Private equity has become an increasingly important asset class for institutional and individual investors. However, the private equity investment process remains complex and opaque to many. This article provides an in-depth look at the key stages and best practices of private equity investing, drawing on insights from industry experts and real-world case studies. We will examine the origins and growth of private equity, the critical steps of the investment process including deal sourcing, due diligence, deal execution, value creation and exit, as well as the risks and returns of private equity investing. With a better understanding of how top firms source, execute and manage private equity investments, investors can make more informed decisions around private equity allocation and portfolio construction.
Origins and Growth of Private Equity Demonstrate the Value Proposition
Modern private equity has its origins in the post-World War II era, but remained a small niche of the investment universe until the 1980s. However, the past four decades have seen an explosion in private equity activity. Preqin data shows total private equity assets under management globally have grown from $50 billion in 1991 to over $4 trillion in 2019. This growth has been driven by private equity’s ability to generate outsized returns relative to public markets. Top-quartile private equity funds have consistently delivered net returns of 15-20% annually over long horizons. With investors hungry for yield in a low-return environment, private equity’s demonstrated performance has attracted huge inflows of institutional capital. However, the private equity investment process remains very hands-on, specialized and opaque compared to traditional public market investing.
Deal Sourcing and Origination Requires Deep Networks and Experience
The first step of the private equity investment process is originating and sourcing potential deals. This requires extensive networks and relationships to gain access to the best opportunities. PE firms spend significant time developing networks with investment banks, commercial banks, accounting firms, law firms and corporate executives to uncover proprietary deals before they run an open auction process. Screening potential deals also requires deep industry expertise to identify attractive targets, understand value drivers and competitive dynamics. Many firms organize industry-focused or regionally-focused teams to leverage specialized operating knowledge. Sourcing high-potential companies and assets is like finding needles in a haystack, so developing differentiated sourcing channels takes time and credibility.
Rigorous Due Diligence Process Critical for Value Creation
Once a potential deal is identified, PE firms conduct an exhaustive due diligence process including commercial, financial, legal and tax diligence. This allows the PE firm to identify key value creation drivers, downside risks and develop a hands-on value creation plan. Diligence may involve assessing market dynamics, meeting with management, inspecting facilities, analyzing financials and tax structure, and conducting customer calls. PE firms use diligence to validate investment thesis and valuation models. Many deals fail to progress after detailed diligence. Completing diligence allows firms to negotiate deal terms and valuation with the company owners or executors of the estate. Since information asymmetry favors the sellers, diligence helps level the playing field during negotiations.
Value Creation Strategies to Improve Operational and Financial Performance
After closing a deal, PE firms focus on creating value and improving performance through hands-on operational involvement, applying strategic expertise and leveraging financial engineering. PE firms install oversight via board seats, recruit top talent into key positions, support add-on acquisitions, enter new markets, optimize the capital structure and implement operational improvements. The goal is to significantly improve growth and profitability over a 3-5 year hold period. PE firms take a very active role, in contrast to passive public market investors. Strong value creation and multiple expansion leads to higher exit valuations.
Exit Paths Realize Returns Through IPOs or Strategic Sales
The final step of the private equity investment process is exiting the investment through some type of liquidity event. The most lucrative exits are via IPOs or sales to strategic acquirers that allow the PE firm to fully realize gains built up during the hold period. However, recapitalizations, secondary sales to other PE firms, and write-offs also occur. Timing and selecting the optimal exit path involves weighing factors like public market conditions, M&A environment, company progress and exit competition. The exit returns cash to the PE fund to be distributed to its institutional LP investors. Top-tier PE firms excel at entering deals at reasonable valuations, strengthening operations over time, and exiting at a substantial premium to cost.
In summary, the private equity investment process requires specialized networks, diligence and expertise to source, execute and create value in deals that generate outsized returns compared to public markets. Though complex, PE’s demonstrated ability to provide excess returns to LPs has driven huge asset inflows. With a solid understanding of the PE playbook, investors can better evaluate this complex asset class.