Hello everyone! I wrote this article to demystify the private equity industry and provide more clarity on the basics. It’s a deep dive on the industry, so get ready for an exciting few minutes!
WHAT IS PRIVATE EQUITY (PE)?
• The investment of money into (typically) private companies, in return for an ownership stake in them. We use the word "typically" here because sometimes private equity houses (firms) may invest into public companies before taking them private.
• Unlike public companies, private companies are less in the ‘spotlight’ – they are literally ‘private’ as they face less scrutiny from external regulators such as the FCA or SEC. Additionally, investors in private companies may be able to have more of a ‘say’ in investment decisions as they will often sit on the Board of Directors, which is comprised of fewer people than those sitting within a public company.
• Private equity (PE) firms purchase businesses, make them better, and later sell them for a profit. These investments are called private equity deals. PE firms are responsible for pooling together money/funds from external investors, otherwise known as institutional investors. These institutional investors include insurance companies, pension funds, and sovereign wealth funds, to name a few. Sometimes an investor in a PE deal may very well be another private equity firm – ironic, right!
• There are many different types of equity investments, depending on the lifecycle of the target company (for example, venture capital, growth equity, distressed equity, and so on). Private equity is just one of them. With PE, investment occurs in established companies with a high growth potential. These companies that later fall under the belt of the PE firm are referred to as ‘portfolio companies’. The PE firm works to improve the portfolio companies' overall performance and profitability. This could be through employing strategic hires, cutting down costs, a combination of both, or adopting other profitability drivers.
• The lifecycle of a portfolio company usually lasts 6-10 years, after which the PE firm sells the portfolio company for a profit. This means profit for the PE fund, as well as profit for the institutional investors.
• Now you may be asking, how does the PE firm itself make money in this way? Often times, this could be through making a monetary claim for managing the fund or pulling out some profit before seeking to exit their investments. We will talk more about the ‘2/20 principle’ later.
• Just like any sort of investment, PE investments also give rise to potential risks. For example, plunging money into companies with a high ‘growth potential’ requires that potential to be translated into added value – into profit. Furthermore, the shares the PE firm acquired in the portfolio company will only form into cash once the private company undergoes an IPO (initial public offering) and its shares are visible on a publicly traded stock exchange, such as the NYSE or LSE. We describe private companies in this regard as being less ‘liquid’ than public companies. Sometimes, the PE firm can also sell the portfolio company to another company, or even another PE firm – ironic again, right!
THE DIFFERENCE BETWEEN DEBT AND EQUITY: WHY ARE THEY USED?
• Before answering this question, let’s first address why it is important to know the distinction between debt and equity in the first place. Another way PE firms maximize profit is through using a combination of equity and debt to finance their transactions. Thus, it’s important we unpick these further.
• Equity refers to the money invested in by the PE fund managers (General Partners/GPs) and its investors (Limited Partners/LPs) through the acquisition of shares in the portfolio company. This action gives the PE firm a stake in the business, as well as control rights on how operations are managed.
• Debt refers to a sum of money the PE firm borrows (from a bank, for example) for the purpose of the transaction. We call this a fancy term - ‘leverage’. Now you may be wondering why debt is used. Why would borrowing money be attractive to PE firms when they have to pay it back with interest? Would this not mean that they are losing out more? Funny thing, it’s actually cheaper long-term and less risky. I have included a brief scenario below:
The Operation of Leverage in PE: An Example
Ø Sophie wants to buy a bag for her niece because her birthday is coming up. The bag costs £1000 but she only has £300. The only other option is for her to borrow £700 from a few of her colleagues and friends, so she does this. From this, we have seen that Sophie gets the benefit of buying her niece a bag, where she only contributed £300. The £300 represents the equity, whereas the £700 represents the debt.
Ø Later on, Sophie is sad when her niece gives her back the bag. She says that it is out of fashion, and they all laugh about it. Soon after, Sophie sees on the news that only two copies of this unique bag exist in the world – and she happens to be in possession of one! Sophie screams of joy.
