Everything You Always Wanted to Know About Private Equity ... But Were Afraid to Ask
Setting the record straight on Private Equity
When I was first asked to present Private Equity investments I didn’t know where to start: indeed, after 20 years spent working in this industry, I don’t think I have ever seen an asset class so badly treated by the media and so often caricatured.
Reading the media coverage on Private Equity, you can legitimately wonder what went through the mind of investors who put $546bn in to this asset class last year! That’s why I decided to start by sweeping the floor clean of all stereotypes.
OK, let’s begin with a definition:
Private equity consists of investing in unlisted companies at different stages of their development, with the objective of creating added value and then selling these companies a few years later with a significant capital gain.
To facilitate investments in private companies, Private Equity funds have been created for the most part in the 90s to raise money from investors and deploy it progressively by acquiring strong performing companies to grow them bigger and help them become more profitable. This business model now extends from the Americas to China, covering all Europe and more recently Africa.
So, these players must be doing something right, don’t you think? Maybe it is about their returns to investors? Did you know that global buyout Private Equity funds’ net return (IRR) over a 10-year time horizon stands at 14.4% per year as of midyear 2014, after bottoming at a net IRR of 8.8% per year during the financial crisis, in 2009 and 2010 (according to Bain& Company’s Global Private Equity Report 2015)?
Stereotype #1: Private Equity firms are asset-strippers
Detractors will say that Private Equity funds generate high returns by stripping companies out of their best assets. This does not stand a serious analysis and many examples contradict this theory: did you know that famous companies like Orangina, Heinz (yes, your favorite ketchup!), Center Parcs or Moncler have developed supported by Private Equity money?
Private Equity firms work hard at growing their companies by investing money to support a diverse range of value creation strategies, such as:
Expanding their geographical footprint – like Hunkemöller, the northern European underwear chain, created in Holland and now present in over 16 countries with the support of a European Private Equity firm;
Repositioning an-out-of date concept to turn it into a trendy product – like Materne’s Pom’pote, whose expansion in the US (where it is known as “GoGo SqueeZ") is supported by a French PE fund, or like Leica, which was bought by a large international PE firm;
Making buildups (i.e. acquisition and integration of smaller competitors) to create a worldwide leader like Swissport, global leader in the airport ground handling services, whose market share has grown significantly under the leadership of a European fund.
Market statistics support these examples: between 2005 and 2012, 10% only of PE-backed companies made net disposals vs. 44% making net acquisitions (Myth and Challenges - EY PE report, 2013).
Private Equity firms provide not only money but also expertise in various fields; they often give the management of their companies access to the best experts in a given industry and to a high level of information, acting as door openers.
Stereotype #2: Private Equity firms are cost-cutters
For the same reason, I have always found ludicrous statements blaming Private Equity for job destructions; cutting costs does not generate 2x returns. Private Equity businesses may cut unnecessary costs but generally with a view to reinvesting the money into other functions (i.e. sales, marketing, research, etc.) in order to support the company expansion.
In fact, Private Equity-backed European firms have seen their employee numbers increase annually by 2% between 2005 and 2012 (EY 2013 PE report) and these firms account for 12% of Europe’s industrial innovation, which is far more than their proportionate share (EVCA Essential Work, 2014-2019).
Stereotype #3: Investors' money is blocked for 10 years
Because growing companies takes time, investments in Private Equity funds are generally seen as illiquid and long-term; however, the widely held idea that your money will be trapped for 10 years is false.
Private Equity funds do indeed usually have a 10-year maturity; however, it is not rare to see a company sold after a 4-year holding period. The fund will have to liquidate the assets left in its portfolio after 10 years, but you may well expect to see all the money invested over the first 5 to 7 years of the fund’s life. All the money you receive afterwards is capital gain. However, the life of a company is always an adventure; therefore Private is a risky investment where capital is not guaranteed.
Stereotype #4: Private Equity is a black box
Finally, Private Equity is often mistaken for more esoteric types of funds and accused of being a black box; seriously, there is nothing more unfair than that. Private Equity is an investment in the “real economy”: you participate in the acquisition of a company, you create value (hopefully) and you sell the company with a gain. You don’t trade assets, and when a Private Equity fund calls money from you it tells you exactly what it is going to do with it.
Valuations of portfolio companies are conducted at least twice a year, in accordance with international guidelines (IPEV). What is true, however, is that Private Equity funds do not communicate on their performances outside of their investor group. The assistance of a well-connected industry expert is therefore often necessary when it comes to selecting the best performers.
Now that we set the record straight about Private Equity, I invite you to stay tuned for our next articles!