Private Equity: Understanding Payouts And Returns

Private equity firms buy and sell companies, but how do they pay out their investors? Private equity funds are generally not open to small investors, and are instead backed by large institutional investors such as pension funds, sovereign wealth funds, endowments, and very wealthy individuals. These funds are managed by private equity firms, which use both investors' contributions and borrowed money.

Private equity firms receive a small percentage of a company's total assets as a management fee, typically 2% of assets, and a cut of the resulting profit from the sale of the company, usually 20%. This compensation scheme is called two-and-twenty. Even if a portfolio company is unprofitable, the private equity firm still makes some money.

Private equity firms can also increase their returns through dividend recapitalization, where a private company takes on more debt to pay a special dividend to private investors or shareholders. This can be detrimental to the company, as it increases the risk of bankruptcy if the debt cannot be paid back.

Dividend recapitalization

A dividend recapitalization is when a private equity firm issues new debt to raise money to pay a special dividend to the investors who helped fund the initial purchase of the portfolio company. The dividend reduces risk for the PE firm by providing early and immediate returns to shareholders, but it increases debt for the portfolio company.

Despite the benefits, dividend recapitalization can be dangerous for the company undergoing the process. As a company increases its leverage, there is a higher probability of defaulting on its financial obligations, which may ultimately lead to bankruptcy. Because of this increased financial risk, creditors and shareholders who are not entitled to receive a special dividend generally do not favor the practice. It leaves the company more vulnerable to unforeseen business problems and adverse market conditions. In addition, the company's credit rating may decrease.

Leveraged buyouts

LBOs have a reputation for being ruthless and predatory because the target company's assets can be used as leverage against it, and the acquiring company can purchase a much larger company while only leveraging a small portion of its assets. The high debt burden can lead to situations where the acquired company becomes over-leveraged and unable to generate sufficient cash flow to service its debt, resulting in insolvency or debt-to-equity swaps where the original owners lose control.

There are four main LBO scenarios:

• The repackaging plan: A private equity company uses leveraged loans to take a public company private, makes adjustments, and then returns it to the market through an initial public offering (IPO).
• The split-up: The acquiring company purchases a target company and then sells off its different units, dismantling the acquired company. This scenario often involves massive layoffs and is considered predatory.
• The portfolio plan: A company uses leverage to acquire a competitor or any company where it can achieve synergies from the acquisition. This plan is risky, as the return on invested capital must exceed the cost of acquisition for it to be successful.
• The savior plan: Management and employees borrow money to save a failing company. While well-intentioned, this scenario often arrives too late and has a low likelihood of success unless significant changes are made.

LBOs can have both positive and negative effects, depending on the perspective. They can save companies from failure and generate fees for private equity firms, but they can also lead to massive layoffs and asset sell-offs if the acquired company becomes over-leveraged.

Venture capital

VC firms receive returns on their investments when a portfolio company is acquired by another company or goes public through an initial public offering (IPO). The process by which VCs realise their returns is called an "exit", and there are several exit strategies available to them. One common exit strategy is to sell their holdings to new investors during later funding rounds, which takes place in the private equity secondary market. Another strategy is for the VC firm to sell its shares in the open marketplace following an IPO, although there is usually a lock-up period during which insiders are not allowed to sell their shares. A third option is for another firm to acquire the investee company, either as a strategic buyer interested in the company's growth and technology or as a financial buyer.

VC firms typically gain ownership of a percentage of the business in exchange for their investment. They generally purchase no more than 50% of the company, allowing them to diversify their investments across multiple companies to spread out the risk. When profits are distributed or the company is sold, the VC firm receives a percentage of the total profits or sale price equivalent to their ownership stake. For example, if a VC firm invests $250,000 for a 15% equity stake and the company is later acquired for $10 million, the firm would receive a payout of $1.5 million.

VC investments are usually long-term and illiquid, with a time horizon of around 10 years. This structural time lag increases the liquidity risk, so VC investments tend to offer very high prospective returns to compensate for this higher-than-normal risk.

Private equity crowdfunding

Private equity investments typically payout through the sale of the acquired company, which is often sold to another private equity firm. Private equity firms buy and manage companies with the goal of overhauling them to increase their value before selling them for a profit. This process can involve making operational improvements, cost-cutting, restructuring, or saddling the company with debt.

In private equity crowdfunding, investors can get started by investing small amounts, usually around $1000, although some platforms offer investments as low as $50. The process is simple and convenient, as everything is done online. Investors can browse funding portal websites to view and choose from a range of investment options. There are some restrictions, such as a minimum age of 18 and limits on investment amounts based on an individual's net worth and income.

Exchange-traded funds

ETFs are made up of a basket of underlying securities, such as stocks, bonds, currencies, debts, futures contracts, and/or commodities. Shareholders of an ETF indirectly own the assets of the fund and are entitled to a share of the profits, such as interest or dividends. They also have a claim on any residual value if the fund is liquidated.

ETFs are priced continuously throughout the trading day and, therefore, have price transparency. They can be bought and sold at any time during the trading day, unlike mutual funds, which can only be traded at the end of the day.

There are many different types of ETFs, including:

• Stock ETFs: These are baskets of stocks that track a single industry or sector.
• Industry or sector ETFs: These focus on a specific sector or industry, such as energy or financial services.
• Commodity ETFs: These invest in commodities like gold or crude oil.
• Currency ETFs: These track the performance of currency pairs.
• Bitcoin or crypto ETFs: These provide exposure to cryptocurrencies like Bitcoin or Ethereum.
• Inverse ETFs: These allow investors to profit from stock declines by shorting stocks.
• Leveraged ETFs: These seek to return multiples of the returns of the underlying investments.

ETFs typically have lower fees than other types of funds. They are also more tax-efficient than mutual funds as most buying and selling occur through an exchange, reducing tax costs.

Frequently asked questions