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You have likely heard of private equity as one of the major practice areas in a law firm. It is a fast-paced and lucrative practice area with many headline-grabbing deals. Find out what this really entails to boost your commercial awareness.

What is Private Equity?

According to Investopedia, private equity refers to capital investment made into companies that are not publicly listed or traded. This private financing is supplied by private equity firms. The ‘equity’ part represents ownership in that entity. Private equity takes place most commonly through leveraged buyouts (LBOs) and venture capital (VC).

Private Equity Is Still Popular

This type of investment grew in popularity following the financial crisis of 2008, since becoming one of the best performing asset classes. Investment has grown further as a result of the pandemic. Analysts have pointed out that a low interest environment has both enabled private firms to borrow money more cheaply than before and also provided an incentive for institutional investors, who are looking for higher yields.

The UK Is A Private Equity Hot Spot

The UK is particularly popular with private equity firms. One motivating factor is the depressed valuations of many British companies after years of Brexit uncertainty. In the past 5 years, the total return investors earnt from the FTSE 100 was 26%; S&P investors received a 125% return in the same period.

Another compelling reason for private equity investors to choose British companies is the UK’s liberal attitude towards takeovers. The Financial Times points out that it is easy to buy and restructure companies here; in France for example, there are strict labour laws meaning mass lay-offs can be difficult.

Britain is also very open to foreign investment; other governments are more reluctant to take on foreign acquirers. One example is the Dutch government’s rejection of private equity firms’ bids to buy the Dutch phone company Royal KPN.

A mesh of these factors has led Britain to become a global private equity hotspot. The world’s largest private equity firm, Blackstone, has already invested more than $20 billion into the country. Since the beginning of 2021, private equity firms have collectively announced 124 deals for UK companies with a combined value of £41.5bn. This is clearly a huge practice area with many exciting deals to come.

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How Does Private Equity Work?

It Provides Investment Funds or Capital From Investors

A private equity firm is an investment management company which utilises either its own funds or capital from investors to help its asset companies to grow. These firms have two major sources for their capital: High-Net-Worth Individuals (HNWI) and Institutional Investors. They may also raise capital through retirement and pension funds.

It Buys Stakes In The Company With The Money

The private equity firm will buy stakes in the company or ‘target’ with the hope of making a profit later. The company is usually a distressed asset, but shows potential to be competitive again. Historically, private equity firms in the UK have spent an average of 5.9 years invested in each company before exiting, and selling the remaining assets for a profit.

The pandemic has been an unparalleled time for private equity firms, which have struck more deals in the UK in the first half of this year than any other 6-month period on record. The best performing firms in the UK include the Bridgepoint Group, Charterhouse Capital Partners, Cinven, CVC Capita Partners, Permira and TDR Capital. Notable deals include the private equity bidding war over Morrisons, a takeover of British motorising association AA and purchase of mutual insurer LV. Many of the deals have included the firms putting their own fund capital into the equation, alongside that of HNWI and Institutional Investors.

They Advise But Don’t Often Manage The Companies

Typically, private equity firms do not involve themselves with the day-to-day running of their portfolio companies, but will advise on strategy, financial management and operations.

Often, private equity firms use a substantial chunk of their capital to help the company update new accounting, procurement and IT systems, hoping to increase profitability in the long-term. They may also help to streamline the business by simplifying supply chains. This often involves cutting staff and selling off the company’s lesser performing assets. The more money invested, the more presence the firm will likely have. This approach however has seen mixed results.

There Have Been Criticisms Of Private Equity

Historically, private equity houses have been criticised for corporate greed. The most famous example is the leveraged buyout (LBO) of American tobacco and food conglomerate RJR Nabisco, where private equity titan KKR saw its founders labelled as ‘Barbarians at the Gate’ in a subsequent book and movie deal. Eventually, RJR Nabisco left the deal with $30 billion in debt, and the company split in two.

Similar criticisms have befallen the private equity consortium of TPG, CVC Capital and Merill Lynch, which took over Debenhams in 2003. At the time, Debenhams owed £100m; when the company returned to the stock market in 2006, it was in debt more than £1bn. The department store has never fully recovered.

But It’s Seen Huge Successes

Private equity has also seen huge success stories, with many productive buyouts. Household names Waterstones, Poundland, Reiss, and most recently GAIL’s Bakery have all been saved by private equity. GAIL’s Bakery’s parent company, Bread Holdings, secured investment from Bain Capital Credit in early September. This followed a 2020-2021 trend, where private equity snapped up struggling hospitality outlets, devalued and cash strapped as a result of the pandemic. Many of these brands may not have survived if private equity firms had not intervened.

Many Supermarkets Have Been Bought By Private Equity

All eyes are now on management of the supermarkets which have been bought by private equity. Morrisons: will private equity firm Clayton, Dubilier & Rice sell off any of Morrisons 87%-owned assets? Asda: How will TDR Capital ensure they are ‘responsible owners’ of the supermarket chain? Sainsbury’s: Will anything come of the rumours private equity is circling?

They Charge Management Fees To Generate Income

Private equity firms make money through managing their assets as part of a ‘management fee’ – this represents the 2% of the ‘2 and 20 model’. This fee is calculated as a percentage of assets under management (AUM) and is charged regardless of any profit generated for investors. This 2% fee is often termed as income that ‘keeps the lights on’ at the private equity firms.

Investors Then Exit At A Profit

The end goal for those in the private equity field is to sell the company for more than they paid for it. Acquisition by another company is the preferred exit method, but private equity firms are also known to put companies through an IPO (initial public offering), particularly for tech-based assets. For example, US private equity firm Vista Equity Partners allowed three of their portfolio technology companies to go public between September 2019-December 2020: Ping Identity, Jamf and Datto.

The Future of Private Equity

Financial data analyst Preqin believes that private equity will continue to grow, with AUM set to top $9 trillion by the end of 2025, an substantial increase from the $5 trillion of assets currently under private equity management.

One challenge for private equity is conducting its operations in line with ESG investing with ESG now as important and central to a company as any other type of financial risk. HNWI and family funds are typically drawn to companies and entrepreneurs who can explain their sustainability initiatives. As a result, more than one-third of firms now have a sustainability officer.

It will be interesting to observe how private equity firms react, especially since so many of their management duties involve cutting costs, which inevitably leads to job losses – arguably going against the ‘S’ in ESG.

Wider Private Equity Reading:

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