Private Equity Investment Strategies: Where Does The Money Go?

Private equity firms are investment management companies that buy and manage companies before selling them. They invest in private companies or public companies, often in their entirety, with the aim of making a profit. Private equity firms are known for using large amounts of borrowed money to fund purchases, and they typically overhaul the companies they buy to increase their value before selling them again. Private equity firms have a finite term, usually 10 to 12 years, and the money invested in them is locked in for the duration.

Leveraged buyouts (LBOs)

In an LBO, the acquiring company will borrow as much as possible from lenders, typically up to 70-80% of the purchase price, and fund the rest with their own equity. By putting in as little of their own money as possible, PE firms can achieve high returns on equity. Since PE firms are compensated based on their financial returns, the use of leverage in an LBO is critical in achieving their targeted internal rates of return (IRRs), which are typically 20-30% or higher.

While the use of leverage increases potential returns, it also increases risk. The high levels of debt involved in LBOs mean that if cash flow is tight and the company's performance declines, they may be unable to service the debt and will have to restructure, potentially wiping out all returns for the equity sponsor. Therefore, LBOs typically target mature, stable companies with predictable cash flows and low fixed costs. These companies are more likely to be able to service the debt and repay it over time, resulting in a lower effective purchase price.

LBOs have a reputation as a ruthless and predatory business tactic as they often involve strict cost-cutting measures, such as making staff redundant, and can leave the target company with excessive debt, increasing the risk of future bankruptcies.

LBOs are usually held for 5-7 years, after which the company is sold through an initial public offering (IPO) or to a competitor.

Venture capital (VC)

VC funding typically comes from wealthy investors, investment banks, and specialised VC funds. The investment provided is not always financial; it can also be in the form of technical or managerial expertise. VCs usually take an equity position in their target companies, meaning they will ask for a minority stake in exchange for their investment.

VC firms tend to focus on specific industries, such as technology, AI, healthcare, or clean energy. They also tend to focus on particular stages of investment, such as seed, early-stage, or late-stage. Companies in the "seed" stage might only receive a small amount of money from a VC firm, whereas those in the "expansion" phase with consistent and promising growth may receive larger sums.

VC investments are considered riskier than private equity investments as startups without a profitability track record are more likely to fail. However, with this higher risk comes the potential for substantial returns.

Growth capital

Unlike in a buyout, where investors acquire ownership of the target company, growth capital investors typically take a minority stake in the company. They will, however, expect significant influence over how the business deploys the proposed investment and in terms of the ongoing operations of the company.

From the investor's perspective, growth capital can potentially deliver high returns, as a well-executed expansion strategy can take an already profitable company to new heights. This is especially attractive to investors seeking less volatility of returns than those typical in early-stage venture capital investments but still looking for attractive growth profiles.

Recapitalization

There are several reasons why a company may consider recapitalization:

• To defend against a hostile takeover by issuing more debt to make itself less attractive to the potential acquirer.
• To reduce financial obligations and minimize taxes by trading in debt for equity, thus reducing the amount of interest paid to creditors.
• To prevent a drop in share price by swapping equity for debt to push the stock price back up.
• To provide venture capitalists with an exit strategy.
• To reorganize during bankruptcy.

Dividend recapitalizations can offer several benefits:

• Early returns on investment: Private equity firms can realize a portion of their investment value without selling their stake in the portfolio company.
• Improved internal rate of return (IRR): By receiving substantial cash distributions earlier in the investment lifecycle, private equity firms can demonstrate strong performance to their limited partners.
• Potential tax advantages: Dividends are often taxed at a lower rate than capital gains.
• Potential tax shield from increased interest payments: The interest payments on the new debt are typically tax-deductible, creating a potential tax shield on earnings.
• Discipline imposed by debt servicing requirements: The increased debt load creates new financial obligations, encouraging management to focus on operational efficiency and cost control.

However, dividend recapitalizations also come with risks:

• Increased financial risk and leverage: By adding debt to a company's balance sheet, dividend recapitalizations increase the leverage ratio, meaning the company must allocate more cash flow to interest payments and debt repayment.
• Limited future borrowing capacity: Additional debt may exhaust a company's borrowing capacity, constraining its ability to raise capital for future growth opportunities or necessary investments.
• Negative impact on credit ratings: Credit rating agencies often view dividend recapitalizations unfavourably as they increase a company's debt without improving its business prospects.
• Reduced financial flexibility: The increased debt service requirements can reduce a company's financial flexibility, which can be problematic during economic downturns or industry-specific challenges.

Mergers and acquisitions

Private equity firms are involved in mergers and acquisitions (M&A) as they seek to buy, operate, improve, and then sell companies to realise a return on their investment. They are one of the two primary types of acquirers involved in M&A, the other being industrial or trade enterprises.

Private equity firms have a different business model and strategy from industrial or trade enterprises. They are professional investors who buy companies, increase their value over time, and then sell them for a profit. Their goal is to make a smart purchase and then exit with substantial gains. Due to their focus on buying and selling, private equity firms conduct extensive due diligence and take a disciplined and relationship-oriented approach to acquisitions. They also have a finite timeline for acquiring and exiting businesses, unlike industrial buyers who seek permanent ownership and long-term growth.

In M&A deals, private equity firms primarily focus on the financial aspects, such as market potential and the value of the company being acquired. They evaluate market attractiveness, growth potential, and financial health. Their objective is to enhance the target company's market position, revenue growth, and profitability, ultimately generating a favourable return on investment. Private equity firms may also implement operational improvements and cost optimisation strategies to increase the acquired company's value.

Private equity firms play a crucial role in the economy by infusing capital into struggling companies, potentially saving them from bankruptcy and preserving jobs. They have the financial resources and strategic expertise to carry out necessary changes and drive growth. However, private equity firms have also faced criticism for their aggressive cost-cutting measures, such as layoffs and reductions in worker benefits, which can negatively impact employees and local communities.

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