Structure of Private Equity Buyout - Essay Example

Financial strategy Contents Contents 2 Introduction 3 Discussion 4 Structure of Private Equity buyout: 5 Current trend of the Private Equity 6 The Future of the private equity 7 Arguments for the Private Equity 7 Arguments against the Private Equity 11 Conclusion 13 References 15 Introduction Private equity can be defined as the source of investment of capital from the institutions and high net worth individuals required for the use of investing and deriving equity ownership in the respective companies. The private equity mainly consists of the funds and the investors that make direct investment in the private companies. Private equity market has steadily expanded its market in 1970s. The private equity firms mainly attempts to accumulate the pool funds for converting the large public companies into private. Most of the equity firms maintain the leverage buy out where huge amount of debt are required for funding large purchases. Then the private equity firms attempts to develop the prospect and financial results of the company for reselling the company to other firms. The strategies or tactics that are adopted for adopting private equity by the firms are Growth capital, Leverage buyout, Venture capital and Mezzanine capital. Among this strategies the leverage buy out is considered as the most important and useful strategy of the private equity firms. Figure 1: Private equity funds of fund The diagram represents private equity funds of fund in which the firms collect the management fees and returns the net profit to its investors. In many cases the investors mainly reinvest the funds of fund. Private equity is considered as the source of capital that has been acquired from outside the public equity market for investment in asset or company. The private equity funds are mainly sourced from the investors that are known as the limited partners. Discussion Private equity is focusing on the sustainability issues of the funds. The changes in the structure of the private equity industry is increasing the competition and creating the value of the companies (Cruz, 2012). Figure 2: Sustainability of the private equity firms The private equity firms are engaged in raising the private equity fund. The private equity funds are composed of the close ended vehicles in which the investors determines to provide a fixed amount of money for paying for the investment done in the companies and also maintaining, managing and providing management fees to the private equity firms (Blackman, 2014).The private equity firms are legally organized as the limited partnership where the general partners of the firm maintains the capital and the limited partners of the firm generally involves the institutional investors. Figure 3: Market value of the private equity firms The above diagram represents the private equity from fundraising and the private equity from transactions. The figure reveals that the private equity fundraising has increased from the year 2005 to 2007and the market is experiencing boom phase. But the fundraising will decline in the next or coming several years. In case of the private equity transactions the private equity firms generally agrees to purchase or buy the company. When the company or the firm is public the private equity firms attempts to make payment of 15 to 20 % of premium over the current price of the stock. The buyout is mainly financed with debt of 60 to 90 % which is termed as the leverage buy out. Structure of Private Equity buyout: The private equity firm generally comprises of number of funds and each fund is connected and bounded by different types of investments. The black arrows in the diagram explain the flow of capital in case of the sponsored buyout of the private equity. The private equity firm and the staff of the firm generally make investment in the firm with their own capital into the fund of the firm. Figure 4: Structure of private equity buyout When the investment manager or the partner of the firm finds out the prospective or the attractive investment the investor will then invest and utilize its portion of the capital fund that is combined with the debt of the bank for purchasing the target company or the firm. The red arrows in the diagram explain the payment of the dividend, interest, capital gains and fees. The private equity firm also takes share of profit in terms of the carried interest (Bain and company, 2010). Current trend of the Private Equity The private equity firms are experiencing a significant amount of problem in closing the deals or finding out the companies at appropriate and proper values. It is very difficult for the private equity firms to compete against its conglomerates or strategic buyers with good amount of cash in order to pay off its debts and liabilities and develops short term synergy opportunities for Target Company that mainly fits the portfolio of the product. The private equity firms are adopting fundraising for entering into new deals. But the limited partners are adopting stringent terms of the deal on the funds which includes the fund raised from the management fees and performance wise. With the emergence of the private equity firm as the major or main asset class in 1980s the private equity has experienced three major types of boom. The expansion mainly results in the industry resourcefulness, capacity for innovation, adaptability for the fast changing in the market (LPEQ, 2014). The Future of the private equity The present situation of the private equity firm is good. But to maintain the consistency the private equity firm is required to be developed. The industry has focused and diverted its attention from the majority stakes in companies to the widening and expansion of capital within the various sectors and industry. Therefore the private equity firms are required to focus on the improvement and development of its growth capital. Together with it the industry requires considering itself accountable and responsible for learning from its past failures or mistakes for bringing transformation in the private equity industry (Banerjee, 2012). Arguments for the Private Equity The private equity buyout is used or applied for debt financing and the effects of discipline in the firm. Greater or the increase in the leverages results in the regular payment of the interest and reducing or decreasing the free cash flows. The decrease