Sunday 24 March 2013

Private Equity: The Inside Story

In the previous post on Private Equity, I provided an overview of what the industry is all about. But for those interested in knowing the minutiae of how a PE firm operates, this post will satisfy their queries. It is a gloves off, no-holds-barred post which will tell you all about the internal workings of a Private Equity firm.

Fair warning: Hold on to your horses, folks. This one is gonna get technical. In case you do proceed, make sure to read to the end - that's where you'll find the best part.

So what really happens in Private Equity? Let’s take a small journey, starting from the birth of a PE firm to the end of one deal, to understand what takes place in this secretive world.

Organization Structure – Nearly all PE firms are organized in two parts, the first of which is the “Fund”. For tax reasons, the Fund is usually located in an overseas tax haven like Mauritius or Singapore. The investors’ money is held by this overseas fund and all returns are diverted there to take advantage of the minimal tax rates in these countries (hence called “tax havens”). The Fund stays behind the curtains and only the senior-most people in the PE firm know its details.

The second part is called the “Management Company”, which is where all the action takes place. It is the face of the organization and all the employees of the PE firm will be registered its name. For all intents and purposes, the Management Company represents the Private Equity firm.

In short, the “Management Company” manages the money and the “Fund” holds the money.

Deal origination – The birth of the idea of a deal, sometimes called “sourcing the deal”. A deal can be sourced in two ways:
  • A company is in need of money and approaches a PE firm for funding. 
  • The PE firm comes across a hotshot upcoming company and approaches the latter to provide funding for growth and expansion.
As you might expect, in the first scenario, the PE firm is in the driver seat and will be in a position to dictate terms. This is especially applicable when the company in question is in a distressed position.

In the latter case, many times multiple PE firms are competing at the same time to grab the deal, leaving the company blushing like a pretty princess. This happens when the company’s prospects are so strong that a lot of ‘suitors’ are vying for the company’s hand. Inevitably, the deal goes to the PE firm which is able to provide the most attractive terms.

From here-on-out, all the following steps proceed in tandem and there is a fair bit of overlapping among them.

Teaser – The private equity equivalent of a movie trailer. Need I explain more?
The trailer will give a glimpse of the company and its business, expected growth, funds required and, the part most important to investors, the expected return.

Due Diligence (DD) – Once the deal is sourced, the PE firm combs through the books of the company to check if everything is in order. This is when the company’s claim of “projected growth at 80%” is put to test. The firm will verify and try to validate all projections and will also be on the lookout for any legal issues that might crop up in the future.

Financial Model – The staple of most analysts. If you don’t know what a financial model is, you need to read THIS.

Information Memorandum (IM) – If the Teaser is a movie trailer, IM is the movie. As the name indicates, the IM contains all the relevant details about the company and the deal itself. That is to say, the IM will provide insights into the company’s business, its history, an industry overview, a transaction overview (explaining how the transaction will be structured), investment highlights (advantages) and risks and mitigants (disadvantages).

Apart from these, there will be a host of legal documents involved – Term Sheets (similar to ‘Terms and Conditions’ – just as long and just as boring, but far more important), security and collaterals, share pledge documents and other papers with similarly boring names. Personally, I find this legal documentation part incredibly boring. Good thing almost all of it is outsourced to the lawyers.

So once all these documents have been finalized (after anywhere between 30 – 100 iterations), signed and executed, the funding is released and the deal is said to be “closed”.  There is only one thing that causes more of a celebration among the fund managers than a closed deal, but we’ll come to that in a bit.

Keeping track of big fat wads of money:
Now once the deal is closed, what happens next? Do the fund managers just lie back and count their big fat wads of money while they look for more cash cows? Well, depends.

The firm needs to keep track of how the company they invested in is performing. The company needs to send periodic reports to the firm, which contain its financial and operational details. As long as the company is performing well and is keeping up with, or even better, beating its projections, most fund managers are content with keeping their involvement restricted to a quarterly meeting. But there are some micro managers who take a more hands-on approach and get involved in overseeing the company’s operations either personally or via a consultant.

However, it’s when the company is not performing so well that the tensions start building up again. The PE firm will bring on consultants to help the company turn around their operations and if even that fails, the fund starts withdrawing its money. If you thought banks were stingy in lending out money, the terms on which PE firms provide money will make you cringe.

Earning the big fat wads of money:
And now we come to the interesting part. A typical PE deal in India is of 5 to 7 years.  So let’s talk about how the fund and its investors earn money during this period.

Typically, the terms of the deal provide that the investee company will pay a certain cash return to the investor on an annual basis, apart from the return of principal at the end of the deal tenure. This repayment of principal is called as the ‘exit’ in industry terms and is generally accompanied by a ‘terminal equity stake’ in the investee company. If the value of the company has increased significantly during the deal period, the exit can result in a windfall gain for the investor.

The Fund:
Most PE firms follow the 2/20 rule – a 2% annual management fees on the investment size and a 20% share in the profits resulting from the deal.

Say the investment size is USD 50 million. This means, the fund will earn an amount of 2% on $50 million on an annual basis – that’s free money to the tune of $1 million every year.

Now the minimum threshold return multiple on any PE deal is about 3x. That means a profit of 200% on the original investment amount, which is $100 million. And the fund will get 20% of this profit, which comes to a cool $20 million. Remember when I said only one thing makes fund managers happier than a closed deal? Now you know what I was talking about.

Compare this to the money earned by investment banks – they charge a fee of 2-10% of the deal size plus an annual retainer and sometimes, an equity stake. There is no astronomical profit to share – only the management fees. And that explains the mad rush of investment bankers to switch to the buy-side.

So there you have it. Now you know everything there is to know about the Private Equity industry. In case you are wondering why the PE guys charge so much, it’s because although the concept of what they do sounds simple, it’s the implementation of this concept that takes some brains.

So go back out there, network your bum off, land and crack those PE interviews and come back to tell the story. Amen!


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