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Demystifying private equity


Private equity (PE) investment enables entrepreneurial businesses to expand quickly and clears the way for skilled and ambitious people to step up. If managed in the right way, private equity can be an exceptionally positive route to growth.

Partnering with a PE firm should be a positive experience, especially for those doing it for the first time. It can help entrepreneurial leaders professionalize, grow, and achieve transformation in their business by having support from investors who will have many years of experience, and realizing profit for all shareholders, typically over a three- to seven-year period—depending on the specific strategy of the fund.

This article can help you decide whether private equity is the right choice for your business.

How does private equity work?

Private equity is a term given to capital that is aggregated into funds for investing predominantly into private companies. This capital is typically pooled from pension funds, insurance companies, sovereign wealth funds, high net worth families, and individual investors.

Typically, PE funds are closed ended and have a life of 10 to 12 years. This is an important factor to consider when considering private equity investment because where a fund is in its lifecycle influences its investment behaviors, which is important for business leaders to understand. Generally, funds will be invested for three to seven years but the investment duration could be longer if it makes commercial sense.

Private equity funds

A private equity fund is a generic term applied to businesses that invest capital on behalf of the investors. They are advisers to the fund and are normally a separate legal entity with a different ownership group.

The PE fund can also be referred to as the fund manager and/or general partner (GP). This is because many PE funds are structured as limited partnerships (LPs). There is a general partner (the PE fund/fund manager) and there are limited partners (the pension funds, insurance companies, etc. whose funds are managed by the fund). The fund’s terms will also invariably require the PE fund/team to invest its own money in the fund, too.

Two colleagues meeting with a chart on a big screen

Carried interest

Typically, the PE fund will charge a management fee to cover the running costs. The carried interest (or carry) is an agreed proportion of the profits of the fund. The carry begins to accrue once the LPs have made a specified return, and eventually results in an 80:20 split of fund profits between the LPs and the carry.

The carried interest is split up amongst the team members of the PE fund. Senior team members will also be asked to invest in the fund in their own right. As a result, the investment managers, executives, and partners are all aligned with the success of each investment in the portfolio.

Typical structure

Chart of private equity typical structure

How does private equity buy a company?

The funds controlled by the PE fund are invested in a new company (often referred to as Newco), which is formed just to make the acquisition of the target company. The funds used to form Newco are not just sourced from the PE fund (typically in the form of a relatively small amount of ordinary equity with the balance as loans, or possibly preferred shares or preferred equity, subject to tax and legal structuring advice), but often also from the vendors of the target company and, invariably, the management team as well as lenders.

The vendors and the management team often roll over a proportion of their equity in the target company into loans and ordinary equity alongside the incoming PE fund. The management team will invariably be asked to invest in the venture from their own resources; this is so all stakeholders have skin in the game.

The ownership proportions of Newco are determined by the value of target, the relative amounts of funding provided (bank debt, loans, vendor rollover, and management investment) and negotiation. There are no hard and fast rules, but the more negotiating power the vendors and management have, the better their packages will be. 

Over the period of the investment, the cash generated by the target company may be used to pay down the bank debt, and sometimes the loans. However, most of the loans and the balance of the bank debt (often the majority of that) are repaid at exit (i.e., when the shareholders sell their stakes). As the returns on the bank debt and loans are restricted to the repayment of the principal plus accrued interest, any excess growth in value accrues to the ordinary shares.

The majority of private equity buyouts are funded through loans or preferred shares from PE fund and bank debt. Bank debt attracts an interest rate that is paid periodically. The loans attract an interest rate, typically between 8% and 12%. The interest can be paid but is most normally rolled up into the principal or paid by the issue of further notes, referred to as payment-in-kind (PIK) notes. The balance is funded by a thin sliver of ordinary equity.

How will it work day to day?

What the structure of your business and its management looks like will vary depending on the deal with the PE fund. Sometimes, the investor will take a board seat, appointing someone from the PE fund. There may be new schedules and structures for board meetings, and some investors will be very hands on with management teams.

Often, PE funds have dedicated portfolio teams, focused on managing the investments. A portfolio team may take over from the investment team, however, the handover from investment to portfolio team will be done as soon as possible, to allow you to develop a relationship.

The importance of the CFO

PE funds place significant importance on the quality of your people, so will look at the experience and competence of your whole management team. This is especially pertinent for the chief financial officer (CFO) or finance director.

The right CFO will create value, not just protect it, because bankers and investors place a heavy emphasis on this role. or finance director. The right CFO will create value, not just protect it, because bankers and investors place a heavy emphasis on the role.

Their appetite to lend or invest will be enhanced when a strong CFO is running the company smoothly, and your business will be more likely to strike the right deal and get better terms.

For the CFO and the finance function, the most important thing to demonstrate to investors is the ability to make full use of the complex financial and management information needed to drive the transformation and growth that investors expect. After the deal, the PE fund will rely on your CFO and finance function to deliver high quality management information together with relevant key performance indicators (KPIs). Your PE investor will be focused on the future, closely watching earnings, profit, and operational cash generation against what are likely to be ambitious forecasts and budgets.

How private equity makes money

As time progresses, the business and its earnings before interest, taxes, depreciation, and amortization (EBITDA) grow; bank debt is paid off or amortized; operations are improved; and the value of the business increases. This drives value into the ordinary shares, provided that the growth outstrips the total cost of debt and the loans.

The value of the equity grows further if there is multiple accretion, which happens when the exit multiple exceeds the entry multiple. As you can imagine, PE fund executives not only focus on EBITDA growth but also on things that might positively affect multiples. This includes keeping an eye on the market and the timing of any exit.

If everyone has done their job well, timing of the exit is picked well and the business has been prepared for the sale process efficiently, the returns can be excellent for the fund, the PE fund, its executives, the vendors, and the management team.

Two colleagues discussing options on a laptop

Is private equity right for you?

Your management team will be aware of the importance of agenda alignment amongst the leaders of your business. This comes into even sharper focus when a private equity investor joins the board.

The agenda of your investors is to drive value. Investors may not share the altruistic objectives of your team, although there is considerable growth in impact investing. Real success in a relationship with private equity comes where there is significant alignment, and non-aligned factors can be clearly de-prioritized. It’s important to have absolute clarity about your own objectives and those of your team before deciding to look for an investor.

Questions you might find helpful to pose include:

  • What is your definition of success for yourself and for your business in the medium to long term?
  • What is your business plan or strategy to achieve this?
  • How much investment do you require to fund your business plan?
  • How much money would you/the vendors like to take out?
  • How could you accelerate your plans and grow your business faster?
  • How risky is your business? Do you have sustainable plans and financing without investment?
  • What are the things that you would be unwilling to compromise on?
  • What impact (both positive and negative) might private equity have on you and your business?
  • What alternatives are there to private equity?

A trusted advisor can help you identify and prioritize your objectives and understand how they can be aligned with those of private equity investors.

Navigating private equity

The next article in our series, Navigating private equity, is appropriate if your business is speaking with PE firms and preparing for a potential investment.

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How we can help

The reasons for embarking on private equity investment may be complex, but whatever your motivation, our Private Equity group can deliver practical solutions for your business. This practical team has a profound understanding of the private equity industry, particularly in the Canadian mid-market space. Our people are part of the process at every level, interacting with funds, advising on deals, and working closely with portfolio companies to help them realize their goals.

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