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Private Equity Explained

Private equity is medium to long-term finance provided in return for an equity stake in potentially high-growth unquoted companies.
Private equity investments typically support management buyouts and managing buy-ins in mature companies, as opposed to venture capital which provides funding for early-stage and younger companies – more information about venture capital can be found here.

As a model private equity is a proven driver of sustainable business growth. This is achieved through operational expertise, sound management and, importantly, through the close working relationship between the private equity backer and the company management team.

In contrast with publicly-listed companies, which can often have thousands of shareholders, private equity managers work alongside the management team to enhance the running of the business. This governance structure leads to much shorter lines of communication between manager and investor, ensuring constant engagement between the two.

This ‘active ownership’ approach means the private equity manager will work alongside the company management team to enhance the value in the business. This can involve all areas of operation, from the top-line growth, efficiency savings, cash generation and procurement, to supply-chains, marketing and sales, improving reporting and human resources.

Such an approach becomes self-perpetuating and ingrained within the company, ensuring that the business remains committed to creating value and increasing growth even after the private equity firm has sold its stake.

Private equity firms will typically look to hold investments for between four and seven years, at which time they will look to sell, or ‘exit’, their stake, either on the stock market, to a corporate buyer or to another investor.

Funds and returns

Independent private equity and venture capital firms typically raise money from institutional investors such as pension funds, insurance companies and family offices. This money is committed to a fund and is drawn down over several years as investments get made. The fund (often structured as a limited partnership) is managed by a private equity or venture capital firm, known in industry parlance as a ‘General Partner’ or ‘GP’.

The capital is used to invest in companies that, typically, are not listed on a stock exchange, either for a minority or majority equity stake. The firm will generally also invest their own money into the funds they manage to ensure their interests are aligned with that of their investors.

Private equity and venture capital funds usually have an initial life-span of 10 or more years and it is intended by the end of this period they will have returned to investors’ share of the original money, plus any additional returns made. This generally requires the investments to be exited for cash or listed shares, before the end of the fund’s life.

The investors in the funds first receive any distributions generated by a fund and it is only when these returns pass a certain point, known as the ‘hurdle rate’ (typically around 8%), that the private equity or venture capital firm receives any pay-out, known as carried interest.

In order for GPs to be able to successfully raise funds from LPs, they need to be able to demonstrate a track record of delivering good returns from their previous funds. Private equity has a long and successful history of recording such returns, as demonstrated by the most recent BVCA statistics.

Transparency

In February 2007, the BVCA asked Sir David Walker to undertake an independent review of the adequacy of disclosure and transparency in private equity, with a view to recommending a set of guidelines for conformity by the industry on a voluntary basis. This review resulted in the publication of the Guidelines for Disclosure and Transparency in Private Equity in November that year.

The Guidelines require additional disclosure and communication by private equity firms and their investee companies where those companies meet the Guidelines criteria. In addition to the enhanced disclosure requirements, the Guidelines also include requirements for data to be provided by portfolio companies and private equity firms to the BVCA, valuation methods, reporting to Limited Partners, detail on gender diversity and the responsibility to ensure timely and effective communication during periods of significant strategic change.

The Guidelines Monitoring Group was set-up in March 2008 under the leadership of Sir Mike Rake to monitor conformity to the Guidelines. It was renamed the Private Equity Reporting Group (PERG) in September 2015 and publishes an annual report to summarise the industry’s conformity with the guidelines. More information about the group and the reports can be found here.

FAQs in Private Equity

What is private equity?

Private equity is finance provided in return for an equity stake in potentially high growth companies. However, instead of going to the stock market and selling shares to raise capital, private equity firms raise funds from institutional investors such as pension funds, insurance companies, endowments, and high net worth individuals. Private equity firms use these funds, along with borrowed money and their own commercial acumen, to help build and invest in companies that have the potential for high growth.

It backs or has backed, companies in a range of different sectors, such as consumer brands like Boots, DFS and Poundland, to leading market names including Dr Martens, Moonpig and Wise.

What is the difference between private equity and venture capital?

Venture capital refers to funds used to invest in companies in the seed (concept), start-up (within three years of the company’s establishment) and early stages of development. In turn, private equity denotes management buyouts and buy-ins.

In general venture capital funds invest in companies at an early stage in their development when they often have little track record of profitability and are cash-hungry. In contrast, private equity funds invest in more mature companies with the aim of reducing inefficiencies and driving business growth through often increased margins and/or new sources of revenue growth.

What are the advantages of the private equity model of ownership?

