Private Equity Investments & How To Replicate Them

A private equity market is a group of funds that were able to raise capital. They do this by seeking investments from several large financiers where the funds will be invested in equity positions in corporations. In this article, we will talk about replicating private equity investments.

As soon as the assets accumulate 100% of the pending equity of a public company, a going-private negotiation occurs. If you borrowed funds to acquire the deal, then that makes it a leveraged buyout or an LBO.

Private Equity Investments vs. VCF

What sets private equity apart from venture capital? The former seeks out more established companies with lengthy revenues. Meanwhile, the latter often makes investments in new companies that have limited revenues.

A club deal or a consortium deal, on the other hand, occurs when private equity funds acquire stock in a target company individually. They may also combine with other private equity firms in order to acquire a target.

Private equity returns have a tendency to surpass those of the market. We have discussed this before. One downside is that private equity funds cater only to a few investors who are usually large institutions like pension funds.

Average smaller investors are not ideal for them. The aggressive use of leverage by the funds also augments private equity returns.

What Are Private Equity Investments?

Smaller or mid-sized companies with low EBITDA multiples, like value stocks, are what private equity funds tend to invest in. They do this to generate acceptable returns for their own investors. Hence, they really need to purchase target companies at prices that let them achieve a particular hurdle rate. These investments and returns also feature long holding periods.

Significant investor activism as private equity funds usually accumulates across entire companies. They have their representatives on the board while choosing managers. Can smaller investors match private equity returns through various options? Individual investors, according to Erik Stafford, duplicate several qualities characteristics of the private equity model except for activism.

According to him, portfolios made of companies with components that are just like those preferred by private equity funds earn high risk-adjusted gains. They are eclipsing the mean pre-fee equity gains. This happens when the target portfolio influence is selected to match the returns. This refers to returns that are leveraged accumulating inside private equity funds.

Anchoring on Stafford’s study, SummerHaven Index Management LLP offers an investable index that aims to copy the long-term return characteristics of diversified private equity funds.

Interlocked boards also affect corporate governance. But Stuart and Yim used a sample of all US publicity traded companies from 2000–2007 and discovered that firms were 42% more likely to get offers from private equity firms.

This is when they had directors that had a previous positive experience in receiving private equity bids while at other companies. But with negative experiences, the “PE Interlock Effect” disappears. They concluded that the companies which become takeover targets are based on board members and the social networks they bring to the board.

Private Equity Investments Secondary Market

There was a time when LPs were passive investors. They invested their capital and just waited for automatic high returns. LPs are private equity funds investors. Hence, a relatively inactive market has been around for private equity investments.

The transactions here have come in different forms. For instance, an LP could adjust its portfolio by using this market to escape specific private equity investments.

This sale also involves not only the investment but also other financial commitments by LPs. This investment’s buyers could be institutions and hedge funds. The investment agreement governs the extent to which the LP can enter into such a sale.

This will demand the GP’s approval so that it would be completed. If the potential seller is a large investor, the approval is easy to get.

That’s especially true if they have made other investments with the GP and with whom the GP wants to continue to work. The sale can be relatively seamless, and the partnership can continue to function undisturbed by a switch of LPs.

Everything changed when the economy and market turned down. Now private equity managers have to work harder for their returns and they find themselves under closer scrutiny from the LPs.

Private Equity GPs

As we already know, the general partners of a private equity fund can earn a fixed income. This income is independent of the performance of the fund. Aside from that, they earn a variable income, a function of that performance.

The payment for the fixed management fees comes from committed capital. Committed capital is the money that limited partners provide. If you add limited capital and investment capital, you will get committed capital. The GP and LP have varying management fees, like a fixed percentage over the life of the fund or a decline over that time period. They calculate these fees by an application of the relevant [percentage to some base, like committed capital or some alternative.

Private Equity Firms & Takeovers

Private equity firms have been so involved in takeovers that they find themselves forming competing groups or partnerships. They also bid against each other for takeover targets. This happened in 2005, when KKR joined forces with Silverlake Partners to acquire Agilent Technologies Inc.

When KKR allowed investors to sell parts of their stakes in buyout funds in 2014, the secondary market took a step forward. This occurred through a private market that the Nasdaq OMX Group manages.

Pension funds and other institutional investors could utilize the market to sell their private equity investments to other investors, even smaller investors. Before this development, smaller investors who planned to invest in private equity could buy shares in some private equity companies that turned public.

Some examples include Blackstone Group and Carlyle. But these are shares in the private equity companies themselves compared to certain private equity funds’ investments. These investments had been large institutions’ exclusive domain.

Only in its development phase, the new markets already have plans to be open to sophisticated investors with a minimum purchase requirement. It is possible for this to mean tens of thousands of dollars, and the market should make these investments more liquid. Capital raising would logically be easier with this.

© Image credits to Anni Roenkae