What is Private Equity? A Complete Guide for Law Students
If you’re applying to and interviewing at private-equity-focused firms, you can expect to be asked questions to test your understanding of what it is, how it works, and the role of lawyers in this sector.
This guide has two primary aims: 1) to provide you with the information you need to excel at interviews with a private equity focus and 2) to teach you about private equity in an easy-to-understand manner. Structured through a series of practice interview questions, you’ll gain an understanding of private equity and learn how to articulate your answers to challenging interview questions.
This guide will also be useful if you are beginning a vacation scheme at one of these firms and want to refresh your memory, or if you want to express an interest in private equity at a general interview, and seek to be able to handle possible follow up interview questions.
For some questions, the points to note will help you to formulate your answer to the interview question, whereas the bonus information is designed to give you additional knowledge about the topic. You wouldn’t be expected to know much of this bonus information, but they may help you to handle follow up questions.
A note on the sample interview answers: these answers should be used as guidance rather than scripted answers. Why? Firstly, the aim of this guide is to teach you about private equity through a series of interview questions, which is why a lot of these answers are far more detailed than you would be expected to give in an interview answer. Second, most points carry across well in text but don’t convey how they should be said in an interview where delivery and tonality is important. Scripted answers are easy to see!
Mock Interview Answers
Interview Question: Why are you interested in private equity?
Points to Note: Private equity accounts for a substantial amount of income for some of the top US law firms in London. Their practice areas are often positioned to service the needs of these private equity clients, whether it’s assisting in the fundraising process, driving the deals, or in supporting clients on an advisory basis.
At these firms, as private equity will account for much of your day-to-day work as a lawyer, a recruiter will want to know: Do you have a genuine interest in this area? Will it excite you in the long term? Is your interest enough to keep you working the demanding hours associated with private equity work?
Equally, as a very lucrative sector, private equity is a core strength of some of the largest firms in London. If you do have an interest in private equity and decide to express that in your application or interview, it is important you are able to express why that is the case.
In these sample answers, we want to interweave your interest with a clear understanding of private equity.
Sample Answer: I am interested in private equity because…
- The clients: I like how private equity clients are unlikely typical corporate clients. Due to the nature of private equity, clients will be experienced in raising funds and completing deals under high pressure and within a short period of time. What this means for me as a lawyer is that I’ll be dealing with smart and sophisticated clients; clients who know what they want and what to expect from their lawyers. I am the kind of person that thrives under this high intensity environment, and I feel working in private equity will push me outside my comfort zone.
- Speed of transactions: I like how private equity moves at a very fast pace. As time plays an important role* in the success of a private equity firm, deals must be completed under a relatively shorter time frame compared to normal corporate transactions. This means I’ll likely be working on a number of deals at any one time and potentially complete more deals than I would normally have the opportunity to in a typical corporate seat. I feel this offers a steeper learning curve, which is important to me in my career, allowing me to develop into a more experienced commercial lawyer.
- Commercial interest: My interest in private equity aligns with why I wanted to be a commercial lawyer in the first place. It’s exciting how private equity firms seek to create value in companies, and invest and acquire businesses at some of the most critical points in their development. I’ll gain a real insight into what makes businesses tick and how they compete in the market to gain a competitive advantage. These deals will also often be crucial for the portfolio companies in their next stage of growth, and it might lead to working on some of the most complex transactional deals I can expect to see.
- Variety: As private equity firms invest in companies across different sectors, geographies and lifecycles, I feel working in private equity will offer a level of variety that I wouldn’t see in other practice areas. I find it exciting how one day I might be working on a deal for a high-growth tech company, while the next may be dealing with issues for a distressed retail business. This will make my day to day to work continuously new and interesting.
Interview Question: What is private equity?
Sample Answer: Private equity is:
- The investment of capital in (usually) private companies in return for an equity stake (shares in the business).