Ø Sophie decides to sell the bag to a trader for £30,000. She also pays back the £700 her friends and colleagues gave her. In return, she makes £29,300 in profit. This is significantly higher than if she initially bought the bag for her niece by herself. In fact, she would not have been able to do this without acquiring debt - without acquiring leverage. The maximisation of profit in this way is referred to as ‘leveraged returns’.
Ø Private equity houses do exactly just that. The only difference is that they move around significantly more assets of a higher value – we’re talking billions and trillions of dollars oftentimes!
• Debt is paid back with interest. As interest rates are the reward for saving and the cost of borrowing, a lower interest rate will mean the portfolio company will pay back less money – vice versa with higher rates. This is why the state of the global economy is a key consideration for PE firms before they contemplate whether to take on additional portfolio companies. It’s also worth noting here that interest payments on debt are tax-deductible. This decreases financial pressures on the target company.
• Where a company is bought using a higher proportion of borrowed money (leverage) than equity, we call this a ‘leveraged buyout’, or an ‘LBO’.
WHAT IS THE 2/20 PRINCIPLE?
• I had mentioned earlier that we will come back to the 2/20 principle. This is to ensure that we go deeper into how fund managers, or GPs, are adequately compensated.
• GPs earn their money through the 2/20 fee structure:
1. The first arm is the 2%. This represents a management fee of the total value of money the PE fund is managing. Remember, this is not a charge on the profits; it is a charge on the money managed and contributes to satisfying operational costs, for example. Let’s say a PE fund manages £10 billion. It will charge 2% of this for every year the fund is under its control, meaning the fund makes £200 million yearly.
2. The second arm is the 20%. This is called the performance fee, or the carried interest, which the GPs earn after the LPs and other investors have received a return on their investment (ROI). After this, the next thing the investors will be paid is the ‘hurdle rate’. This represents the amount of money that was stated to be the ‘preferred return’ (usually 8%) from the PE activity. The 20% performance metric exists to encourage fund managers to prioritise the performance of the portfolio company, as the more profitable the company is, the more money they make. Furthermore, the more money the PE firm makes on a single portfolio company, the more money it can then use to invest in more companies.
THE ROLE OF COMMERCIAL LAWYERS IN A PRIVATE EQUITY DEAL
• Within a law firm, there exists a Private Equity practice area. This will be the main practice area that deals with such transactions. Common features include drafting the fund agreements and negotiating contracts with the LPs, as well as advising on the governance of the fund, including carried interest clauses.
• However, other practice areas get involved too. See below for more specific examples:
• Corporate: Similar to the PE practice, the corporate team advises on the acquisition of the portfolio companies. They also recommend different strategies on the structure of the acquisition, including whether a share or asset purchase should be executed. NOTE: A share purchase is an outright acquisition of the shares of a given company, while an asset purchase allows the cherry-picking of which assets to acquire – usually the profitable divisions of a portfolio company. Due diligence here could also involve investigating any ongoing litigation and the severance of these. Sometimes, the corporate practice in a firm is the PE practice.
• Finance: Provides advice on the debt financing issues associated with the deal. As high amounts of debt are used in an LBO, this is an important role for finance lawyers. They also negotiate loan agreements and security documents with lenders, as well as tackle the restructuring of current debt for the portfolio company after the acquisition.
• Tax: Advises on tax-related concerns for not just the target company, but also the PE fund itself. Where companies are situated around the globe, the Tax team also advises on cross-border tax matters. Further, advice is given on the financing of the leveraged loans, particularly in relation to the interest deductibility of these loans (refer to the debt vs. equity heading above).
• Restructuring and Insolvency: Usually more applicable to distressed private equity deals, where the target company is facing significant financial issues, such as being unable to pay back its debts. Here, the lawyers will advise on debt restructuring and identify growth opportunities to allow the company to continue operating and maximize profit turnover.
This list is not exhaustive, as often Antitrust and Employment practices, among others, get involved as well.