in the free cash flows helps in exerting discipline on management of the company by eliminating the resources which could have been used by the management in investing in net present value of the projects which derives a negative value. Buying out a company or the firm that is listed and then taking it out of the public spotlight would result in providing comfort and lightening the pressure for meeting the short term gain or achieving profitability targets (Paglia, 2012). The capital gain on the investment of the private equity firms reflects the value added in redesigning the company for example the increase in margins and the increase in revenues. The profit will determine the extent of the skill in developing the strategy and for introducing to new management structure. The increase in valuation done by the investors in comparable firms over the holding of the private equity firms are required to expect profit by maintaining investment in the company. The private equity firm mainly borrows the money from the lenders or banks and `increases money which it includes in its fund and allows the private equity firm to gain and acquire majority stake in other companies. The private equity firm maintains the position for restructuring and redesigning the company which will help the firm in selling its stake for earning profit. When the companies are bankrupt, the mezzanine debt is used for paying off the debt. Private equity firms helps in re evaluating the various aspects of the business for maximizing its value. The individual partners in the private equity firm generally invest their money and also earn additional amount of money from the fees that is acquired from the performance when the firm is able to earn profit. Therefore the private equity has the ability to strengthen the incentives in order to increase and improve the value of the company. The private equity firm generally prefers to invest in those companies that will yield more profit and is valuable in nature and it appreciates or develops the value that has been created. The accountability between the shareholders and the managers of the company increases the tangible value and reward of the company. Private equity mainly determines an increasing element of the overall allocation of the asset among the institutional investors. The investors are expected to attain return that is highly attractive to its stakeholders. The private equity provides return which includes the combination of the four major factors such as leverage, growth of the revenue, increase in the valuation and the efficiency gains that improves the margin. The private equity facilitates the company by providing the right combination of the growth and the size that is likely to exist in the market based economy. The private equity firms are very particular and they make expenditure in the important and valuable resources for identifying and accessing the potential of the companies for understanding the risk and then mitigating the risk. Private equity generally assists the firm in achieving growth. The private equity facilitates in purchasing the shares of the public companies or the private companies that is delisted from the public stock exchanges. Private equity is able to captivate and draw the attention of the investors and the corporate. Private equity generally adopts the strategy or tactic which is popularly known as the popular exit strategy which results in the development and improvement of the middle market company. The most common and the appropriate tool that is used by the private equity firm for the investors of the company is Earning before interest tax depreciation and amortization. When a company is being acquired by the private equity firm the investors together with the management contribute significantly in improving and developing the EBITDA during its investment period. The company with good portfolio increases and develops the EBITDA by acquisition. The return that is provided to the investors of the private equity mainly depends on the growth and success of the business. Private equity provides good return to its investors when the company is able to derive more profit (Wilton, 2013). The number of private equity firms is looking forward for the increase in investment. The private equity is increasing the investment options. The investors of the private equity have widened the focus of its consumer and industrial products and services. The private equity of the firms are looking forward for financing the new transactions that are required to capture the alternative sources for providing high yield on the bonds, debt funds, vendor notes and mezzanine capital. The companies that are sponsored by the Private equity is interested in taking and adopting the wait and see approach which deals with expecting a better deal by the company. But it is also required that the private equity should recognize and identify the various known and the unknown factors of the company. The components of the leverage buyout explains that the private equity firms apply the governance, operational engineering and financial to the portfolio of the companies for improving the operation of the firms and creating and developing the economic value. The private equity firms generally use the operating knowledge in order to identify the investment that are attractive in nature for developing the value creation plan for the investments and implementing the various value creation plans . The plan includes the elements that are required for cutting the cost opportunities and the changes in the management (Kaplan and Stromberg, 2009). Arguments against the Private Equity While analyzing the arguments against private equity the points to consider are tabulated below: The private equity is not considered as safe or secured for any asset though it is regarded as an important part or element of the non equity funding. The private equity firm generally faces the risk or danger of failure or defeat like the other shareholders. The private equity is a lengthy process or method from the time when the private equity managers decided to organize or conduct or perform in the detailed financial, environmental, legal market and also the management with due intelligence. The use of private equity is restricted through limited partnership. This is the most traditional method which is followed in the investment process of private equity. The