- The way this works is private equity firms raise money from investors* which is pooled into a fund. The fund will identify companies which they believe they can improve, perhaps because they’re fast-growing, in trouble, or not being run in the most efficient way possible. They’ll aim to sell these companies to generate a return for themselves and their investors.
* The investors we are referring to here tend to be institutional investors, which are investors with huge amounts of money to invest, such as insurance companies or pension funds.
Interview Question: What do you think makes private equity unique and different to other funds?
Sample Answer: I think private equity is unique because…
- It’s long term capital: When investors give their money* to a private equity firm, it’s locked up for the long term. With an average lifespan of ten years, investors to a private equity fund lose the ability to invest their money elsewhere. This gives private equity funds the space, time and control to make long-term investments – buying, improving and then selling a variety of portfolio companies. This is why the investors to a private equity fund also tend to be sophisticated.
- Private equity funds are closed: Once investors give their money, they cannot get their money back as and when they demand. Instead, they receive money when the portfolio companies are sold. This is unlike many other types of funds where you can invest or exit when you want.
- Blind pool: While investors may know the broad remit of a private equity fund, they commit capital on a ‘blind pool’ basis, which means they have little say on the individual acquisitions a private equity fund will make.
- High risk/returns: Private equity typically beats most benchmark indices, making it a popular choice for investors like pension funds who seek to allocate a proportion of their assets to funds that can generate a higher return. This comes with risks, however, as investors this is a long-term investment in an illiquid asset class (investors can’t take their money out easily).
Interview Question: What is a private equity fund?
Sample Answer: A fund is…
- A vehicle for a private equity firm to pool together money from investors (together with its own money) and invest in companies.
- Private equity funds are typically set up as limited partnerships, and the investors who invest in private equity funds are called limited partners. They are passive investors, which means they aren’t involved in the day to day running of the fund. In return, they get the benefit of limited liability, which means they are only liable for the money they invested.
- The private equity firm serves as the general partner and is responsible for managing the fund and its investments. The general partner owes duties to the limited partners and, unlike the limited partners, are personally liable for the debts and liabilities of the fund.
- The general partners will contribute a small percentage of their own capital to the fund. This gives them skin in the game, aligning their interests with that of the limited partners, because they are incentivised to achieve returns.
- It is the Limited Partnership Agreement that sets out the relationship between the general partners and limited partners.
- A private equity fund does not receive all the money from investors upfront. Instead, investors will commit to invest a certain amount, the total of which we call committed capital. The private equity fund will then issue capital calls when it needs the money to make purchases.
Interview Question: What is a buyout?
Sample Answer: In the context of private equity, a buyout is…
- Where a private equity firm acquires a controlling stake (over 50% of shares) in a company.
We’re concentrating on buyouts here as, at the firms you’re applying to, these are the kind of investments private equity firms will make. Note, however, that private equity can take different forms and there are a large variety of funds with different strategies and focuses. For example, a venture capital fund will tend to make minority stake investments in small, early stage companies. There are even funds of funds, which are funds that invest in other private equity funds. That way, a private equity investor will have a diversified investment portfolio across multiple funds.
There are also different types of buyouts. If the existing management of a company wants to buy it out with the support of a private equity firm, this is called a management buyout or MBO. If a private equity firm seeks to buy a company and bring in new management, we call this a management buy in or MBI.
We’re most concerned with institutional buyouts, where a private equity firm initiates the buyout.
Interview Question: What is a leveraged buyout?
Sample Answer: A leveraged buyout is…
- Where a private equity firm acquires a controlling stake (over 50% of shares) in a company, using a high proportion of borrowed money (debt).
Again, at many of the top commercial firms, the types of buyouts you can expect to work on will be leveraged.
Because of the high amount of debt being used, private equity firms will want to invest in companies with a strong cash flow. They can then use the cash flow of the company to pay off the interest payments. This does come with risks, but it also has the effect of encouraging management to be efficient and have a better handle of their costs – to be able to service the debt payments.