CURRENT TRENDS IN PRIVATE EQUITY
· A Shift in Activity: There is a rise in PE activity among companies that have specialties in retail, healthcare, and technology. SEE AN ARTICLE HERE
· Environmental, Social, and Governance (ESG): ESG becomes a strong consideration for sustainable investing. PE companies are now investing in target companies that pride themselves on having strong ESG credentials. As more regulations are enforced relating to conformity with ESG principles, this becomes a crucial factor on where PE firms decide to put their money in. There are also discussions on the use of Sustainability-Linked Loans (SLLs). With SLLs, terms such as the interest rate are dependent on the borrower (in this case, the target company) meeting specific ESG requirements. Meeting these requirements will decrease the interest accrued on repayment of the loan, whereas a failure to adhere to the targets result in an increase on the interest attached to the loan. SEE AN ARTICLE HERE
· Globalisation: As the world becomes more interconnected and companies with high growth potential set up bases in multiple countries, we witness the increase in cross-border PE deals.
· IPOs: PE firms have been going public. CVC, for example, listed its shares on the Amsterdam Stock Exchange. The reason was simple – to get permanent capital to fund their expansion.
· Shifting Dynamics: Discussions on the possibility of shareholders getting a claim to management fees are on the rise. This revolutionises the 2/20 principle. SEE AN ARTICLE HERE
PRIVATE EQUITY: INTERVIEW PREPARATION
All the points above are great foundational knowledge for interviews. I have included a list of non-exhaustive but common interview questions below. Some questions go outside the scope of what has been covered in this guide, so a fantastic opportunity to test your research skills!
· What is private equity?
· What is debt and equity? What are the differences between the two?
· Explain the 2/20 fee structure.
· Describe and analyse current trends in the private equity sector.
· What do lawyers do in a private equity deal?
· In line with the last question, what departments of a law firm are involved in a private equity deal from start to finish, as well as post-exit? Is this only the private equity practice area?
· Why is debt used?
· How does private equity differ from other forms of investment, such as venture capital?
· How do private equity firms create value?
· How do you think the private equity industry will change in the next decade and why?
· Why are you drawn to exploring the private equity practice of our firm further? (NOTE: This question will require you to go in-depth on the intricacies of your passions/work experiences and why they align with PE work. Furthermore, it will require you to explore what exactly it is about the specific firm’s PE practice that appeals to you).
CONCLUSIONS
This concludes our basic guide to private equity. For more in-depth insights, feel free to check out TCLA’s PE course!
WHAT IS PRIVATE EQUITY (PE)?
• The investment of money into (typically) private companies, in return for an ownership stake in them. We use the word "typically" here because sometimes private equity houses (firms) may invest into public companies before taking them private.
• Unlike public companies, private companies are less in the ‘spotlight’ – they are literally ‘private’ as they face less scrutiny from external regulators such as the FCA or SEC. Additionally, investors in private companies may be able to have more of a ‘say’ in investment decisions as they will often sit on the Board of Directors, which is comprised of fewer people than those sitting within a public company.
• Private equity (PE) firms purchase businesses, make them better, and later sell them for a profit. These investments are called private equity deals. PE firms are responsible for pooling together money/funds from external investors, otherwise known as institutional investors. These institutional investors include insurance companies, pension funds, and sovereign wealth funds, to name a few. Sometimes an investor in a PE deal may very well be another private equity firm – ironic, right!
• There are many different types of equity investments, depending on the lifecycle of the target company (for example, venture capital, growth equity, distressed equity, and so on). Private equity is just one of them. With PE, investment occurs in established companies with a high growth potential. These companies that later fall under the belt of the PE firm are referred to as ‘portfolio companies’. The PE firm works to improve the portfolio companies' overall performance and profitability. This could be through employing strategic hires, cutting down costs, a combination of both, or adopting other profitability drivers.
• The lifecycle of a portfolio company usually lasts 6-10 years, after which the PE firm sells the portfolio company for a profit. This means profit for the PE fund, as well as profit for the institutional investors.
• Now you may be asking, how does the PE firm itself make money in this way? Often times, this could be through making a monetary claim for managing the fund or pulling out some profit before seeking to exit their investments. We will talk more about the ‘2/20 principle’ later.