investment opportunity is mainly limited to sophisticated investors and some institutions. The minimum amount that the investors must commit is fairly large and so it acts as the barriers to entry. It is known that private companies are mainly illiquid in nature. It is the expectation of each private organization that investors will commit the sum for several years. Keeping this expectation in mind the limited partnerships are commonly structured on a ten year forecast. It can be said that the private equity is the grim reaper (Ernst & Young, 2006).Private equity buyouts incorporate a sense of uncertainty to the public investors at the time the business is taken over. The private equity shops take the help of debt to perform transactions in the financial market. This sort of behaviour may cause damage not only for the company but also to the financial market as a whole. The financial crisis has led to oversight of the private equity market. The financial market is still under the scanner of regulation than the traditional modes of investments. The policymakers are often alarmed about the controversial practices followed by the private equity owners. Although many disadvantages have been discussed earlier, it is now time to talk about the most important drawback of all. Acceptance of private equity money leads to loss of control. The loss of control has potential negative impact upon a couple of things. The entrepreneur may fall in dilemma when there are disagreements with the private equity firm. It may even be the case the employees of the private equity firm support a decision which the entrepreneur considers as poor. Since the investments through private equity are liquid in nature it is not possible for the investors to sell or buy the investments as their wish. Coupled with it there lies the barrier of high investment. Investments are under a threat of losing money since investments through private equity are mainly channelized in small companies of even start ups. The private equity fund managers try to interfere in the daily activities of the business and the lack of potentiality is a challenge for the private equity firm. The private equity firm involves many personnel in the business activities are therefore the operating expenses and the management costs take the steep rising curve. It affects the normal activities of the organization. The NAV of the private equity firm cannot be calculated in a proper fashion and often difference between the best and the worst performing form are huge. It also highlights the risk involved in investing in private equity (Cumming, 2009). Figure 5: Acquisition of UK companies by private equity funds Private equity firm has provided relaxation on the non price term. Therefore the loosening terms of the credit and the buyout of the funds has utilized more of its debt and very less amount of its equity as compared to its debt while taking over the UK based companies. This has resulted in the increase of debt and the consequence was the increase in the debt as compared to its earnings ratio of the acquired company started rising. Conclusion The commitment of the investors to the private equity funds always remains vigorous. Whereas the debt market remains or becomes unfavourable that is likely to create pressure for the private firms to make investment in the capital that is committed. The increase in the indebtedness of the private equity owned by the corporate sector is more susceptible and fragile to default. The challenges in refinancing of the private equity is owned companies but the company experiences some evidence in case of the poor performance of the loan as compared to the sponsored firms of the private equity. Creating value is considered as the important element of the private equity model. The private equity is improving or developing the business over the lifetime of the investment done so that the company can attain and achieve better position at the time of sell. The investors of the private equity generally have the freedom and the talent or the skill for selecting and choosing the timing and the target of their investments. Private equity generally allows the company to identify the business, helping the company to develop or improve the fresh plans for its rapid growth and development and also creating the value which will help the company in exceeding its acquisition price. The private equity investors generally act as a catalyst for changing rapidly through the combination of the management teams, new plans and the investments with the strong involvement of the investors. References Bain and company. 2010. Global Private Equity Report. [pdf]. Available at:< http://www.bain.com/Images/Global_PE_Report_2010_PR.pdf >. [Accessed 7 January 2015]. Banerjee, A., 2012. What are the recent trends of private equity funding in India. Pratibimb.2(1). pp: 8-15. Blackman, A., 2014. The Pros and cons of having private equity firms invest in your business. [online]. Available at: < http://business.tutsplus.com/tutorials/the-pros-and-cons-of-having-private-equity-firms-invest-in-your-business--cms-19887>. [Accessed 7 January 2015]. Cruz, L. 2012. Sustainability gains importance for private equity funds. [Online]. Available at: < http://www.greenbiz.com/news/2012/09/11/private-equity-ESG>. [Accessed 7 January 2015]. Cumming, D., 2009. Private equity: fund types, risks and returns, and regulation. Canada: John Wiley and Sons. Ernst & Young., 2006. How do private equity investors create value. [pdf]. Available at: < http://www.pegcc.org/wordpress/wp-content/uploads/how-do-private-equity-investors-create-value_ernstyoung_global_report_.pdf>. [Accessed 7 January 2015]. Kaplan, S.N. and Stromberg, P., 2009. Leveraged buyouts and private equity. Journal of Economic Perspectives. 23(1).pp:121-146. LPEQ, 2014. An international association of listed private equity companies. [online]. Available at: < http://www.lpeq.com/Privateequityexplained/Advantagesofprivateequity.aspx>. [Accessed 7 January 2015]. Paglia, J.K., 2012. Did they build that? The role of private equity and venture capital in small and medium–sized businesses. [pdf]. Available at: < http://bschool.pepperdine.edu/newsroom/wp-content/uploads/2012/12/Paglia-Harjoto-PE-VC-11.29.2012-IEGC.pdf>. [Accessed 7 January 2015]. Wilton, D., 2013. The benefits of private equity investment.[pdf]. Available at: . [Accessed 7 January 2015]. Read More