What is Private Equity?

Private equity is capital made available to private companies or investors. The funds raised might be used to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company’s balance sheet. Unless you are willing to put up quite a bit of cash, your choices in investing in the high-stakes world of private equity are minimal. 

Private equity investing includes early-stage, high-risk ventures, usually in sectors such as software and healthcare. 

These investors try to add value to the companies they invest in by bringing in capital, new management or selling off underperforming parts of the business, among other things. 

The minimum investment in private equity funds is relatively high—typically $25 million, although some are as low as $100,000. 

Investors should plan to hold their private equity investment for at least 2 to 10 years. 

Is Private Equity an asset class?

Private equity is an asset class consisting of equity and debt investments in companies, infrastructure, real estate and other assets. Capital invested in this asset class is typically raised from a range of investors through private, rather than public, means. 

What are typical private equity returns?

The U.S. Private Equity Index provided by Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20 years ending on June 30, 2020. During that same time frame, the Russell 2000 Index, a performance tracking metric for small companies, averaged 6.69% per year, while the S&P 500 returned 5.91%.

Is Private Equity High Risk?

Overall, the risk profile of private equity investment is higher than that of other asset classes, but the returns have the potential to be notably higher. For investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of a portfolio. 

What makes a good private equity investment?

Strong market position and sustainable competitive advantages: This may seem obvious, but strong candidates include companies that are market leaders with sustainable business models. This can be characterized by high barriers to entry, high switching costs, and strong customer relationships. 

Multiple avenues of growth: It is always helpful to have a balanced and diverse growth strategy so that a company’s success is not completely reliant on one driver. This could include growth through the introduction of new products, increase in the number of locations, new customers, increasing the penetration of current customers (upselling products), exploring adjacent industries, and expanding into new geographies, among other possibilities. 

Stable, recurring cash flows: Due to the reliance on high leverage, PE firms and investors must find companies with stable and recurring cash flows to have sufficient cash flow to service all their debt requirements. This requires having relatively low exposure to seasonal fluctuations in cash flows, as well as low sensitivity to cyclical fluctuations (i.e., relatively immune to economic downturns and/or commodity prices). 

Low capital expenditure requirements: Companies with low maintenance capital expenditure requirements provide management more flexibility in terms of how it can allocate the company’s capital and run its operations: investing in growth capital expenditures, making bolt-on acquisitions, growth in its core operations, or give back capital to its shareholders in the form of a dividend. Capital-intensive businesses will typically generate lower valuations from private equity firms since there is less available capital (after interest expense), and there is increased financial risk in the deal. 

Favourable industry trends: Private equity firms are continually searching for companies that are well-positioned to benefit from attractive industry trends since it results in above-market growth and provides stronger equity return potential as well as stronger downside protection for the investment. Examples include increasing automation, changing customer habits, adoption of disruptive technology, digitalization, changing demographics, increasing regulation, etc. 

Strong management team: A strong management team is crucial to success as private equity firms will provide strategic guidance but will almost exclusively rely on management to execute their operating strategy. If a company does not have a strong management team, the private equity firm must have a replacement ready before even seriously contemplating the investment. 

Multiple areas to create value: In addition to the characteristics above, a good LBO target candidate will also have multiple areas where the PE firm can create additional value. Examples include selling underperforming assets, increasing the efficiency of operations, pricing optimization, organizational structure, and diversifying the customer base. 

 

Areas of Due Diligence

A crucial part of the investment process is the due diligence performed on the company. Think of it like an investigation process for a potential investment: PE firms will perform very detailed due diligence to ensure that they are making a sound investment. This process is crucial to the success of the investment, and the financial sponsor must look at all critical aspects of the target company:  

commercial, financial, and legal. Much of the time is spent on commercial due diligence while the financial and legal areas are more confirmatory. PE firms rely on consultants for their expertise and advice for portions of the due diligence process, but ultimately the investment decision is the firm’s responsibility.  

 

Commercial due diligence includes understanding the company’s value proposition, market position, historical performance, and industry trends to assess the target’s ability to achieve its forecasted projections. 