• Just like any sort of investment, PE investments also give rise to potential risks. For example, plunging money into companies with a high ‘growth potential’ requires that potential to be translated into added value – into profit. Furthermore, the shares the PE firm acquired in the portfolio company will only form into cash once the private company undergoes an IPO (initial public offering) and its shares are visible on a publicly traded stock exchange, such as the NYSE or LSE. We describe private companies in this regard as being less ‘liquid’ than public companies. Sometimes, the PE firm can also sell the portfolio company to another company, or even another PE firm – ironic again, right!
THE DIFFERENCE BETWEEN DEBT AND EQUITY: WHY ARE THEY USED?
• Before answering this question, let’s first address why it is important to know the distinction between debt and equity in the first place. Another way PE firms maximize profit is through using a combination of equity and debt to finance their transactions. Thus, it’s important we unpick these further.
• Equity refers to the money invested in by the PE fund managers (General Partners/GPs) and its investors (Limited Partners/LPs) through the acquisition of shares in the portfolio company. This action gives the PE firm a stake in the business, as well as control rights on how operations are managed.
• Debt refers to a sum of money the PE firm borrows (from a bank, for example) for the purpose of the transaction. We call this a fancy term - ‘leverage’. Now you may be wondering why debt is used. Why would borrowing money be attractive to PE firms when they have to pay it back with interest? Would this not mean that they are losing out more? Funny thing, it’s actually cheaper long-term and less risky. I have included a brief scenario below:
The Operation of Leverage in PE: An Example
Ø Sophie wants to buy a bag for her niece because her birthday is coming up. The bag costs £1000 but she only has £300. The only other option is for her to borrow £700 from a few of her colleagues and friends, so she does this. From this, we have seen that Sophie gets the benefit of buying her niece a bag, where she only contributed £300. The £300 represents the equity, whereas the £700 represents the debt.
Ø Later on, Sophie is sad when her niece gives her back the bag. She says that it is out of fashion, and they all laugh about it. Soon after, Sophie sees on the news that only two copies of this unique bag exist in the world – and she happens to be in possession of one! Sophie screams of joy.
Ø Sophie decides to sell the bag to a trader for £30,000. She also pays back the £700 her friends and colleagues gave her. In return, she makes £29,300 in profit. This is significantly higher than if she initially bought the bag for her niece by herself. In fact, she would not have been able to do this without acquiring debt - without acquiring leverage. The maximisation of profit in this way is referred to as ‘leveraged returns’.
Ø Private equity houses do exactly just that. The only difference is that they move around significantly more assets of a higher value – we’re talking billions and trillions of dollars oftentimes!
• Debt is paid back with interest. As interest rates are the reward for saving and the cost of borrowing, a lower interest rate will mean the portfolio company will pay back less money – vice versa with higher rates. This is why the state of the global economy is a key consideration for PE firms before they contemplate whether to take on additional portfolio companies. It’s also worth noting here that interest payments on debt are tax-deductible. This decreases financial pressures on the target company.
• Where a company is bought using a higher proportion of borrowed money (leverage) than equity, we call this a ‘leveraged buyout’, or an ‘LBO’.
WHAT IS THE 2/20 PRINCIPLE?
• I had mentioned earlier that we will come back to the 2/20 principle. This is to ensure that we go deeper into how fund managers, or GPs, are adequately compensated.
• GPs earn their money through the 2/20 fee structure:
1. The first arm is the 2%. This represents a management fee of the total value of money the PE fund is managing. Remember, this is not a charge on the profits; it is a charge on the money managed and contributes to satisfying operational costs, for example. Let’s say a PE fund manages £10 billion. It will charge 2% of this for every year the fund is under its control, meaning the fund makes £200 million yearly.
2. The second arm is the 20%. This is called the performance fee, or the carried interest, which the GPs earn after the LPs and other investors have received a return on their investment (ROI). After this, the next thing the investors will be paid is the ‘hurdle rate’. This represents the amount of money that was stated to be the ‘preferred return’ (usually 8%) from the PE activity. The 20% performance metric exists to encourage fund managers to prioritise the performance of the portfolio company, as the more profitable the company is, the more money they make. Furthermore, the more money the PE firm makes on a single portfolio company, the more money it can then use to invest in more companies.