Even More Bonus Information (don’t worry, you won’t be expected to know this!):
Due to the sums involved, private equity firms may borrow money from a variety of lenders to finance the acquisition. The largest will often be from one or more banks, which is called senior debt. The transaction will be structured in a way that ensures they have priority when it comes to being paid interest. They’ll also often be given security, which gives them the right to repossess assets if the company fails to pay its interest. Junior debt may also be involved, in the form of mezzanine financing or high yield bonds. They are further along the chain when it comes to receiving interest payments and they typically don’t have security over the assets of the company.
Interview Question: Why use leverage?
Sample Answer: Leverage is used because…
- It frees up capital: The private equity firm can use less money from the fund, which therefore frees up capital to purchase other companies.
- Increases the rate of return:
- It has tax benefits: The interest payments on the borrowed money can be netted against the earnings of the company.
Interview Question: How do private equity firms influence the companies they acquire?
Points To Note:
A key distinction between typical M&A deals and private equity transactions comes down to what happens after an acquisition takes place. Private equity firms buy companies with the intention to improve them and then sell them again, typically within three to seven years. To be able to improve the companies they buy, it’s important for private equity firms to have influence over the companies they acquire.
A private equity firm might influence the companies by…
- Acquiring a controlling stake: Private equity firms will seek to buy over 50% (and often 100%) of the shares of the companies they acquire. With this ownership stake, they will have the ability to appoint and remove directors, giving them influence over the running of the company.
- Aligning incentives: Private equity firms tend to give management a compensation plan that gives them an ownership stake in the company. This means the management are incentivised to work with the private equity firm.
- Board approval: Partners from the private equity firm may join the board of the company and/or appoint outside advisers. Importantly, this will give them influence over important decisions, which may require approval of the board – such as selling assets, spending increases etc.
Interview Question: How do private equity firms add value to the companies they acquire?
Points To Note:
Remember, the pitch of private equity firms is that they have the tools, knowledge and resources to buy companies, improve them, and sell them for a greater return.
- Private equity firms undertake substantial research before buying a company. This means they’ll typically have already identified areas for improvement before the acquisition.
- The way they improve the company depends on that particular company; it may be to install new management, restructure the debt of a company, bring in experts to scrutinise the financials of a company and build financial models, invest in new technology, identifying trends and underperforming companies, selling off assets, buy other businesses, improve existing processes and streamlining operations, or leverage more debt.
- Importantly, private equity firms bring in their expertise and relationships, having worked with a substantial number of companies in the past.
Interview Question: How is the success of a private equity fund measured?
Sample Answer: The success of a fund is measured by:
- Its internal rate of return: This is the return on capital generated by a fund over a particular period (minus the fees of the firm).
You don’t need to worry about the calculation of the internal rate of return as it’s complicated, but note that it’s the most important ranking for a private equity fund. Because it’s based on a period of time, this is why private equity firms seek to generate a return and sell a company quickly.
There are other metrics to also measure the success of a fund, but we don’t need to worry about them here.
Interview Question: How do private equity firms make their money?
Sample Answer: Private equity firms make their money through:
- Carried interest: A share of the fund’s net profits (typically 20%) is paid to the general partner.
- Management fee: The limited partners also pay annual management fees (typically 2% of committed capital) to cover the day to day expenses/overheards of the private equity firm.
Carried interest or ‘carry’ is how a private equity firm generates wealth.
The Limited Partnership Agreement will set out how the money is distributed between the general partner and limited partners. Typically, the limited partners receive a minimum rate of return first before the carried interest is paid to the general partner.
Interview Question: What is ‘dry powder’?
Sample Answer: In the context of private equity…
- Dry powder refers to money that has been ‘committed’ by investors but is yet to be invested.
As discussed above, rather than receiving money upfront, a general partner draws down on the money from its investors over the course of a fund, making capital calls as and when it is ready.
You might have seen the phrase ‘dry powder’ frequently referenced in the news. For some time now, private equity firms have accumulated record levels of unspent cash (as of December 2019, this hit $2.5tn across all fund types, according to Bain & Co).