The best ways to invest in private equity

The multi-year time frames of private equity are highly beneficial to the managers. Once the investors – who are known as limited partners (LPs) – have committed to invest a certain amount, the private-equity fund manager – or general partner (GP) – will call the capital in stages over the investment period to fund the acquisition of companies. This phase will usually last five years. Investments will usually be held for three to seven years, after which the manager will exit by selling the firm to another private-equity fund or a trade buyer (another company in the same industry), or listing it on the stock exchange through an initial public offering (IPO). The fund may be able to make some distributions to the LPs relatively soon if the investments are performing adequately, but it takes a few years to get one’s initial capital back and up to 12 to 15 years to realise all the returns.

Meanwhile, PE managers can generally charge 1.5% management fee on committed capital (even though it is not invested yet) and take a performance fee (known as carried interest) – typically 20% – if the fund achieves returns above a certain rate (an internal rate of return, or IRR, of 8% is common). The manager may be able to use bridge financing (short-term loans taken out with the intention of replacing them with longer-term funding) to postpone the call of capital or to accelerate distributions, both of which help juice the IRR by altering the timing of cash flows. (For this reason, you should not look solely at IRR as a measure of the manager’s returns, but also look at the multiple – what it paid for the company and what it’s now worth.)

The secret of their success

When a PE manager sets out to raise a new pool of capital, the detailed documentation (known as the private placement memorandum) will underline how they will deliver returns by finding undervalued firms and adding operational value to them by cutting costs, outsourcing production, investing in brand growth and internationalising operations. However, the true skill of PE managers is financial engineering. They take advantage of low interest rates to gear up their investments (and often to fund small acquisitions or “add-ons” at lower valuation multiples that grow the size of the businesses quickly). Higher leverage improves tax efficiency because interest costs are tax deductible, it imposes financial discipline on the firm’s management and magnifies returns if all goes well. It also supports high prices: the ratio of enterprise value (equity plus debt) to earnings before interest, tax depreciation and amortisation (EV/Ebitda) on new deals averaged 11.4 in the US and 12.6 in Europe last year (versus a past average of between eight and nine), with over half of deals geared above seven times Ebitda.

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