Have you ever taken an ancestry test with Ancestry.com? Have you ever visited Sea World or Movie World in Queensland? Have you ever shopped at Toys “R” Us? Have you flown with Virgin Australia?
Although seemingly very different, the brands mentioned above have one crucial thing in common: they are all owned by private equity (PE) firms.
What is private equity?
Private equity is a form of investment partnership whereby a (private equity) firm provides capital to private companies (businesses that are not publicly traded). Private Equity funds usually receive an ownership stake in the investee company in return for the capital.
Where do private equity firms receive their funding from?
The core source of a Private Equity fund’s funding is the fund’s investors/clients. These investors are usually high-net-worth individuals, family offices, or large financial institutions such as superannuation funds, sovereign wealth funds, and other Private Equity firms.
Private equity fund managers operate the fund and complete transactions on behalf of its investors/clients.
How does Private Equity create value?
Private equity funds are designed to create significant value for all parties involved in a PE transaction.
PE firms provide large sums of capital to the investee company. Investee companies typically utilise the capital supplied by Private Equity firms to capitalise on unique growth opportunities (including acquisition) or return the business to profitability (i.e., a turnaround).
PE funds also provide strategy consulting to the management team of the investee companies within its portfolio. The advice provided by the fund is designed to improve profitability and accelerate growth within the investee company.
Private equity investors in Private Equity funds also derive value from investing with private capital partners. Private Equity managers possess Merger & Acquisition (M&E) expertise and resources that PE investors typically need to have.
For instance, private equity funds can collect larger pools of capital than individual investors. This capital allows capital partners to make larger acquisitions and investments than individual private equity investors. Furthermore, PE firms can use this capital to make a more significant number of investments. It allows capital partners to diversify their portfolios across multiple sectors and businesses. This diversity protects the PE firms’ portfolio against the poor performance of an individual company or sector.
How do funds receive a return on investment?
Funds commonly profit from their investment through two forms of return. Firstly, through dividends generated from profitable investments. Secondly, by increasing the value of the acquired company and realise a return through a sale or initial public offering.
Private equity is classified as an alternative investment. Private equity and other alternative investments are considered higher risk than traditional asset classes, such as stocks and bonds. As a result, firms require a higher investment return to compensate for the risk assumed.
To ensure adequate returns are achieved, Private Equity funds often take an active management role in their investee companies – or hire a team of professionals who work closely with senior management teams to help improve profitability and accelerate growth.
As a result, some private equity funds focus on specific sectors or a specific theme where fund managers have a level of expertise. For example, Carlyle Group focuses on investments in the aerospace, defence and government services sectors, whereas Blackstone leans toward investments in real estate, infrastructure, insurance and credit.
Private Equity investment strategies
Private Equity firms often adhere to a mix of investment strategies. Strategies include:
Leveraged Buyouts (LBOs)
LBOs fall under the broader “Private Equity Buyouts” umbrella, whereby a Private Equity fund acquires a controlling stake in a private company. In the case of an LBO, the Private Equity fund secures debt to acquire the controlling stake.
This strategy aims to improve the company’s operations and financial performance and resell the company at a higher value.
Growth Capital Partners are private equity funds that provide capital to an already profitable company to accelerate growth or expand operations into new markets.
Turnaround Investors are private equity funds that acquire underperforming businesses to turn them around and resell them at a higher price in the future.
Distressed Investing is where the private equity fund invests in a company facing bankruptcy, intending to return the business to profitability.
Venture Capital firms invest in early-stage businesses with high growth potential.
General Partner (GP) Stakes
GP Stakes is an investment strategy that is gaining traction at the moment. A GP Stake is where a Private Equity firm takes a minority, non-controlling stake in another Private Equity firm. Typically, the acquiring firm’s position will be non-strategic and passive.
Investing in an industry peer allows the firm to gain exposure to the investee’s entire balance sheet instead of an individual investment or fund. The investor is granted access to the investee’s revenue generated from management fees as opposed to the returns generated by the appreciation of an individual fund.
The added level of diversification ultimately makes this strategy attractive to the investor fund. It exposes them to a broader portfolio of companies, industries, themes, and even investment strategies than what would be available in an individual fund.
This strategy also benefits the investee firm as the acquisition capital provides liquidity, allowing the investee to back up new initiatives.
According to the Australian Investment Council yearbook, in 2022, the Private Equity market remained Australia’s dominant private capital market (including Private Debt, Real Estate etc.) with $42.2 billion in assets under management. It represents approximately one-third of total private capital markets. Over the past five years, the Private Equity market in Australia has grown, on average, at 11% annually. The aggregate deal value reached $20.1 billion in 2022 (an increase of 32% on the prior year).
