Everyone has the same questions when it comes to Private equity strategies: "Which one is the best for quick returns? And "How do I get in?
Here is the answer to the first question: "If you're looking for short-term gains, large traditional firms are the ideal choice."
They leverage buyouts of companies and hence tend to pay more. However, it gets more complex over the long term.
For the answer to the second question, "Read all about Private Equity Recruitment and Interviews on this Site."
There are other interesting questions: What strategies are the best for the future? Will private equity continue to attract billions of dollars?
How to classify private equity firms
It is difficult to classify private equity firms as many have diversified and moved into areas other than traditional "company investing," i.e., equity strategies.
The main criteria for classification are
- Size (in assets under management (AUM), or average fund size)
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Stage of investment
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Geography
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Industry
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Investment strategy.
Firms Size:
Size is important because the firm's assets under management (AUM) are directly proportional to the firm's diversity. For instance, Smaller firms with $100-500 million AUM are more specialized than firms with $50-100 billion AUM that do a bit of everything.
The biggest PE firms, commonly known as "mega-funds" , tend to have more than $50 billion in AUM, with some, such as Blackstone or Apollo, reaching over $300 billion.
Below them are middle-market funds, which can be split into "upper" or "lower", and then boutique funds.
Stage of Investment
There are four major investment stages in equity strategies.
- The Early Stage - This category is for companies in pre-revenue, such as biotech and tech startups, and companies with product/market fit, some revenue, but with no substantial growth whatsoever. Venture capitalists and angel investors pilot companies in these stages.
- Growth - This category is for companies in the later stages of their development, with established business models and products. However, they still require capital to expand and diversify their operations. This category is where many startups end up before going public. Groups and firms that invest in growth equity invest here.
- Mature - These companies are larger (tens of millions, hundreds of millions, or billions in revenues) and do not grow as quickly. However, they have greater margins and substantial cash flows. This is where the traditional leveraged buyouts take place.
- Declining - A company may find itself in trouble as it matures due to changing market dynamics, new competitors, technological changes, or over-expansion. If the company is in serious trouble, a firm that is into distressed investing might come & use a new strategy to attempt a turnaround; this is often a "credit strategy".
Credit and asset-level investment (real estate & infrastructure) is not much about the "stage" but focuses on "How risky this section of the capital structure?" Or "Are we acquiring an existing asset or building one?"
Geography
One firm may focus on one country or a few, or an entire region (e.g., North America or Europe), or it can also focus on emerging and developed markets. In practice, it is uncommon to have a single country focus unless the country has a large domestic economy (e.g., the U.S. and China). While most mega-funds are located worldwide, they may be more focused on specific regions.
Industry
An investment firm could diversify and invest in many industries, including technology, retail, healthcare, manufacturing, and financial services. Or, It could also specialize in one sector.
While Size plays an important role, there are also large firms that specialize in certain sectors.
Example: Silver Lake, Vista Equity, and Thoma Bravo are all experts in this area: Technology
They are, however, all among the top 20 PE firms globally according to 5-year totals.
Investment Strategy
Should you focus on "financial engineering," AKA using leverage to do the initial deal and continually adding more leverage with dividend recaps? Or should it focus on "operational improvement" such as reducing costs and increasing sales rep productivity?
Some firms use "Roll-up" strategies to consolidate smaller competitors by acquiring one firm via bolt-on acquisitions. The strategy is to achieve accelerated growth at all costs in the earlier stages of investment. The exit strategy is also a factor: If a firm purchases companies or assets but can't sell them, it won't make money.
There are two main options: IPOs or M&A deals (sales to normal companies or other PE firms). However, many firms rely upon dividend recapitalizations in emerging markets if they don't have any obvious buyers.
Private Equity Strategies: How to Put the Pieces Together
These criteria can be used to identify the three main equity strategies: venture capital, leveraged buyouts, and growth equity.
Private Equity Strategy 1 Venture Capital
Venture capital firms invest in companies that are early stages but have high-growth potential in exchange for ownership in those companies.
VC firms raise money from Limited Partners, such as pension funds, endowments, and family offices.
As a general rule of thumb, VCs expect 50%+ of their portfolio companies to fail. Still, there is always the possibility of gaining high returns if they stumble upon the next Google or Facebook.
Venture capital attracts a different group of professionals than other categories within private equity.
These professionals include former CEOs, entrepreneurs, product managers, and engineers.
