How Does the Private Equity Market Work?
I’m trying to better understand the private equity market. How do private equity firms operate, source deals, and structure investments? What are the key mechanisms that drive value creation, and how do they differ from public markets or venture capital? Would love to hear experiences and insights from professionals in the field or those who’ve been part of private equity transactions!
7 comments
Private equity market is comprised of private equity firms and private investment sources such as HNWI, family planning offices, institutions.
Think of them like a few steps further along than VC’s. Typically VC’s are buying potential and emerging businesses. More often than not PE are buying established business.
The PE firms employees create a value thesis for a certain vertical. They create a “fund” to allocate capital towards an investment thesis. Within the fund they are the general partner responsible for making investments. They also put up their own money. For the rest of the money in the fund, they raise money from those investment sources (family offices etc.) and they are known as limited partners. A single firm can operate one or many funds depending on size and investment strategy.
So a Firm, starts a fund comprising of itself as a General partner, and fundraise from limited partners.
The firm then looks for investment opportunities with a 3-10 year horizon to exit. So they basically buy a bunch of companies that match their investment thesis, improve them in some way or extract value from them and then sell the results to either another fund or to a private source or eventually IPO.
In the pre-purchase phase the firm is assessing investment opportunities and doing their due dilligence to decide if the target company is a good buy or not, they’re also working with banks to structure the capital needed for purchase and fundraising with the limited partners.
Post acquisition the purchased company is now a “portfolio company” and Firm appointed management team is responsible for executing the value creation plan they set out in their investment thesis. If the existing management were good they could be the same people as pre acquisition or they could be entirely new.
Lets look at an example.
Say within a given US state there are several dentists. Each one alone is run by the practicing dentists and they have to pay for all of their supplies.
A private equity fund thinks they can run the business parts of this better. They buy 10 dental practices and now they can negotiate bulk with providers. They can centralise the business process and software and auxiliary staff. Now it only costs 7 dental practices worth of capital to effectively run 10 practices via synergies from being able to centralise a bunch of systems and negotiate in bulk.
Later they sell the entire dentistry group for a profit.
That’s the basic idea, there are obviously nuances at every step.
Think of them like a few steps further along than VC’s. Typically VC’s are buying potential and emerging businesses. More often than not PE are buying established business.
The PE firms employees create a value thesis for a certain vertical. They create a “fund” to allocate capital towards an investment thesis. Within the fund they are the general partner responsible for making investments. They also put up their own money. For the rest of the money in the fund, they raise money from those investment sources (family offices etc.) and they are known as limited partners. A single firm can operate one or many funds depending on size and investment strategy.
So a Firm, starts a fund comprising of itself as a General partner, and fundraise from limited partners.
The firm then looks for investment opportunities with a 3-10 year horizon to exit. So they basically buy a bunch of companies that match their investment thesis, improve them in some way or extract value from them and then sell the results to either another fund or to a private source or eventually IPO.
In the pre-purchase phase the firm is assessing investment opportunities and doing their due dilligence to decide if the target company is a good buy or not, they’re also working with banks to structure the capital needed for purchase and fundraising with the limited partners.
Post acquisition the purchased company is now a “portfolio company” and Firm appointed management team is responsible for executing the value creation plan they set out in their investment thesis. If the existing management were good they could be the same people as pre acquisition or they could be entirely new.
Lets look at an example.
Say within a given US state there are several dentists. Each one alone is run by the practicing dentists and they have to pay for all of their supplies.
A private equity fund thinks they can run the business parts of this better. They buy 10 dental practices and now they can negotiate bulk with providers. They can centralise the business process and software and auxiliary staff. Now it only costs 7 dental practices worth of capital to effectively run 10 practices via synergies from being able to centralise a bunch of systems and negotiate in bulk.
Later they sell the entire dentistry group for a profit.
That’s the basic idea, there are obviously nuances at every step.
Just want to highlight this portion:
> or extract value from them
"Only costing 7 dental practices' worth of capital to effectively run 10 practices" is the idealized vision for what PE can and wants to do.