Sample due diligence questions include: 

Competitive Landscape and Market Position: It is important to understand how sustainable the target’s business model is and where it is positioned relative to its competitors. 

What is your competitive advantage (e.g. product offering, technology, price, premium brand, distribution capabilities, geographic presence, fully integrated solution, etc.)? Is this a disruptive business model (i.e., one that changes the landscape of how business is done in this space in some way)? 

What are the barriers to entry into the business? What are the costs of switching to a competitor’s product? 

Where does the company fit in the industry value chain? How has the industry changed over the last 5 years? How do you expect that to change over the next 5 years? 

Who are your main competitors? From whom have you been gaining/losing market share? What firm is the biggest threat to your company? What is the biggest share gain opportunity? 

What is the market landscape (e.g. oligopoly, fragmented market, first-mover, etc.)? How saturated is the market? 

Industry Growth/Addressable Market: When evaluating the industry, it is crucial to understand the market environment and the external factors affecting the business. 

 

What is the historical growth of the market? What is the projected growth of the market over the next 5 years? How mature is the industry? 

What is the total addressable market? What segments of the industry are growing faster than others? 

Describe the key macroeconomic drivers of the business. What are the trends? 

Have there been any significant changes to the industry landscape (e.g. disruptive new entrants, consolidation, vertical/horizontal integration, demand/supply imbalance, etc.)? 

What are the regulatory concerns and how can they adversely affect the business? 

Customer Base/Suppliers: This entails understanding the “stickiness” of customers and the company’s reliance on suppliers. 

 

How many customers do you have? What is the concentration of your top 50 customers? 

What is the typical contract length of a customer relationship? What is a typical renewal rate? What percentage of customers have multiple products? 

Who are the key decision-makers for the customers? What are the buying dynamics? How long is the entire sales process? 

How many suppliers do you have? What is the concentration of your top suppliers? How large of a customer are you to them? What is the average length of the relationship? How often are your supply contracts renegotiated? 

Capital Requirements of the Business: A good understanding of the total capital needed to run the operations of a business is needed, especially during difficult times. 

How capital intensive is the business? What percentage of capital expenditures is growth capital vs. replacement/maintenance capital? How has that trended over the last 5 years? What kind of lead-time is needed (i.e. time from purchase order to delivery) when making a purchase order? How large of a deposit is customary for new purchases? 

How cyclical is the business? Are there any severe seasonal changes in demand? What are the factors? How much visibility do you have in expected sales? 

What percentage of the COGS cost structure is fixed vs. variable? What is the breakdown of operating expenses? 

What is the normal working level of cash to run the business for a year? 

At what manufacturing capacity is the company running right now? How quickly and to what extent can it be reduced if demand falls? 

What would be your biggest concern in a downside scenario? 

Financial Performance (Historical & Projected): This analysis provides a deeper look into the company’s historical performance to understand how realistic the company’s forecasted projections are. 

Provide a comparison of the historical performance to the management budgets for the last 5 years. Describe the methodology behind the budget and the reasons for beating/missing the budget. 

What are the key performance indicators (KPIs) the management uses to monitor the business? Describe the trends in these indicators. 

Break out your organic growth over the last 5 years (not including the impact from acquisitions). 

Provide your 5-year financial model and describe the key drivers in your projections. 

Growth: Please describe the key assumptions. How does it compare to expected market growth? Where will it come from (increase in price, increase in volume, increase in market share, new products, acquisitions, etc.)? 

 

Margins: Please describe the key assumptions. Why (for example) do you expect margins to increase so significantly compared to historical performance? Where will it come from (operating leverage, cost efficiencies, higher margins on products, revenue/cost mix, etc.)? 

KPIs: Describe key assumptions. How do they compare to the industry average and/or your main competitors? 

What are the primary risks to this forecast (new product introduction, successful expansion into a new geography, customer concentration, sufficient hiring of employees, R&D resources, etc.)? 

Financial due diligence confirms that all the financial information provided is accurate and helps PE firms understand some of the unique dynamics of the company from a financial reporting perspective. The firms typically hire accountants and/or auditors to review the financials, operations, customers, markets, and tax issues in detail. This is usually referred to as “transaction advisory services.” 