Private Equity “dry powder” (cash or liquid securities held in reserve and ready to be deployed) is estimated to stand at $10 billion (as of September 2021), which is 11% lower than the prior year. This trend is often a sign that Private Equity firms have sufficient avenues to invest in.
The largest Australia-focused fund raised in recent years (from 2016-2022) was raised by BGH Capital (BGH Capital Fund II), which raised $3.6 billion in March of 2022.
In recent years, the largest completed Australian buyout was a public-to-private purchase of Vocus Communications (a fibre and network solutions provider). The acquisition was made by a consortium consisting of Macquarie Infrastructure and Real Assets and superfund Aware Super for $3.5 billion in February of 2021.
International private equity firms have also completed notable buyouts of local businesses recently, including KKR’s buyout of Probe Group for $1.1 billion and Blackstone’s all-cash takeover of Crown Resorts for $6.3 billion in February of 2022.
Case study: Myer
One of the more famous private equity case studies is that of Myer. Established in 1900, Myer became one of Australia’s largest department stores. In 1985, Myer and Coles completed a $1 billion merger in the largest deal in Australian history (at the time).
By 2006, Myer had begun to struggle financially due to a lack of investment in technology and systems, combined with slow decision-making management, and increasing competition from brick-and-mortar specialty retailers and online retailers.
In 2006, Coles Myer Ltd sold its Myer stores to a consortium of US Private Equity firm TPG and its associates Blum Capital and the Myer Family for $1.4 billion. The consortium’s capital financed only $450 million of the $1.4 billion Myer price tag. The remainder was financed by debt.
TPG purchased Myer in a bid to turn the department store around. TPG quickly hired Bernie Brooks, Woolworths’ marketing guru, as CEO, began clearing inventory of old stock, and invested in new technology and systems. The consortium also began shutting down underperforming stores and sold its flagship Melbourne store (which it later leased back).
In 2009, three years after the purchase, TPG and the consortium sold Myer, which was relisted on the ASX. The consortium netted around $2 billion from their initial investment of $450 million.
Lessons from the Myer case study
The case study of Myer, TPG and its consortium displays the “Turnaround Investing” private equity investment strategy whereby TPG seeks to purchase an underappreciated business at an attractive price to improve operations and increase the value of its investment.
Frequently Asked Questions
Who funds private equity firms?
Funds receive their capital from high-net-worth investors (private equity investors) and other organisations (including private equity firms).
Why do people invest with private equity firms?
Private equity investors invest with PE firms to generate a higher return than what can be achieved in public markets.
PE funds are also considered portfolio companies. Portfolio companies hold an interest in a number of businesses. Therefore, funds also provide private equity investors with a diversified approach to private markets.
Further, PE firm fund managers allocate capital on behalf of private equity investors.
What is the average private equity return?
According to the Australian Investment Council, private equity and venture capital funds have returned 15.1% to investors over the 5 years ending 2021 (net of fees). The ASX300 and ASX Small Ords have yielded 10.6% and 11.3%, respectively.
Over the ten years ending 2021, PE and VC funds generated 14.5% in returns. Over the same period, the ASX300 and ASX Small Ords yielded 7.8% and 3.3%, respectively.
Finally, over the 20 years ending 2021, PE and VC funds generated 12.9% returns, against the ASX300 and ASX Small Ords’ 7% and 4.3% (respectively).
What is the difference between private equity and hedge funds?
Hedge funds and PE funds are alternative investments that pool funds from various investors. PE funds invest directly in private businesses, whereas hedge funds use a variety of strategies and techniques (including derivatives) to generate returns. These strategies are applied to both private markets and public companies.
Hedge funds typically abide by the 2-20 rule: the hedge fund charges a 2% management fee to its investors and a 20% performance fee for investments that realise their upside.
What is venture capital?
Venture capital funds are a form of private equity focused on investing in small start-ups with high growth potential. However, these investments require a more significant risk tolerance.
Who regulates private equity firms?
In Australia, PE firms are regulated by the Australian Securities and Investments Commission (ASIC). ASIC oversee Australian public companies, financial markets (including the ASX) and services (including banks, insurers and superannuation funds), and financial professionals (including those that advise on investments).
What are the key risks of private equity?
- The key risks of private equity are:
Illiquidity – Investments often include lock-up periods in which investors cannot exit their positions without penalty. Lock-up periods can be uncomfortable for investors who wish to exit their positions or need access to capital quickly.
- High leverage – buyouts funded partially by debt increase the risk associated with the transaction as it quickly becomes expensive if interest rates rise above expectations.
- Conflicts of interest – private equity managers may pursue deals that benefit their interests more than those of shareholders.