In practice, what ends up happening is extracting value by financial maneuvers like directing the companies they own to sell off assets, but charging a transaction fee so the PE group gets a cut of the sales. Or by owning a company and being its largest creditor -- getting to discharge liabilities as the owner by declaring bankruptcy but subsequently still maintaining control over the company as its largest creditor. [0] (Ctrl+f for "Sun Capital" in the page).
Disclaimer: I am an employee of a firm that was somewhat recently acquired by private equity.
[0]: https://www.ineteconomics.org/perspectives/blog/private-equi...
> or extract value from them
"Only costing 7 dental practices' worth of capital to effectively run 10 practices" is the idealized vision for what PE can and wants to do.
In practice, what ends up happening is extracting value by financial maneuvers like directing the companies they own to sell off assets, but charging a transaction fee so the PE group gets a cut of the sales. Or by owning a company and being its largest creditor -- getting to discharge liabilities as the owner by declaring bankruptcy but subsequently still maintaining control over the company as its largest creditor. [0] (Ctrl+f for "Sun Capital" in the page).
Disclaimer: I am an employee of a firm that was somewhat recently acquired by private equity.
[0]: https://www.ineteconomics.org/perspectives/blog/private-equi...
I'm curious how this actually works. If it were that easy to buy a company, bankrupt it, and somehow make money selling it off again why wouldn't everyone do that instead of going through the trouble of operating the business? It doesn't make sense why selling capital equipment would pay for the acquisition, when almost every business trades over book value. Loading it with debt and paying the PE firm a fee doesn't sound like it would cover the cost of acquisition, either.
A lot is said on the internet of the practice of loading companies with debt, but done within reason this is the financially responsible thing to do. There's even a financial theory that debt provides a disciplining effect on management[0], meaning that the management of companies with reasonable debt levels are less likely to take on unfavorable risks and more likely to find returns above the WACC.
The point of leverage is that it increases returns. Here's a really good example of that in the context of real estate, where leverage almost doubles the IRR. [1]
[0]https://www.jstor.org/stable/1818789
[1]https://www.youtube.com/watch?v=ocnMZDp52zA&list=PLyyvHNlYa0...
A lot is said on the internet of the practice of loading companies with debt, but done within reason this is the financially responsible thing to do. There's even a financial theory that debt provides a disciplining effect on management[0], meaning that the management of companies with reasonable debt levels are less likely to take on unfavorable risks and more likely to find returns above the WACC.
The point of leverage is that it increases returns. Here's a really good example of that in the context of real estate, where leverage almost doubles the IRR. [1]
[0]https://www.jstor.org/stable/1818789
[1]https://www.youtube.com/watch?v=ocnMZDp52zA&list=PLyyvHNlYa0...
They “sell” stuff to closely held entities and then lease them back. The principals take a vig from everything.
It’s not always an objective for the target company to go bankrupt, but if they do, the management has already pulled their money out. A company I worked for was a cash cow used to borrow and buy 3 other companies. The combined entity grew due to some growth hack stuff and one-shots, then got acquired. The PE boys made a lot of money, and the company itself was pretty much toast after the second acquisition.
It’s not always an objective for the target company to go bankrupt, but if they do, the management has already pulled their money out. A company I worked for was a cash cow used to borrow and buy 3 other companies. The combined entity grew due to some growth hack stuff and one-shots, then got acquired. The PE boys made a lot of money, and the company itself was pretty much toast after the second acquisition.
Thanks I appreciate the clarification. You're referring to a leaseback, right? From the research I've done, I've mostly seen it happen in the context of real estate, e.g. with Darden when Starboard Value took over [0]. I think the rebuttals to management on slide 38.
What I wonder about this is in cases where the real estate is spun off into a REIT, does the original company keep shares in the REIT, or are transactions like this purely for one-time raising capital?
[0]https://www.sec.gov/Archives/edgar/data/940944/0000921895140...
What I wonder about this is in cases where the real estate is spun off into a REIT, does the original company keep shares in the REIT, or are transactions like this purely for one-time raising capital?
[0]https://www.sec.gov/Archives/edgar/data/940944/0000921895140...
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