While accounting and finance are still important, product/market knowledge is more important. For instance, many Ph.D.'s and M.D.'s end up life science venture capital as scientific knowledge is critical in the field.
Venture capital could be further sub-divided into
- Seed stage
- Early-stage
- late-stage
- Pre-IPO stage
Size: The AUM of the largest VC firms is between $10 and $20 billion across all funds. Mid-sized firms are in the single-digit billions while smaller firms are in the tens or hundreds of millions.
Stage of investment: From the early stages to the growth stage.
Geography: Although diversified, most of the investing is done in North America or Asia.
Industry: There is a heavy focus on technology and healthcare (biotech). However, some investors also invest in cleantech, retail, education & other sectors.
Investment Strategy: Minority-stake deals; Growth at all Costs
Representative Large Companies: Accel, Andreesen Horowitz (a16z), Benchmark, IDG Capital, Index Ventures, Kleiner Perkins, New Enterprise Associates, and Sequoia.
Private Equity Strategy 2 Growth Equity
Growth equity is also known as "growth capital" or "expansion capital". The Firms invest minority stakes in companies with proven markets and business models that need the capital to fund a specific expansion strategy. There is very little risk that a company will fail, unlike venture capital. The worst-case scenario is that it fails to grow as expected. Many "classic" growth equity companies often buy shares from employees or investors to acquire secondary stakes in companies.
In this instance, the company does not receive any cash or very little cash. It's all about choosing winners and finding ways to increase growth without additional capital.
However, newer firms operating more like late-stage VCs invest capital to support growth.
Many firms employ both strategies. For example, some of the largest growth equity firms also do leveraged buyouts of older companies. Sequoia is one example of a VC firm that has moved into growth equity. But, of course, many mega-funds also have growth equity groups.
Size: Tens of billions of dollars in AUM, with the top sharks at over $30 billion. Smaller firms may be in the millions or hundreds of thousands.
Stage of investment: Growth stage; could mean "just achieved product/market fit" or "ready for an IPO."
Geography: Diversified but with a strong focus on emerging markets and North America.
Industry: There are still many tech and healthcare and consumer/retail services, media/telecom, and financial services.
Investment Strategy: Deals to increase growth by minorities; Minority-stake deals.
Representative Large Companies: TA Associates, General Atlantic Partners, Summit Partners, and Insight Partners. JMI, Providence Strategic Growth. Accel-KKR. TPG Growth. Sequoia Growth. Warburg Growth. Spectrum. Great Hill.
Private Equity Strategy 3 Leveraged buyouts
Leveraged buyouts are different from VC and growth equity. They do not involve minority stake investments in early-stage companies or growing companies. Instead, they acquire majority ownership, usually 100% - of mature companies. Firms invest using a combination of debt and equity to improve the potential IRR; more debt means that they contribute less of their capital.
The split of equity and debt varies depending on where you are located and what industry you work in. The amount of debt is often based on a multiple of EBITDA rather than a percentage of the total purchase price.
Traditional LBOs & financial leverage go hand in hand because the companies are mature, growth opportunities are limited. This works in both directions: leverage increases returns. However, a highly leveraged deal could also become a disaster if the company performs poorly.
Some companies also use restructuring, cost-cutting, or price increases to improve company operations. However, these strategies are less effective now that the market is more saturated.
The internal target rate of return (IRR) for leveraged buyouts has declined over the years. Then, it was 30%+ but is now closer to 20-25%, especially for larger deals.
Size: Private equity firms with the largest AUM have hundreds of billions. However, only a small portion of that is devoted to LBOs. The top funds may be between $10 and $30 billion, while smaller funds could be in the hundreds of millions.
Stage of investment: Mature.
Geography: Diversified but less activity in frontier and emerging markets because fewer companies have steady cash flows.
Industry: Companies can be diverse, but they often avoid some too speculative industries (e.g., biotech).
Investment Strategy: Financial engineering, operational improvement, roll-ups, and industry consolidations.
Representative Large Companies: Blackstone, Brookfield Apollo, Carlyle TPG, CVC Apax Partners Warburg Pincus EQT Partners Silver Lake Advent Bain Capital, Onex
CONCLUSION: THE FUTURE OF PRIVATE EQUITY STRATEGIES
- Firms at the asset level, particularly in infrastructure, are more likely than others to be sustainable in the long term because returns, fees, and compensation are already lower, and they're perceived as doing some social good.
- The outlook for Credit strategies, except for maybe distressed/turnaround, isn't great because companies and governments are already over-leveraged.
