private equity funds -- 10/17/23
Today's selection -- from The Problem of Twelve by John Coates.The structure of private equity funds:
“Private equity funds are created by financial advisory firms. Those firms, along with their individual managers, typically invest 1 percent of their own money in a private equity fund's total capital. The rest of a private equity fund’s capital is raised primarily from institutions, such as pension funds. Private equity funds use this capital to invest in operating businesses, just as index funds do.
“Index funds, however, buy stock in small amounts at a time, which in aggregate has grown enormously. Private equity funds usually buy all of the stock of a company, taking it over completely. In the seventies and eighties, these acquisitions were called buyouts. Funds borrowed money, a form of financial leverage, giving them greater buying power, so their deals were called ‘leveraged buyouts,’ and the entire industry was known as the LBO industry. That activity persists--most private equity deals are debt-fueled purchases of entire companies. Most private equity assets remain in buyout funds.
“Another difference between private equity and index funds is that the latter are heavily regulated. Private equity funds, by contrast, are exempt from this kind of regulation, and private equity advisors are regulated only under the light-touch Investment Advisers Act. Unlike index funds, private equity firms, like venture capital and hedge funds, are permitted to charge potentially lucrative incentive fees. Typically, private equity firms get a 2 percent management fee plus 20 percent of profits. They have a large upside for good outcomes, and even some upside for bad outcomes. Such asymmetric fees--‘heads I win, tails you lose’--are illegal for index funds.
“Private equity funds' relationships with their own investors also differ from index funds. While index funds provide daily liquidity by redeeming and selling shares, private equity funds collect capital commitments, and once invested in a business, do not allow their investors to exit for many years. Instead, each fund typically has a termination date--effectively a preset commitment to liquidate, seven to twelve years after formation.
“As a result, private equity funds plan to exit each business they buy, to generate cash for their investors. They are not truly ‘flippers’--they rarely buy and sell companies rapidly. However, they are also not long-term investors--their median holding period for a company is six years. At first, private equity exits were initial public offerings. Over time, other exits became more common: sales to public companies; sales to other private equity funds (secondary buyouts); and most recently, sales to new funds managed by the same private equity firm (continuation buyouts).
“Private equity firms provide operational and strategic vice to companies they acquire, reshaping operations and en strategy. Because they use debt, they maintain relationships with banks, insurance companies, hedge funds, and other lenders (including other private equity funds). The debt they incur, plus their planned exits, lead private equity firms to try to increase a company's cash flow rapidly. They cut costs, often by laying off employees, cut capital investments, and try to expand profit margins and sales by refining product mixes and marketing strategies.
“A private equity firm typically operates at the hub of a wheel, with many private equity funds. Different funds are at the ends of the spokes, in different stages: some in formation, some on the hunt for deals, some existing prior acquisitions, and some winding up. A private equity complex, as they are called, is in fact complex. In all, private equity is a stylized image of Joseph Schumpeter's ‘gale of creative destruction’ as the ‘essential fact’ of capitalism, characterized chiefly by constant churn--fundraising, dealmaking, and change management as a business.
“Today, more than a third of total corporate equity in the US is managed outside of public companies, with the fastest growth in businesses owned by private equity funds. US-based private equity firms have diversified globally, and gone into other financial businesses. They now sponsor or affiliate with hedge funds, broker-dealers, and venture capital funds. Private equity firms now sponsor funds that focus not on traditional buyouts but on real estate and credit.
“Private equity's share of the economy continues to grow. Private equity funds were on course to raise more than $1 trillion of new capital in 2022. Total assets under management by private equity funds passed $12 trillion, an all-time record. Private equity in 2020 managed assets that were 18 percent of total corporate equity, as measured by the Federal Reserve, compared to 4 percent in 2000. Private equity's assets under management from 2000 to 2020 experienced an astonishingly compound annual growth rate of 15 percent, vastly outstripping the economy overall, which grew at a compound rate of 3.6 percent."