 

Corporate filings: This component of the legal due diligence process is to confirm that all corporate filings have been filed correctly (corporate organization and documents) and to understand the legal organization of the company, such as whether there are any strange corporate structures. 

Material contracts: Prior to acquiring a company, it is important to look at past and current material contracts. This includes the debt structure, acquisitions and other liabilities, and it may include key customer, partner or supplier agreements. 

Property, plant and equipment: It is important to consider the company’s property, plant and equipment to study its assets and liabilities. One example of this is a detailed review of key operating or capital leases. 

Human resources: HR due diligence is another important area in legal due diligence, and it refers to the target company’s management team and employees. Any HR risks need to be captured in the valuation model. The firm will look at employment terms/agreements, individual contracts, collectively bargained agreements and retention/severance agreements. In conjunction, a review of the management and employees are necessary. The compensation structure is crucial to understanding the organizational and operational structure of the company. This includes compensation for executives, and the possible severance required if they are to be terminated during the deal. This also includes other salary and stock option plans for key employees. 

Health and welfare plans: The target company will have various benefit plans set up, which must be evaluated as the acquisition is taking place. The firm reviews the health benefit plans, retiree health plans, and retirement plans to understand any regulations or legal issues surrounding the benefits. 

Information technology: Reviewing the company’s IT structure during legal due diligence is very important. Assessing the company’s information technology and related agreements can provide further insight into the company’s weaknesses and strengths. The review includes looking at software or hardware agreements with external parties, contractually obligated product features or service level agreements, license agreements, and other technology agreements 

Lawsuits/litigation/patents: A look at the company’s lawsuits/litigation provides a summary of any pending litigation, history of past litigations, and what may arise in the company, such as environmental, employment, customer or worker compensation issues. Similarly, a careful review of the in

The main areas of financial due diligence

Quality of earnings: The PE firms need to confirm the historical earnings of the company excluding non-recurring costs/expenses, as this will affect the valuation of the company. Consequently, they hire accountants to ensure that the information the company provides is accurate. 

Accountants review the company’s historical performance to understand the target’s actual EBITDA, adjusted for non-recurring costs. Adjusted EBITDA is critical because that is what will drive the company’s valuation (Adjusted EBITDA × EBITDA multiple = Purchase Price). These adjustment types include management adjustments, business-related adjustments, and pro forma adjustments. 

Management adjustments are common when purchasing family-founded businesses where compensation is very flexible. Adjustments include one-time or excess owner/executive compensation, transaction costs, legal settlements, and personal expenses (like a private jet, accounting fees, etc.). 

Business-related adjustments include accounting-related issues, such as accounting true-ups for bonuses and reserves, inventory valuation, revenue recognition, accrual/reserve reversals, etc. These adjustments also include lost customers and unsustainable margins or cost cuts. 

Pro-forma adjustments occur when the company has made recent acquisitions or divestitures. They are attempting to answer the following question: given the current business structure, what would historical earnings have been, pro forma for the acquisitions/divestitures? This review includes synergies (eliminated positions & facilities, scaled pricing, major customers, audit/tax fees, open positions, known cost increases, etc.). 

Debt and debt-like items: During the review, firms need to calculate the company’s total debt-like items outstanding, because it will impact the total amount given to the sellers (Total purchase price less debt = cash given to sellers). All liabilities will be categorized as either working capital or debt, not both. Sellers have an incentive to have lower debt & debt-like items, but buyers need to ensure that the amount of debt owed is not misrepresented. For example, capital expenditures may not be accurate because the company could have ordered a lot of equipment but have yet to pay for the purchase, which results in a payment post-acquisition, thus affecting the total cash available after the deal. Also, debt-like items are often buried in accounts payable and accrued expenses. Other common debt-like items can be found in deferred compensation, termed accounts payable, shareholder payables, legal settlements, tax-related liabilities, and liabilities associated with certain cash transactions. 

