Chapter One

1. The Field

You’re the athlete, accomplished in your own right, but now you’re contemplating an entirely different ball game and need to understand the facets of this new game. First up, we’ll address the playing field: private equity. What is it? How does it operate? How has it evolved?

Defining the Private Equity Fund

Let’s start with the concept of a mutual fund. A mutual fund aggregates money from a variety of investors and pools that money together. A fund manager decides what stocks to buy with the money. The funds have readily available liquidity and are publicly traded. If you want to buy a typical mutual fund, you hop onto your E*TRADE account (or wherever you invest) and purchase a piece of it. That money is then aggregated with everyone else who has contributed. You can hold that investment as long as you want—for one day or five years—but you have no say over the trades made by the fund manager.

I liken a private equity fund to a mutual fund. A private equity fund, by its very nature and name, is private. It aggregates capital from a number of sources: primarily pension funds, wealthy families, individuals, and companies that have meaningful assets available for investment. Depending on the size of the fund, it is typical for an established firm to have a minimum investment size of $5 million. These funds are then used to purchase companies or buy a stake in a company.

People who invest in a private equity fund are called limited partners. Limited partners have no decision-making authority over the private equity firm or the investments made by the fund. The private equity firm serves as the general partner and has total control over the funds’ investments. Limited partners pledge capital for a specified amount of time, generally the life of the fund and thus cannot buy and sell on a whim. There generally is no liquidity, and a private equity fund typically has a charter, or a life span, of ten years. This means you’re committing capital for a period of up to ten years. (Note: it’s typical for funds to have built in, up to two, one-year extensions that don’t require further approval of limited partners, so the money could actually be locked up for as long as twelve years.)

Limited Partners Supply Capital

The way a private equity fund starts investing is by issuing capital calls for the money it needs from limited partners. Here’s an example.

You are an investor in a small private equity firm’s fund that is $100 million in size. You commit $1 million to the fund, or 1 percent. You don’t invest that money up front; rather, you’ve committed the capital, and as the fund seeks investments, it will issue a capital call when it needs the money.

The private equity firm decides to purchase a company that has $4 million of EBITDA—discussed further in chapter 9, “EBITDA” (pronounced as three syllables: e-bit-dah) is earnings before interest, taxes, depreciation, and amortization. The firm buys this company for 8x EBITDA, or 8x $4 million, for an enterprise value of $32 million. Typically, when a private equity firm buys a company, they use the maximum amount of leverage or debt the cash flow of the company allows. In this example, we will use 5x leverage, so 5x EBITDA is $20 million of debt financing, leaving another $12 million of equity from that $100 million fund needed to complete the purchase. The fund issues a capital call, and as a 1-percent limited partner, you get a call that states you need to send $120,000, which is 1 percent of the $12 million of equity needed. This is the pro rata portion of the equity needed by the firm to purchase the company.

Private Equity Means No Liquidity

The private equity fund is made up of people committed to providing capital. They’ve signed up for it. They may not get their money back for ten years or more. The firm makes investments and issues capital calls to the limited partners. As a limited partner, you send in your portion to meet the demand for the cash that’s needed at the time. Because it’s private, there’s no liquidity, and a limited partner has no decision power. There’s no way to get your capital back on demand. This is typically why investment sizes are large. Private equity firms are not geared to handle nonaccredited investors who may need to get their money out quickly.

The return of capital happens over time. Anytime a private equity fund sells a company or refinances for the purpose of creating a distribution, it returns capital to its limited partners. Using the same example as above, let’s say the company is sold five years later. Instead of the $4 million of EBITDA when it was purchased, the company now has $12 million of EBITDA. Earnings increased 3x over a five-year period. The company is sold for the same 8x multiple, only now the enterprise value is $96 million for something that they paid $32 million for five years earlier. That $20 million in original debt financing plus perhaps another $40 million in additional debt and transaction expenses (from buying add-on companies, legal fees, diligence fees, investment banker fees, and carried interest fees) leaves $36 million in equity remaining. As a 1-percent limited partner, you now receive a distribution from the fund for 1 percent or $360,000.

The initial investment was $120,000, but your distribution five years later, net of fees, is $360,000 or a 3x multiple of invested capital (MOIC)—discussed further in chapter 2.

This example shows how a private equity fund receives and distributes money. The capital calls are fulfilled as the fund makes purchases, not up front. In this case, the distribution from the fund back to the limited partner occurred five years after the initial capital call when the purchased company was sold.

Many larger private equity firms often have multiple overlapping funds—some late stage and some early stage—operating with dozens of portfolio companies. Those companies aren’t all bought and sold on the same date. There’s a flow of money, mostly coming into the fund from limited partners in early years to fund platforms and then mostly being returned in later years as platforms are sold.

Life Span of a Private Equity Fund

In the early years of a new private equity fund, the fund will be buying companies that become platforms for growth and will require further investments during their hold period. These are the anchor holdings of the new fund. Some private equity groups state a time limit in their fund’s limited partnership agreement that essentially says all platforms have to be bought within the first six or seven years. Others don’t include the time limit; typically, the hold period in private equity for each portfolio company purchased by the fund is three to seven years, with five being a good average for general planning purposes.

As soon as the fund buys a platform company, they go about the business of trying to grow that platform. There are many different levers for growth that we’ll talk about later in the book.

In the later stages of the fund, the private equity firm works to sell off the remaining assets of the fund. It all works within the ten-year limited partnership agreement that asks for money from the limited partners up front as platform companies are bought, begins to return the money as they are sold, and by the end of the funds term, has returned all capital—plus earnings and less fees—to the limited partners.

Sometimes private equity funds use captive, proprietary, or family-generated funds and don’t really need limited partners to make investments. Examples include MSD Capital, which is the private “family fund” of Michael S. Dell of Dell computer fame, and OMERS Private Markets, the direct investing arm of the Ontario Municipal Employees Retirement System, which is a self-contained arm of the pension fund that actually does its own investing. These funds are self-investing their own capital, which means they don’t necessarily have to buy and sell within a specific time frame or hold period.

Reporting Requirements

During the fund’s life, there are reporting requirements to the limited partners. Let’s call it a score card. Typically, a quarterly financial report is sent out to discuss the funds: where the money has been invested, what capital has been returned, and the current value of invested funds.

Most firms hold an annual meeting with the limited partners of a specific fund, especially if it’s a large private equity shop that has multiple funds ongoing. The firm gets the limited partners together and presents information about the companies that have been purchased and sold by the fund. They may even bring in some CEOs to speak and/or answer questions about individual portfolio companies.

Common Fund Types and Strategies

Private equity firms can invest in various types, styles, and strategies. Here are a few of the more popular fund types and styles typically found in the world of private equity.

Buyout...