MODULE 3: PUBLIC-PRIVATE EQUITY 3.2 Lifecycle of a private equity investment

This video presents a deeper dive into the lifecycle of a private equity investment, from acquisition to exit, with a focus on how private equity managers seek to create value in their portfolio companies. 

Pat Nelson

Principal of private equity strategies at KKR

5MINVIDEO

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Patrick Nelson, Principal of private equity strategies at KKR

 

Welcome. In this lesson, we’ll go deeper into how private equity works. We’ll cover the lifecycle of a private equity investment from acquisition to exit and talk about some of the strategies managers can use to create value within a portfolio company. 

 

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Company acquisitions are at the end of the first stage of the investment lifecycle, which starts with deal sourcing and due diligence. This is a process that can often span multiple years. Depending on their size, scale and investment focus, a private equity firm might consider hundreds, even upwards of a thousand potential target companies every year and end up investing in only a small percentage of them.  

 

While acquisitions can follow different transaction types, including purchasing a company from its founder, three of the more commonly discussed transactions are corporate carveouts, public to privates and acquiring companies from an existing private equity owner, otherwise known as a sponsor-to-sponsor transaction. 

 

A corporate carve out is a transaction where a private equity firm purchases a specific business unit, division or subsidiary from a larger parent company. The classic carve-out thesis is that a private equity firm can help unlock significantly more value from a non-core business unit than the parent company could. However, these transactions require knowledge and resources, as they are complex, involving significant operational disentanglement from the parent company and requiring careful structuring around legal, IT and operational integration issues. 

 

A public to private transaction is a process where a private equity manager takes a controlling interest in a publicly listed company and delists it from a stock exchange. A sponsor-to-sponsor transaction occurs when one private equity firm sells its portfolio company investment to another private equity firm. Sponsor-to-sponsor deals have become a significant component of the private equity market where, for example, a growth focused private equity manager may sell its portfolio company to a manager that is more focused on companies that have reached the next phase of maturity in their lifecycle. We’ll talk more about that in a moment when we touch on exit strategies.  

 

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Ultimately, the goal for a private equity firm is to exit its investments and realize the value that was created on behalf of its investors. There are several ways private equity managers can directly influence a company's strategy and help create that value. 

 

One way is by strengthening the management team. Private equity managers might work with the existing management team to enhance their capabilities or bring in new talent. This ensures that the company's leadership is aligned with the strategic goals.  

 

Another way is through acquiring other companies which could open up new product offerings, exposure to new markets and perhaps a new area of specialized knowledge or technology that can be integrated with the goal of creating synergies.  

 

Streamlining and improving operations is yet another value creation lever. Working with management teams to identify and implement operational improvements is essential to ensuring there is alignment with the desired outcome.  

 

Lastly, private equity firms may use financial strategies to help enhance returns. This could include refinancing existing debt at lower interest rates, restructuring the company's balance sheet or implementing a tax-efficient approach to help improve cash flow and potential profitability.

 

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Finally, let’s turn our attention to exit strategies. Selecting investments that could pursue multiple exit routes and then building the value that makes them desirable to potential buyers during the holding period can enable a successful exit down the road. Planning for exits early, taking a creative and flexible approach to the exit plan and trying to make good companies great, makes even the most difficult environments navigable.  

 

Exits typically come in three routes: strategic sales to a company within the same industry, sponsor-to-sponsor sales in which a company is sold to another financial sponsor, whether that be another private equity manager, a sovereign wealth fund or a pension plan and finally, the public market route, which would refer to an IPO in which the company lists on a public exchange. 

 

To have multiple exit routes available in a variety of market environments, it helps to own companies that many buyers also want to own. That starts with selecting the right companies and continues with making those companies more valuable through repeatable playbooks. An approach that balances flexibility and discipline, along with getting the fundamentals of operational improvement right, is key for private equity managers.  

 

We hope this lesson has helped deepen your understanding of how private equity funds operate. Thanks for watching.

 

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Deepen your understanding

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Ultimately, the goal of a private equity firm by the time of exit is to generate substantial returns on their investment for their investors. There are several ways private equity managers can directly influence a company's strategy and seek to create value for investors. But these changes do not take place overnight. Building value, and doing it sustainably, can take years of hard work.

A graphic illustrates the lifecycle of a deal from idea to entry, monitoring and exit. The chart shows how value is created in each step, from deal sourcing, detailed due diligence, investment committee review, value creation, exit and realization.

Management:

One way to create value is by strengthening the management team. Private equity managers might work with the existing management team to enhance their capabilities or bring in new talent. This ensures that the company's leadership is aligned with the strategic goals.

Acquisitions:

Acquiring other companies could open up new product offerings, exposure to new markets and perhaps a new, specific area of expertise or technology that can be integrated with the goal of creating synergies. 

Business strategy:

A private equity manager can shape business strategy and work with the company’s management team to set other specific goals and objectives. Part of this collaboration may be to make sure that management’s incentives are aligned with the goals of the business. These goals may include revenue targets, profit margins, market share expansion, operational improvements and more. Private equity managers closely monitor the company's progress toward these goals and may provide guidance to achieve them. 

Efficiencies:

Improving operations is another way private equity managers can add value. This can involve streamlining processes, optimizing supply chains, implementing cost-saving measures and enhancing overall productivity. Private equity managers can work closely with the company's management team to identify areas for improvement and implement operational changes that align with the desired strategic outcomes.

Financial strategies:

This could include refinancing existing debt at lower interest rates, restructuring the company's balance sheet or implementing a tax-efficient approach to improve cash flow and profitability.

In order to help understand what a private equity firm does, consider this fictional case study, inspired by an actual investment.

 

In 2015, Company A (CA) was the leading manufacturer of widgets in North America. It had a reputation for providing high-quality products with great customer service and delivery times. That reputation caught the eye of a firm we’ll call Private Equity A (PEA), which acquired CA through one of its funds. 

 

One of the first steps PEA took was an audit of CA’s current policies and procedures. It found several areas where processes were able to be streamlined, including by removing redundancies on the factory floor and changing truck route logistics for more efficient deliveries. 

 

Aging company laptops were replaced with newer models and improvements were made to the company cafeteria, boosting employee happiness and productivity. 

 

PEA also conducted a survey of current customers and learned there was demand for a new type of widget that CA did not currently produce. 

 

With a fresh infusion of capital, CA was able to launch that new product line, as well as build a new website and run a major ad campaign, which directly led to increased sales. 

 

Seven years later, the company was booming. Its widgets were more popular than ever, and its EBITDA margin (a common profitability measure that stands for “earnings before interest, taxes, depreciation and amortization”) had expanded by 10%. 

 

PEA was ready to exit its investment and realize the return on all the changes it had made at CA. It began talks with Company B (CB), which manufactured widgets in the European market and was looking for a way to enter North America. Ultimately, the sale of CA to CB closed for a significant return on the initial purchase price. 

 

It is important to note that not every investment will have such returns. Investing in private equity, similar to investing in other asset classes, carries the risk of a total loss of capital, among other risks. There can be a significant dispersion in results between private equity managers, and the same is true of individual investments.  

Checkpoint

Now that you have completed this lesson, you should be able to confidently:

 

  • Outline the typical lifecycle of a private equity investment, from deal sourcing and due diligence to value creation and exit. 
  • Describe how private equity managers create value in portfolio companies through each lifecycle step.

Takeaways

The lifecycle of a private equity investment

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End of lesson

In the next lesson, you'll learn about different ways to allocate to public-private equity in a portfolio. 

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