What Do Private Equity Investors Actually Do?

There are four basic things private equity investors do to earn money .

  • Raise money from Limited Partners (LPs) like pension and retirement funds, endowments, insurance companies, and wealthy individuals
  • Source, diligence, and close deals to acquire companies
  • Improve operations, cut costs, and tighten management in their portfolio companies
  • Sell portfolio companies (i.e., exit them) at a profit

Let ’ s front at each of those things in turn .

Raising Money

private equity firms raise funds by getting capital commitments from external fiscal institutions ( LPs ). They besides put up some of the their own capital to contribute into the fund ( normally 1-5 % but it can be higher ). The partners of the firm ( the GP ) might go on a roadshow themselves to raise the money ( as did the partners at the fast I worked at ) or they might use a placement agent ( an outside fundraising team ) to help them do a lot of the legwork.

LPs are normally required to commit a significant amount of capital in order to be allowed to participate in the investment company, since the last thing the partners want is to be fielding “ support ” calls and communications to a “ long buttocks ” of many little investors who only commit a small sum but require a distribute of hand-holding to service. The ideal fund to a PE firm would be comprised of a handful of LPs that each give tens or hundreds of millions of dollars, or tied billions of dollars, each. Huntsman Gay, the Bain Capital spinout that I worked at, had less than 10 LPs that each committed more than $ 100M .
If you ’ re a high net worth individual, the commitment thresholds might be a little lower than a convention LP, but they will probable even be in the millions in orderliness to comply with federal securities laws that basically say you can only sell PE investments to rich people because they are the ones who actually credibly know what they are doing .
But even though LPs make a capital committedness, they don ’ t give all the money to the GP all upfront. rather, the GP begins to source and close deals, and as those deals need to be funded, they “ call capital ” from the LPs. LPs then have a very specify window ( e.g., 2 weeks ) to write a check mark to the GP so that the GP can fund and close the deal. so attached funds are called “ committed capital ” while disbursed funds are called “ contributed capital. ”
many PE funds have something called “ first close ” vs. “ final close. ” First close basically means that when a certain threshold of money has been raised, the PE firm can begin making investments and actually closing deals and newly LPs can however join in by committing das kapital for a limited time ( e.g., 1 year from first close ). Final close means that when a moment threshold has been reach, new LPs can nobelium long join in on that particular fund .

Sourcing, diligencing, and closing deals

When pe firms analyze companies for likely skill, they will consider things like what the company does ( their product or service and their scheme for it ), the senior management team of the company, the industry the company is in, the company ’ south financial performance in holocene years, and the valuation and likely exit scenarios of the company .
prospective deals come in to the firm through a combination of the partners’ reputation ( in which case companies themselves may reach out to the firm ), investment professionals who proactively reach out to electric potential investment targets through their own networks or through cold calls, or through investment banks that may be representing a company and pitching it to investors through the issue of trust books or confidential investing memorandums. When investment banks run a action, they much do it through an auction where several private equity firms bid for the company, and firms drop out along the way as their bids are either rejected or accepted to each consecutive “ beat ” of bidding .
The best means to get deals is through proprietary means because that means the PE firm has an edge against early firms in acquiring the company, either through personal relationships or extra cognition or simply a head begin. At Huntsman Gay, there were a few proprietary deals we looked at and closed, and those were decidedly the ones we tried to move more promptly on, that didn ’ thyroxine tend to get dragged out in a process, and that were more pleasant to close. To get beneficial proprietorship conduct flow, the partners of the fund have to build and maintain impregnable relationships with winder people in industry, advisers, and flush bankers .
once a potential hand has been sourced, then the investing team will conduct heavy due diligence to assess the company ’ s strategy, business model, management team, the diligence and market, the financials, the risk factors, and the exit potential. Diligence is typically conducted in stages that correspond to phases of the bidding process, where fiscal and functional information is increasingly revealed to PE firms based on bidders that are still in the operate at each phase. If the distribute looks promising and no dealbreaker red flags are found, then the investment professionals will present to the investment committee ( comprised of partners ) for funding approval .
final terms of the deal with be negotiated with lawyers on both sides, and the cover will transact, with funds being released and equity being traded .

Improving operations, cutting costs, and tightening management

One thing to be very clear on is that the GP does NOT run the portfolio companies on a day to day basis. They are not installing themselves as CEOs and COOs. rather, they take board seats, they may or may not reshuffle senior management of the company, and they provide advice, support, introductions, etc, relating to operations, scheme, and fiscal management .
How involved the GP is very depends on how adult their interest in the company is. If they only own a small minority venture, then they won ’ thymine be very involved ; preferably, the lead investor owning the biggest post will be most involve. however, if they own either a goodly share of the equity or a significant fortune of the entire fund is invested in the company, then they will be much more highly engaged in streamlining and improving the ship’s company for a profitable exit down the line .
The GP must besides produce official reports for LPs, generally each quarter, on the build up and prize of their portfolio companies, along with general fiscal updates, and LPs may use that data to mark their own portfolios to market when they report their results to their own investors .

Exiting portfolio companies

The end finish for pe firms is to exit their portfolio companies at a solid profit. typically, the exit occurs between 3-7 years after the original investment, but it could be shorter or take longer depending on the strategic circumstances. The main sources of value capture at exit include : growing gross ( and therefore EBITDA ) substantially during the holding period, cutting costs and optimizing working capital ( and therefore increasing EBITDA ), selling the party at a higher multiple than the original acquisition multiple, and paying down debt that was initially used to fund the transaction .
Most exits happen as the resultant role of an IPO or acquisition by another firm, with acquisitions being the more common method. Returns are then measured by the “ internal rate of return ” ( IRR ) ( which is the discount pace that makes the internet introduce value from the entry date of all cash flows between introduction and exit equal zero ), or its agile proxy the “ multiple of money ” ( MoM ) which is just the amount of money returned divided by the sum invested for that particular investing .
note that the IRR depends on the duration of the holding period while the MoM technically does not ( although you will be judged by your investors how long it took to generate that MoM ). so, for case, if a $ 100M investment is sold for $ 200M fair one year late, the MoM is 2x but the IRR is 100 % ; if it ’ s sold after 3 years, the MoM is hush 2x but the IRR has fallen to 26 % ; and it ’ s sold 5 years later, the MoM is even 2x, but the IRR is 15 %.

While partners do a batch of the coordination to sell the firm ’ s portfolio companies, they may besides retain investment banks to handle the execution, specially when the transactions are bombastic or building complex. That ’ s how investment banks earn their fees — on selling the portfolio companies into pe firms and then again on selling them out to downstream acquirers .

Be sure to check out our PDF guide “ How to Nail Your Private Equity Interview (whether you have finance training or not) ” for in-depth tips and strategies on how to successfully interview for jobs at top private equity firms !
besides be sure to check out our bit-by-bit Private Equity LBO Modeling Training Videos for walk-through tutorials on how to build an LBO model, voyage Excel with pitiless efficiency, and quickly create an LBO PowerPoint deck to present to your PE interviewers .

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