies, private equity offers an alternative to a stock exchange listing.

Shareholders may seek private equity investment to realise value in their business through a partial sale, to exit the business entirely, or to buy out other shareholders. Management teams may use private equity to buy out a company from the current owners or to buy into a business that the current owners wish to sell.

Private equity firms work closely with the management teams of the companies they own. Their aim is to improve operations and performance before realising their investment through a stock market flotation or a sale to a trade buyer or another private equity investor, typically after a three to five year investment period.

Private equity-backed companies have been shown to outperform their peers in terms of both growth rate and profitability. Research commissioned by the British Venture Capital Association and the London Stock Exchange showed that companies backed by private equity and venture capital firms outperformed their peers.

Not every company is suitable for private equity investment. In general, suitable companies will:

• operate in a predictable market
• hold competitive advantages
• benefit from barriers to entry
• offer a proprietary product and / or service
• show historic (and forecast) positive revenue and profit growth
• possess a culture of cost control
• be cash-generative

The management team

Private equity investors know that success depends on the quality of the management team that will run the business. The management team needs to demonstrate its experience and competence as well as motivation, commitment and drive, reliability, vision and judgment. The entire team must support the new strategy and operate as one to make it succeed.

Management buyouts or buy-ins are often structured so that managers are asked to invest a relatively small amount initially, but can see the value of their investment grow rapidly if the company thrives. This is usually achieved through debt finance – known as ‘gearing’. Some of the funding for the acquisition is borrowed from a bank and is repaid out of the business’s cash flow, increasing the value of the shares as the loans are paid off. At the same time, the equity element subscribed to by the private equity investor usually includes redeemable funding in the form of loan notes or preference shares.  These are repaid over the long term, either from cash flow or through a refinancing or when the business is sold. Commonly the management team will not purchase loan notes, or will purchase fewer in proportion to ordinary equity, which has the effect of further enhancing the management equity return on successful exit.

For further information on this topic, see ‘The role of management’.

The buyout process

Private equity buyouts usually take place through an auction. A typical process runs as follows:

i) After a strategic review by the vendor, an investment memorandum (IM) is sent to likely private equity buyers. Interested buyers prepare first round bids based on the IM, information they derive from external sources and their own market knowledge. They also respond to the vendor’s ‘due diligence’ questionnaire.

ii) A small number of bidders (usually between three and five) is invited to proceed. They conduct due diligence on the business and its management team. They may be invited to meet the management team at this point, or there may be an additional round of bidding before bidders are invited to attend management presentations and access additional information in a secure ‘data room’ environment.

iii) Either exclusivity will be granted to one bidder, or more than one bidder may be invited to proceed, resulting in a ‘contract race’ to completion.

The company’s existing management are usually not allowed to bid in their own right. They will be 'policed' by advisers to ensure that they do not talk directly to bidders other than in formal presentations. During this phase, the management team may wish to keep as close as possible to the progress of the auction through formal and informal channels, prepare their own business plan, and find out about the aims of different private equity firms so that they are prepared to enter into alliances as and when necessary.

The period immediately after completion is crucial. This is the time when the new owners and the management team must establish a good working relationship. As the new investors await the first set of management accounts, the management team will focus on providing the right information and on ensuring that there are no surprises. The private equity firm will want to build a relationship with the wider company and learn more about the business.

The private equity firm will appoint a non-executive chairman, and sometimes other non-executive directors, to the company’s board. Although the management team runs the business, the private equity firm will provide support and advice at board level. Some private equity firms focus largely on mergers and acquisitions advice and on supporting the business at exit. Those that add value by contributing at an operational level employ investment executives with an industrial background and are more involved on a day-to-day basis.

Post-acquisition, the executive team’s sights will be set firmly on an ‘exit event’ some three to five years ahead. At exit, the private equity fund and the management team will realise their investment in the business, which will then move on to the next phase of its evolution under new owners, either through a stock market flotation, or a sale to another company or private equity invester.