Private Equity – an introduction

Optional reading
 AG912 Special Friday lecture 19th October 2018

Source: compiled from information in exhibit 14.30, p.589, in Arnold (2012)

Private Equity is a collective name given to private investment of medium- to long-term finance
invested in companies not quoted on any stock exchange to profit from their growth. The term
covers a variety of approaches and specialisms, such as investing in start-up companies to investing
in management buyouts, see above graphic.

Usually private equity takes the form of a fund with General partners (GPs) and Limited partners
(LPs), broadly speaking the GPs act as the fund managers and earn management fees (usually 1–2.5
%) and bonuses known as the carried interest (the carry) when certain performance conditions have
been met.

Source: compiled from information in exhibit 14.31, p.592, in Arnold (2012)

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 AG912 Special Friday lecture 19th October 2018

Many private equity funds are established as limited liability partnerships (LLP) for a fixed period of
time, commonly 10 to 12 years. In the investment (set-up) phase GPs set investment strategy &
goals, seek potential investors (the LPs). The raising of money from LPs for investment in companies
of interest can have several stages and those investing at first close may be given different
conditions to those investing at the final close. The private equity fund then invests the money
raised, often over up to 5 years, and usually limit exposure to any one investment to less than 10 per
cent of the fund. A private equity fund may borrow additional money to invest and may allow Co-
investing, where an LP may invest their own money alongside the equity fund in a company.

Source: compiled from information at http://www.celent.com/system/files/privateequity.gif

Investments are held typically for three to five years, occasionally longer. Only when the investee
company is sold or floated on a stock exchange do the investors in the fund receive any return on
their investment, sometimes the only exit option is liquidation, resulting in a loss. Potential exit
routes include:

- repurchase
- secondary/tertiary/quaternary buyouts
- trade sale
- going public
- liquidation

Receiving investment from a private equity fund can be positive for the investee company, since
they get not only much needed funds but also usually benefit from the expertise of the private
equity fund. The experience, however, is not always positive and regulators have for instance probed
conflicts of interest and high fees charged by fund managers to the investee companies.1

1
See: Financial Times 14 July 2014 “A fee too far”
https://search.proquest.com/docview/1552999456/fulltext/CED69241DF384EF6PQ/1?accountid=14116

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 AG912 Special Friday lecture 19th October 2018

More recently, and particularly since the financial crisis, private equity firms have also started to
enter the market for corporate debt by providing loans to companies rather than becoming
shareholders/owners of them. As many small and medium sized companies have found it difficult to
access loans from banks, private equity funds have filled this gap.

It is difficult for individual investors to achieve the same returns as private-equity funds, but now
indices using public shares to track the asset class have been developed. DSC Quantitative Group, a
Chicago-based fund, and State Street, an asset manager, both offer “investable” indices, launched in
2014 and 2015 respectively, that allow investors to mimic the performance of American private
equity.2

You can get information about current developments in private equity for example from these
sources:

Blumenthal, A. (2017) “How Does Private Equity Create Value?”, Yale Insights, available at:
https://insights.som.yale.edu/insights/how-does-private-equity-create-value

EY (2018) 2018 Global Private Equity Survey, available at:

PWC (2018) Private Equity Trend Report 2018, available at:

Schelling, C. (2017) “Private Equity’s Indisputable Problem”, Institutional Investor, available

Whyte, A. (2018) “More Money, More Problems for Private Capital”, Institutional Investor,
available at: https://www.institutionalinvestor.com/article/b16xkjd0rypzlt/more-money,-
more-problems-for-private-capital

In case you are interested, there is a private equity firm right here in Glasgow*:

Maven Capital Partners UK LLP

* This is only an example, not an endorsement of this company!

2
See: The Economist Aug 24th 2017 “Private-equity returns can be replicated with public shares”
https://www.economist.com/finance-and-economics/2017/08/24/private-equity-returns-can-be-replicated-
with-public-shares

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 AG912 Special Friday lecture 19th October 2018

Further reading (optional):

British Private Equity & Venture Capital Association http://www.bvca.co.uk/

European Private Equity & Venture Capital Association http://www.evca.eu/

Barber, F., and M. Goold (2007) “The Strategic Secret of Private Equity”, Harvard Business Review,
September issue, pp.53-115. Available at: https://hbr.org/2007/09/the-strategic-secret-of-private-
equity

Davidoff Solomon, S. (2009) ‘The Failure of Private Equity’, Southern California Law Review 82(3),
pp.481-546. Available at: http://lawreview.usc.edu/issues/past/view/download/?id=1000451

Damodaran, A. (2008) ‘The Anatomy of an LBO: Leverage, Control and Value’, New York University -
Stern School of Business working paper. Available at: http://ssrn.com/abstract=1162862

Fang, L.H., Ivashina, V., and Lerner, J. (2014) ‘The Disintermediation of Financial Markets: Direct
Investing in Private Equity’, Journal of Financial Economics 116(1), pp. 160-178. Available at:
https://doi.org/10.1016/j.jfineco.2014.12.002

Higson, C., and Stucke, R. (2012) ‘The Performance of Private Equity’, London Business School
working paper. Available at: http://ssrn.com/abstract=2009067

Jensen, M.C. (2007) ‘The Economic Case for Private Equity (and Some Concerns)’, Harvard NOM
Working Paper No. 07-02. Available at: http://ssrn.com/abstract=963530