As soon as a private equity house completes an investment, often before, it will sit down with the company’s management team and work out the best strategy to take the business forward and drive growth. This method of working side by side - of private equity backer sitting down with management - is fundamental to why private equity is such a successful way of building a business.

This ‘active ownership’ stands in contrast to public companies, where there are often hundreds or thousands of different shareholders. In private equity, the investors will generally own a controlling stake and are directly involved in the running of the business. A plan may include seeking out and entering new markets for growth, product development and innovation, training of management teams, improving procurement and the efficiency of supply chains, making acquisitions, strengthening financial controls and operating systems and preparing a company for exit.

By having a much shorter reporting line between investor and company management team, it ensures the interests of the two are very much aligned. Both the private equity house and the management team are motivated by the same goal – to increase the value of the business. By keeping the reporting lines short, private equity has a strong incentive to be actively engaged in the running of a company.

What does a private equity investor look for when making an investment?

The ultimate aim of private equity investors is to create value. As such, they look for high quality management teams with a credible plan to grow their business. Private equity investors are long-term investors and work with the company’s management to improve the company’s performance and strategic direction by aligning incentives, improving business plans, making operational improvements and strengthening corporate governance. With this mentality to buy and help build, coupled with a disciplined approach to organisational governance, private equity investors display a nimbleness and adaptability that raises the value of their investment and ensures that value can be realised in the future.

Why would a company want private equity investment?

The attraction of private equity investment to a company and to the management is the opportunity for managers to own a significant portion of their business. Aligned interests between the managers and the investors foster the sense of ownership that is central to the concept of private equity investment. Besides the infusion of capital, companies also benefit from the experience and insight that fund managers bring to the board room.

How do private equity firms add value?

Private equity adds value to a company in a variety of ways. Thorough due diligence sheds light on a company’s strengths and weaknesses alike, and with it comes a sound initial investment rationale. By targeting growth sectors and new markets, private equity investors can focus on creating better revenue generation and implementing programmes that yield operational efficiencies. In addition to cost reduction, organic growth is now increasing in importance as growth by acquisition is becoming relatively harder to undertake.

It is also critical to establish a structure in which both investors and business managers share a common ownership vision, and are motivated to maximise value. Active ownership, effective organisational change and powerful incentive schemes are all part and parcel to the hands-on governance model that includes constant and keen oversight, defined goals and timing, disciplined decision-making and deep resources to match. Ultimately, this approach leads companies owned by private equity to outperform similar publicly-owned companies with relative benchmarks.

Who invests in private equity?

Private equity funds raise money from institutional investors from across the world. This can include international pension funds, sovereign wealth funds or insurance companies, to local authority pension schemes, family offices or university endowments.

Pensions and other institutional investors invest in private equity because they want their investments to outperform the public markets, which it consistently does. Private equity returns were more than double that of the FTSE All-Share over the last decade according to recent BVCA statistics.

What is the impact of private equity on the UK economy?
  • 1 million+ people employed in the UK by companies backed by private equity and venture capital
  • 1,300 UK companies received investment from private equity and venture capital in 2020
  • 5,000+ businesses currently backed by UK private equity and venture capital/li>
  • 9 in 10 investments directed at SMEs (small to medium-sized enterprises) from private equity and venture capital in 2020
  • £9.5bn invested UK companies from private equity and venture capital in 2020
  • £44.1bn raised from private equity and venture capital in 2020
How is the private equity industry regulated?

All private equity and venture capital firms in the UK are regulated by the Financial Conduct Authority (FCA). The industry set up an additional self-regulatory regime in November 2007, in response to the increased demands of its investors and the self-recognition of the industry for it to do more. The Guidelines for Disclosure and Transparency in Private Equity and the supporting Private Equity Reporting Group (PERG) provide a set of rules and established oversight and disclosure comparable to those faced by FTSE 350 companies.

What is the difference between private equity funds and hedge funds?

Generally private equity seeks to create value over the long-term, whereas hedge funds have a shorter horizon more in line with movements in the stock markets. Private equity investors usually buy and own all of a company and so have a strict alignment of interests with the managers of the company – this ensures the investors and the company achieve its growth potential over time and indeed they only succeed if the company does well and their investment can be realised.

Hedge funds are pools of capital that invest in stocks, bonds or commodities and do not usually purchase a controlling interest in a company. Hedge funds try to capitalise on short-term market movements, using complex trading strategies involving options, derivatives and other financial instruments. In some cases, hedge funds bet against the shares of the companies they do not own (i.e. short selling), hoping to profit from falling prices.

Further information

FOR FURTHER INFORMATION PLEASE CONTACT THE BVCA

 +44 (0)20 7492 0400

 bvca@bvca.co.uk