Private Equity 101

Since the inception of this blog, I have been talking about Investment Banking. But what about the other areas of “high finance” – IB’s cousin Private Equity and the distant relative called Hedge Funds? So today, let’s go pay a visit to that rich cousin whom IB envies – PE.

This is the second post in Bateman Begins 101 Series and will introduce you to the little-known world of Private Equity. You can get the definition of PE from anywhere, but below you will find out what actually happens in PE, why it is considered to be “better” than IB and most importantly, why it is so bloody difficult to break in.

So without further ado, introducing Private Equity – the promised land. What even investment bankers dream of.

Private Equity = Wealth Management?

‘Private Equity’ simply put, refers to money (i.e., equity) privately held by individuals and institutions. These individuals and institutions pool their money into a fund which makes investments on their behalf. Remember when you used to pool your money with your friends to go buy that expensive toy? Yeah, this is pretty much the same thing – except that these people buy whole companies instead of toys.

So how is it different from wealth management, you might ask. Well, fundamentally, even private equity is money management. But the difference is, while traditional wealth management works by investing money into stocks and mutual funds, private equity firms buy out entire companies or a major stake in them.

The money factor:

Just like people, there is no shortage of companies who always need more money. It may be because they have fallen into financial troubles, or because they are doing well and looking to expand. Due to various reasons which I will explain in another post, sometimes obtaining funding from banks is not feasible or even possible. That’s when private equity firms step in.

PE firms are always on the lookout for companies to invest in. Even then, there is a huge gap between the number of companies they analyse versus the number of companies they actually invest in. Since they go only for what seem to be a sure-shot thing, very few PE firms fail.

A crucial factor is the kind of return they earn on their investment. There is a barometer called “Return Multiple”, which means the number of times your original investment gets multiplied when you get it back. To my knowledge, a standard 5-year PE deal generates an eye-popping return multiple of 4x at the minimum. It has been known to go up to 15-20x in the best deals, and a return of 8x is not uncommon. Because of such high level of returns, even if one deal goes bad, there is enough cushion to keep the fund going.

PE – A relationship or a marriage?

Careful readers might have noticed above that a standard PE deal is of 5 years. In India, they vary between periods of 5-10 years. This is a vital difference between PE and traditional wealth management – the investor can withdraw his money from a money manager any time he wants; while in PE, his money is locked in for extended periods of time. Moreover, sometimes the fund’s own corpus is also invested into the deals. This is what made one analyst I interviewed compare PE to a marriage and IB to a relationship.

So why doesn’t everybody invest money into PE instead of speculating on the stock market? In poker terms, “the buy-in” is too large for most but the very wealthiest of all. Well known fund managers can, in fact, be selective about who they admit as an investor. Indeed, a common saying among PE analysts is that our goal is to be on the other side of the table, that is, to be the investor. That would be the end all, be all achievement!

Breaking into Private Equity:

But why is it so difficult to break into PE? Most IB analysts do a 2-year stint with their eyes set on breaking into the buy side. What makes PE so special? More often than not, it comes down to money. Yes, the answer is that anti-climactic. Very few people want to move to PE because of the actual role it offers. Since manpower requirement in PE is very low, the astronomical returns also mean more money left over to pay out to employees. A win-win for everyone.

So this was an overview of how Private Equity works. In the coming posts, I’ll talk about how a typical deal works, some more interesting details on money in PE and also, life as a PE analyst!