Why Private Equity Never Loses
Take a look into how this $11 trillion industry fights to keep its self alive.
Before understanding the ingenious tactics deployed by this behemoth machine, it helps to first understand how the industry works:
Background — All About Private Equity
Private Equity (PE) firms make money by investing in companies that have the potential for growth and value creation, with the goal of realizing a return on their investment through a sale or other exit strategy.
The firm will typically take an active role in managing the company, working closely with its management team to identify opportunities for growth and value creation. They may also make operational improvements to the company, such as implementing new processes or streamlining operations.
Let’s see what that might look like:
- In 2013, Bain Capital acquired Apex Tool Group, a leading manufacturer of hand and power tools, for $1.6 billion.
- One of the key initiatives that Bain Capital implemented was to optimize Apex Tool Group’s supply chain. The company had a complex global supply chain with a large number of suppliers, which made it difficult to manage inventory and resulted in inefficiencies. Bain Capital worked with the management team to consolidate suppliers and improve logistics, resulting in cost savings and improved delivery times.
- Bain Capital also invested in new product development, helping Apex Tool Group to introduce innovative new products to the market. For example, the company launched a line of cordless power tools under the CRAFTSMAN brand, which quickly became a best-seller.
- Additionally, Bain Capital facilitated the sale of Apex Tool Group’s joint venture with Danaher Corporation, which generated $400 million in proceeds for the company.
Once the company has achieved its growth objectives and is ready for an exit, the PE firm will look to sell the company or take it public through an initial public offering (IPO). This is where the PE firm realizes its return on investment.
The return on investment can come from a number of sources, such as the sale of the company for a higher price than the initial investment, or through dividend payments or other distributions made by the company. The PE firm will typically receive a percentage of the profits generated from the investment, known as carried interest.
In addition to the carried interest, PE firms also generate revenue through management fees, which are charged to investors to cover the costs of managing the investment portfolio. These fees are typically a percentage of the total assets under management.
So, now that you know how the industry makes money, let’s take a look at how they not only keep it, but make even more:
Leverage— Other People’s Money
Leverage is an essential aspect of PE transactions that allows investors to use borrowed funds to finance their investments in a company.
In a typical PE deal, the investor contributes a portion of the capital needed to acquire a company, while the rest is financed through debt. The ratio of debt to equity in a deal is known as the leverage ratio or debt-to-equity ratio. This ratio can vary depending on the size and risk profile of the investment, but it is not uncommon for leverage ratios in PE transactions to range from 2:1 to 5:1 or higher.
Let’s see what that looks like:
- In 2005, a PE consortium, which included PE firms Carlyle Group, Clayton Dubilier & Rice, and Merrill Lynch Global PE, acquired Hertz for $15 billion.
- The consortium invested $2.3 billion in equity and financed the remaining $12.7 billion through debt, resulting in a leverage ratio of approximately 5.5:1.
Putting down a small capital amount for extra leverage can be useful because it allows PE firms to amplify the impact of any increase in the company’s value. For example, if a PE firm invests $100 million to acquire a company and the company’s value increases by 10%, the firm would earn a $10 million return on its investment. However, if the same firm invests $20 million but finances the remaining $80 million through debt, then the same 10% increase in value would result in a $40 million return on investment ($100 million x 10% increase — $80 million debt = $40 million return).
Keeping It — Hedging The Bets
Hedging and diversification are important risk management strategies in PE investments.
Diversification in PE refers to the practice of spreading investments across multiple companies and industries to reduce the overall risk of the portfolio. PE firms often invest in a diverse range of companies to minimize the impact of any single company’s performance on the overall portfolio. This can be achieved through various methods, including investing in different industries, geographies, and stages of a company’s development.
Let’s see what that looks like:
- As of 2022, The Blackstone Group the firm had invested in more than 150 portfolio companies across a diverse range of industries, including healthcare, technology, and energy.
To take a deeper surface-level look at their diversification, here’s a few of their portfolio companies:
- Authentic Brands Group (ABG): BlackRock invested in ABG, a brand development and licensing company, in 2019. ABG’s portfolio includes over 30 brands such as Juicy Couture, Aeropostale, and Sports Illustrated.
- Marqeta: In 2021, BlackRock participated in a funding round for Marqeta, a leading digital payments platform. Marqeta’s platform enables businesses to issue and manage digital payment cards, and its clients include companies such as DoorDash and Instacart.
- Oatly: BlackRock was part of a funding round for Oatly, a plant-based food and beverage company, in 2020. Oatly’s products include oat milk, oat-based ice cream, and other plant-based food products.
- Unity Technologies: BlackRock invested in Unity Technologies, a leading provider of real-time 3D development platforms, in 2019. Unity’s platform is used by developers to create video games, simulations, and other interactive applications.
- Pegasus Foods: BlackRock invested in Pegasus Foods, a provider of plant-based meat alternatives, in 2020. Pegasus’ products include plant-based burgers, sausages, and chicken alternatives.
Hedging in PE refers to the practice of using financial instruments to mitigate the potential downside risk of investments. One common way to hedge PE investments is through the use of derivatives, such as options and futures contracts.
Let’s see what that looks like:
- In 2016, the PE firm KKR hedged its exposure to oil prices by entering into a series of futures contracts. The firm was concerned about the impact of declining oil prices on the value of its investments in the energy sector. KKR used futures contracts to lock in the sale price of oil at a specific date in the future, providing a measure of protection against further price declines.
Another hedging method used in PE is the use of interest rate swaps. These contracts allow investors to hedge against fluctuations in interest rates by exchanging fixed-rate and floating-rate cash flows.
- In 2018, PE firm Apollo Global Management used an interest rate swap to hedge against rising interest rates. The firm entered into a swap agreement with a counterparty to exchange its fixed-rate payments for floating-rate payments. This allowed Apollo to protect itself against potential losses resulting from a rise in interest rates.
So in sum, offloading risk through derivatives and diversification, generating revenue through fees, dividends, and exits, and using debt to magnify investing power has turned private equity into an $11T, robust and growing industry.
Pretty cool, right?
If this article piqued your interest, you’d likely enjoy some of my other posts just like this one:
- Welcome to The Quant’s Playbook
- Our Sports Betting Algorithm is Live and Profitable!
- Deploying A VIX-Based Volatility Frown System
Happy trading! :)
