Demystifying private equity

How does private equity buy a company?

The funds controlled by the PE fund are invested in a new company (often referred to as Newco), which is formed just to make the acquisition of the target company. The funds used to form Newco are not just sourced from the PE fund (typically in the form of a relatively small amount of ordinary equity with the balance as loans, or possibly preferred shares or preferred equity, subject to tax and legal structuring advice), but often also from the vendors of the target company and, invariably, the management team as well as lenders.

The vendors and the management team often roll over a proportion of their equity in the target company into loans and ordinary equity alongside the incoming PE fund. The management team will invariably be asked to invest in the venture from their own resources; this is so all stakeholders have skin in the game.

The ownership proportions of Newco are determined by the value of target, the relative amounts of funding provided (bank debt, loans, vendor rollover, and management investment) and negotiation. There are no hard and fast rules, but the more negotiating power the vendors and management have, the better their packages will be. 

Over the period of the investment, the cash generated by the target company may be used to pay down the bank debt, and sometimes the loans. However, most of the loans and the balance of the bank debt (often the majority of that) are repaid at exit (i.e., when the shareholders sell their stakes). As the returns on the bank debt and loans are restricted to the repayment of the principal plus accrued interest, any excess growth in value accrues to the ordinary shares.

The majority of private equity buyouts are funded through loans or preferred shares from PE fund and bank debt. Bank debt attracts an interest rate that is paid periodically. The loans attract an interest rate, typically between 8% and 12%. The interest can be paid but is most normally rolled up into the principal or paid by the issue of further notes, referred to as payment-in-kind (PIK) notes. The balance is funded by a thin sliver of ordinary equity.

How private equity makes money

As time progresses, the business and its earnings before interest, taxes, depreciation, and amortization (EBITDA) grow; bank debt is paid off or amortized; operations are improved; and the value of the business increases. This drives value into the ordinary shares, provided that the growth outstrips the total cost of debt and the loans.

The value of the equity grows further if there is multiple accretion, which happens when the exit multiple exceeds the entry multiple. As you can imagine, PE fund executives not only focus on EBITDA growth but also on things that might positively affect multiples. This includes keeping an eye on the market and the timing of any exit.

If everyone has done their job well, timing of the exit is picked well and the business has been prepared for the sale process efficiently, the returns can be excellent for the fund, the PE fund, its executives, the vendors, and the management team.

Navigating private equity

The next article in our series, Navigating private equity, is appropriate if your business is speaking with PE firms and preparing for a potential investment.

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