The Modern Understanding Of Private Equity
When people think of private equity, LBO or leveraged buyouts commonly spring to mind. There are often connotations of greedy bankers or ruthless individuals loading great companies with a bucket load of debt in order to get ownership as if it were some kind of prized position. Some examples that spring to mind are the Glazers ownership of Manchester United bought in May 2005 and Sir Philip Green’s acquisition of BHS in 2000.
Private equity has boomed since the 1980’s, however, and in the U.K alone there are over 2900 private equity owned businesses. In comparison, there are 2600 companies listed on the London Stock Exchange which indicates that private equity is not a flavour of the month and will be with us to stay. It’s therefore a good idea for us to brush up on our understanding of what private equity actually means and how it could affect us as individuals since this kind of ownership structure clearly affects a large part of our economy.
A Definition Of Private Equity
In it’s simplest form, private equity is a form of ownership of a business venture based on financing from only a small number of individuals. These individuals could be family, a group of friends, a collection of strangers or even a single person. Typically, when forming the ownership structure, however, not all the necessary capital is available to fund the transaction so a large part of the financing will be borrowed. The borrowed money usually comes from a financial institution but could just as easily come from high networth individuals or other businesses. The borrowing part of the transaction is what is known as leverage and although there is a common viewpoint that debt is bad, we should explore this in more detail to understand why it is called leverage and how it affects 1) the owners 2) the lenders and 3) the company or venture owned.
A Definition Of Leverage
In order to understand leverage let’s explore a simple scenario of Jonny Appleseed who is looking to make some money so he can feed his family. Jonny is able to walk to his local market once a week and buy Apple’s for 50p each. The walk is long and tiresome, however, and not a lot of people in his village have the stomach for it. He can, therefore, bring back the apples and sell them for £1 so in turn making 50p for each apple he sells.
Jonny’s problem is that he only has £10 in savings. He can make the journey, pick up 20 apples and once sold he can make £10 in profit ending up with £20 in his back pocket. Jonny doesn’t feel the journey is worth it to make £10 for the week as his family require a lot more than that to live on. His grandmother is very wise and old and gives Jonny a good way to solve his problem. During her years, his grandmother Lenda Appleseed has been very thrifty and says I will lend you £100 as long as you return it to me in a few days. For my troubles of lending you the money, you will have to return to me an extra £10 on top so in total I will expect back £110. Jonny believes this enterprise has little risk in failing so agrees and off he goes to market with £110 in his back pocket.
On his return, Jonny sells 220 apples and pockets £220. He gives his grandma Lenda her £110 as promised and walks away with an outstanding £110 i.e £100 profit. You don’t have to be a mathematician to see the effect the borrowed money from his grandma has had on Jonny’s money making capacity. It has in effect ‘levered’ his profits from £10 to £100. Jonny ended up better off, his grandmother who lent him the money ended up better off and even the market who sold Jonny the apples ended up better off. Wow, it’s rare to see but everyone is a winner in this game.
Some Analysis
During the time period Jonny borrowed the money, he had essentially taken on debt. The amount of debt was 10 times his initial capital or the money he had available for the enterprise. In return, the profit made was also 10 times what he would have made without it. The largest part of the enterprise was financed with debt and because of the levering effect the debt has, it is also known as leveraged.
The downside to the leverage was that Jonny also took on an element of risk. If Jonny had lost all of his grandmother’s money on his journey, he would still have to pay her back £110 but with no apples to sell for profit. This element of risk is often why people have a negative view point on debt but as we can see especially in Jonny’s instance, fortune favours the brave. The bravest individuals in our society have been racking up these fortunes for many years.
Why Private Equity Uses Leverage For It’s Buyouts
The scenario given with Jonny Appleseed at it’s core is the same format a private equity company uses to fund it’s ventures. A buyout of a company is seen as a way to own an enterprise with the view to making a profit. Without applying the leverage, the buyout itself might be unfeasible due to the small amount of capital the private equity company has. With 10 times or even larger amount of borrowing, however, the venture becomes a way to create a win-win scenario for everyone involved.
- The owner get’s to own an enterprise from which they are able to generate more profits than embarking on the enterprise with only their small amount of capital
- The lender gets to increase their initial capital by applying a multiplier to the amount of money lent. Thus multiplier is known as interest and is given in the form of a percentage they expect to be returned on top of their initial capital. In Jonny’s case, he gave his grandmother 10% return
- The effect the debt has on the company owned is less straightforward in stating. There are 2 forces at play with the kind of ownership structure involved. One is that the lending puts the enterprise under pressure to meet profit expectations. Adverse effects are always a consequence of less profit for a company but these effects are multiplied when debt is involved. The other force is the magnitude of growth a company can achieve with a large capital injection. Hiring of staff, purchasing of machinery or money spent on marketing are all factors that can achieve substantially more profits for an enterprise
With the number of advantages gained from an LBO, it is easy to see why private equity is inclined to use leverage for it’s acquisitions. Private equity companies are highly motivated to do their due diligence on how a company is affected by the debt obligations undertaken to fund the buyout. The best private equity companies minimize the risk in any of their deals and for the most part ensure that all parties involved in the transaction end up better off.
In Summary
I hope this watered down explanation of private equity has made it clear to see why this form of company ownership is the most popular in the U.K. It will no doubt continue to grow in size and to understand more feel free to read some of the other articles that will be posted over time on this website