THE ROLE OF COMMERCIAL LAWYERS IN A PRIVATE EQUITY DEAL
• Within a law firm, there exists a Private Equity practice area. This will be the main practice area that deals with such transactions. Common features include drafting the fund agreements and negotiating contracts with the LPs, as well as advising on the governance of the fund, including carried interest clauses.
• However, other practice areas get involved too. See below for more specific examples:
• Corporate: Similar to the PE practice, the corporate team advises on the acquisition of the portfolio companies. They also recommend different strategies on the structure of the acquisition, including whether a share or asset purchase should be executed. NOTE: A share purchase is an outright acquisition of the shares of a given company, while an asset purchase allows the cherry-picking of which assets to acquire – usually the profitable divisions of a portfolio company. Due diligence here could also involve investigating any ongoing litigation and the severance of these. Sometimes, the corporate practice in a firm is the PE practice.
• Finance: Provides advice on the debt financing issues associated with the deal. As high amounts of debt are used in an LBO, this is an important role for finance lawyers. They also negotiate loan agreements and security documents with lenders, as well as tackle the restructuring of current debt for the portfolio company after the acquisition.
• Tax: Advises on tax-related concerns for not just the target company, but also the PE fund itself. Where companies are situated around the globe, the Tax team also advises on cross-border tax matters. Further, advice is given on the financing of the leveraged loans, particularly in relation to the interest deductibility of these loans (refer to the debt vs. equity heading above).
• Restructuring and Insolvency: Usually more applicable to distressed private equity deals, where the target company is facing significant financial issues, such as being unable to pay back its debts. Here, the lawyers will advise on debt restructuring and identify growth opportunities to allow the company to continue operating and maximize profit turnover.
This list is not exhaustive, as often Antitrust and Employment practices, among others, get involved as well.
CURRENT TRENDS IN PRIVATE EQUITY
· A Shift in Activity: There is a rise in PE activity among companies that have specialties in retail, healthcare, and technology. SEE AN ARTICLE HERE
· Environmental, Social, and Governance (ESG): ESG becomes a strong consideration for sustainable investing. PE companies are now investing in target companies that pride themselves on having strong ESG credentials. As more regulations are enforced relating to conformity with ESG principles, this becomes a crucial factor on where PE firms decide to put their money in. There are also discussions on the use of Sustainability-Linked Loans (SLLs). With SLLs, terms such as the interest rate are dependent on the borrower (in this case, the target company) meeting specific ESG requirements. Meeting these requirements will decrease the interest accrued on repayment of the loan, whereas a failure to adhere to the targets result in an increase on the interest attached to the loan. SEE AN ARTICLE HERE
· Globalisation: As the world becomes more interconnected and companies with high growth potential set up bases in multiple countries, we witness the increase in cross-border PE deals.
· IPOs: PE firms have been going public. CVC, for example, listed its shares on the Amsterdam Stock Exchange. The reason was simple – to get permanent capital to fund their expansion.
· Shifting Dynamics: Discussions on the possibility of shareholders getting a claim to management fees are on the rise. This revolutionises the 2/20 principle. SEE AN ARTICLE HERE
PRIVATE EQUITY: INTERVIEW PREPARATION
All the points above are great foundational knowledge for interviews. I have included a list of non-exhaustive but common interview questions below. Some questions go outside the scope of what has been covered in this guide, so a fantastic opportunity to test your research skills!
· What is private equity?
· What is debt and equity? What are the differences between the two?
· Explain the 2/20 fee structure.
· Describe and analyse current trends in the private equity sector.
· What do lawyers do in a private equity deal?
· In line with the last question, what departments of a law firm are involved in a private equity deal from start to finish, as well as post-exit? Is this only the private equity practice area?
· Why is debt used?
· How does private equity differ from other forms of investment, such as venture capital?
· How do private equity firms create value?
· How do you think the private equity industry will change in the next decade and why?
· Why are you drawn to exploring the private equity practice of our firm further? (NOTE: This question will require you to go in-depth on the intricacies of your passions/work experiences and why they align with PE work. Furthermore, it will require you to explore what exactly it is about the specific firm’s PE practice that appeals to you).
CONCLUSIONS
This concludes our basic guide to private equity. For more in-depth insights, feel free to check out TCLA’s PE course!
