Understanding the Goals and Processes of Private Equity

One of the best ways to be an informed investor in private equities is to understand how PE firms pursue their opportunities and encourage value in the companies they invest in.

It’s important to grasp the main divisions of all investment opportunities. They break into two main camps: public equities and bonds/debt offerings on the one hand, and “alternative investments” on the other. These alternative investments include real estate, hedge funds, venture capital and PE.

The era of alternate investments as a winning investment option comes as the dominance of public equities — as indicated by IPOs per year — has been in decline. For 20 years before 2000, we saw an average of 310 new IPOs each year; from 2001 to 2012, that figure dropped to 99. That number has since started to rebound; there’s been an average of 186 IPOs per year since 2013, according to Statista.

Tellingly, the proportion of U.S. firms listed on public stock exchanges dropped by about 40 percent between 1977 and 2012.

Alternate investments can take up that slack. For example, real estate has low volatility while providing good risk-adjusted returns. Real estate is also a good step toward diversification because it is uncorrelated with stocks and bonds. It’s likely to continue to do well, according to demographic projections.

Hedge funds can also provide an attractive component of one’s portfolio. Demand is up to 28 percent, the highest we’ve seen in several years. Hedge funds are similar to PE, in that both are sold through private offerings that have registration exemptions and demand a longer investment time frame than stocks or ETFs typically do. Both also generally provide better returns. Yet hedge funds still lag behind PE, which remains the leader in the alternate investments space.

Often, investors new to PE confuse it with venture capital. That’s understandable given that funding in the venture capital sphere is so high — $70 billion in 2016 and 2017 — and deal activity is up by 11 percent.

But PE is different in that it usually buys more established businesses than venture capital does. PE buys in at three basic tiers, based on size: lower middle market, at less than $250 million; middle market, at $250 million up to $1 billion; and mega deals/bulge-bracket transactions that top $1 billion.

Compared to venture capital, which can fund a fledgling startup, PEs focus on buying businesses that have already proven their abilities to generate revenue, reduce instability, and provide opportunity for high return on investment.

The Value of PE

For all these reasons, it’s unsurprising that PE has been so attractive — with more than $3 trillion invested in this asset class globally over the past five years, according to Forbes. Almost a quarter of that investment ($701 billion) happened in 2017 alone.

PE also benefits from active management to increase portfolio companies’ growth and internal efficiencies so that the investment in the portfolio can offer significant returns. That happens only after a sourcing team has identified companies it wants to manage in this way. The goals are to decrease risk, increase value, and improve the probability of future success.

This active management is necessary to ensure that a business produces revenue consistent with its capabilities. Over time, businesses tend to lose some of their advantage, so this management ensures that the operations are tightened up to create the best performance possible in that market niche.

For that reason, PE firms are sometimes “accused” of streamlining companies quickly to maximize value and then exit the business, leaving future business owners high and dry. That is an unfortunate misconception. The goal of most PE firms is to create value. They do that in four ways: buy low, sell high, deleverage the business over time, and increase earnings. Those tactics have evolved along with market conditions, but there is still opportunity to use these principles fruitfully — if a business is actively managed.

3 Points to Understanding PE Investments

Growing sales, cutting costs, improving the business model, and reducing risk by elimination of potential obstacles are all useful tactics that go toward increasing profitability and creating a favorable target for investment.

Clarity and understanding are the best preparations for investing in PE, so let’s identify several actionable strategies for how interested investors can seek guidance on pursuing PE knowledgeably and pragmatically.

1. Assess your overall risk profile.

Investors need to decide what sort of risk they are willing to take. Each asset class — whether bonds, public equities, private debt, or others — has its own risk profile. Your allocations should be informed by your age and your degree of risk aversion, or how uncomfortable you would become if your investments were to decline in value, even temporarily. Private equity and venture capital are the riskiest types of investment but can produce the highest returns if pursued shrewdly.

2. Determine the macroeconomic perspective.

Your decision to invest in PE must also be informed by your confidence in industries in which PE typically involved, such as healthcare, technology, and industrials. Stay informed about these sectors in the time preceding your decision to invest in PE. An informed PE investment specialist can also guide you through a discussion of both the pros and cons of investing in these areas.

3. Invest in a manager that has a solid track record of success.

Finding the right manager is critical to a long-term view of PE investing success. Go with someone who can present his investment process in clear language that is relatively easy to understand. Avoid overly complicated descriptions, which are both alienating to you as a potential investor and suggest a management strategy that may not be robust against changing market conditions.

Understanding PE is not difficult. Once you’re clear on the strategies investors and their managers use to turn increased risk into greater rewards, you’ll feel empowered to allot a portion of your investing budget to this exciting and growing sector. With the right management and long-term view, the ROI can be very compelling.

Martin Stein is the founder and managing director of Blackford Capital, focused on dramatically transforming lower middle-market industrial enterprises through exponentially profitable growth. Since receiving his Bachelor of Arts from University of Chicago and his MBA from Harvard Business School, he has had almost two decades of private equity experience. Among other awards, Martin has been honored as the nation’s Private Equity Professional of the Year by M&A Advisor.