Normal working level of capital: The PE firm assumes that the company needs a normal level of working capital to remain in business, and thus removes it from the purchase price. The accountant must identify adjustments to reported working capital (this involves determining and reporting on the Quality of Operating Working Capital) and assist with setting an operating working capital target. Beyond setting a working capital target for the purchase price, the accountant must perform due diligence to understand the other unique dynamics of the business model to optimize the operations during various economic cycles. This would require looking at the characteristics of the company’s cash flow, deferred revenue, orders, revenue recognition, and seasonality of the business. 

Tax structure: This process entails looking at the tax structure of the company and providing a detailed analysis of the federal, state, local, and international tax situation (both historical and anticipated). Federal taxation occurs at the national level and includes a review of tax assets, structure of the company, step-up calculations, compliance procedures, and identification of the potential tax liabilities. State and local taxation are based on the location of the company. This entails a review of the payroll, use tax, and sales compliance procedures as well as a high-level assessment of potential tax liabilities. International taxation deals with transfer pricing as the company conducts business globally. This also refers to the tax structure of the company after the acquisition. By looking closely at a company’s tax structure, the analysis can provide insight into the best methods and locations for tax compliance so that the company may maximize its net profit and minimize its tax liabilities. 

Information technology: IT issues can cause a significant block in a smooth transition if the systems are not reviewed correctly and comprehensively. The smooth process of IT systems is crucial to conducting accurate reviews of tax liabilities and accounting as well as maintaining historical financial records. 

Human resources: HR plays an important role in due diligence because it affects payroll and that in turn affects the taxes for which the company is responsible. State filing requirements and income regulations are based partly on the location of the payroll. 

Legal due diligence is mainly confirmatory. It is focused on confirming that the target company is not subject to any future liabilities including regulatory issues, threatened or ongoing lawsuits, and unusual or onerous contract provisions. 

Corporate filings: This component of the legal due diligence process is to confirm that all corporate filings have been filed correctly (corporate organization and documents) and to understand the legal organization of the company, such as whether there are any strange corporate structures. 

Material contracts: Before acquiring a company, it is important to look at past and current material contracts. This includes the debt structure, acquisitions and other liabilities, and it may include key customer, partner or supplier agreements. 

Property, plant and equipment: It is important to consider the company’s property, plant and equipment to study its assets and liabilities. One example of this is a detailed review of key operating or capital leases. 

Human resources: HR due diligence is another important area in legal due diligence, and it refers to the target company’s management team and employees. Any HR risks need to be captured in the valuation model. The firm will look at employment terms/agreements, individual contracts, collectively bargained agreements and retention/severance agreements. In conjunction, a review of the management and employees are 

necessary. The compensation structure is crucial to understanding the organizational and operational structure of the company. This includes compensation for executives, and the possible severance required if they are to be terminated during the deal. This also includes other salary and stock option plans for key employees. 

Health and welfare plans: The target company will have various benefit plans set up, which must be evaluated as the acquisition is taking place. The firm reviews the health benefit plans, retiree health plans, and retirement plans to understand any regulations or legal issues surrounding the benefits. 

Information technology: Reviewing the company’s IT structure during legal due diligence is very important. Assessing the company’s information technology and related agreements can provide further insight into the company’s weaknesses and strengths. The review includes looking at software or hardware agreements with external parties, contractually obligated product features or service level agreements, license agreements, and other technology agreements 

Lawsuits/litigation/patents: A look at the company’s lawsuits/litigation provides a summary of any pending litigation, history of past litigations, and what may arise in the company, such as environmental, employment, customer or worker compensation issues. Similarly, a careful review of the intellectual property (IP) will be useful because the company’s proprietary information can help raise its value. Valuable IP can include 

patents/trademarks, domain names, trade secrets, and design rights that are exclusive to the company and help drive its business. Regulatory issues can also come into play here. An example of this is the need to review the possibility of asbestos liability for certain companies in some industries. 

 

Environmental: Another crucial aspect of operations is to understand any potential liabilities the business is exposed to in its environment while conducting the day-to-day processes, such as hazardous material or toxic waste. Each business has specific types of environmental issues, and they will vary based on the industry. 

 

Is Private Equity High Risk?

Overall, the risk profile of private equity investment is higher than that of other asset classes, but the returns have the potential to be notably higher. For investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of a portfolio.