Private equity is a source of investment capital from high net worth individuals and institutions for the purpose of investing and acquiring equity ownership in companies. Partners at private equity firms raise funds and manage these monies for the purpose of yielding favorable returns for their shareholder clients, typically with an investment horizon between four and seven years.
These funds can be used in the purchase of shares of private companies, or in public companies that eventually become delisted from public stock exchanges under go-private deals. The minimum amount of capital required for investors can vary depending on the firm and fund raised. Some funds have a $250,000 minimum investment requirement; others can require millions of dollars. Let's delve a little deeper into private equity firms. (Smaller investors have found ways to get closer to the private equity action.
Introduction to Private Equity
Private equity has successfully attracted the best and brightest in corporate America, including top performers from Fortune 500 companies and elite strategy and management consulting firms. Top performers at accounting and law firms can also be recruiting grounds, as accounting and legal skills relate to transaction support work required to complete a deal and translate to advisory work for a portfolio company's management.
The fee structure for private equity firms varies, but it typically consists of a management fee and a performance fee (in some cases, a yearly management fee of 2% of assets managed and 20% of gross profits upon sale of the company). How firms are incentivized can vary considerably.
Given that a private equity firm with $1 billion of assets under management might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees for the firm, it is easy to see why the private equity industry has attracted top talent. At the middle market level ($50 million to $500 million in deal value), associates can earn low six figures in salary and bonuses, vice presidents can earn approximately half a million dollars and principals can earn more than $1 million in (realized and unrealized) compensation per year.
Transaction Support and Portfolio Oversight
There are two critical functions within private equity firms: •deal origination/transaction execution
Deal origination involves creating, maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks and similar transaction professionals in an attempt to secure both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates referred to private equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners in an effort to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that the funds raised are successfully deployed and invested.
Additionally, internal sourcing efforts can reduce costs related to a transaction by cutting out the investment banking middleman's fees. When financial services professionals represent the seller, they usually run a full auction process that can diminish the buyer's chances of successfully acquiring a particular company. As such, deal origination professionals (typically at the associate, vice president and director levels) attempt to establish a strong rapport with transaction professionals in order to get an early introduction to a deal. It is important to note that investment banks often raise their own funds and therefore may not only be a deal referral but also a competing bidder. In other words, some investment banks compete with private equity firms in buying up good companies.
Transaction execution involves assessing management, the industry, historical financials and...