A Strategic Guide to Private Equity Funds

What are these PE companies or PE funds? How do they work? Why would a company like Carlyle Group want to move out India's second-largest Credit Card firm? This piece explains all about PE funds one should know.

The Jargon - Why does Private Equity mean?

The PE fund expands to 'Private Equity.' Private, because they invest in private firms that are not listed on some stock exchange. Equity, because they work by buying stakes in these private firms.

The Target

The PE Funds have a specific target. This is mostly based on the lifecycle of the target company. Each fund has its own way.

Some funds want to 'catch them young.' They invest in emerging companies.

In this stage, the target company relies on innovation and capturing the market. Resultantly, the company grows fast. The PE funds buy a substantial equity portion of this company. This helps the expansion of the target firm while creating huge assets for the PE fund.

Others invest in established companies. Although the company growth is slower now compared to the emerging stage, there is regular cash flow. PE funds ensure continuous cash flow for themselves when they buy huge stakes in such companies.

 The rest of the others pick distressed companies. The PE fund would buy as many shares. If the company was listed on some exchange, they would de-list the company. The management will be changed, and now the fund would take over the control. The business will be restructured to make it profitable. Once the company stands on its own giving profits, the company would exit taking windfall sums.

The Cycle of PE Funds

Formation of a PE fund takes as low as three months to 3 years. They attract investors during this period. Definitely, much depends on the reputation of its management. Hence, the bigger players would always have an edge.

Much explained already, the PE funds buy huge stakes in a company. This may be even high as 100%. They get actively involved in running the company.

They change the management to what suits them and issue advisories in running the company. Later, they wait patiently for the business to earn adequate profits or bring it to a stage of high valuation.

The company takes an exit finally. 'Divestiture' depends on the state of the economy, market volatility, and the right buyer. If things are good, the company will close the fund taking away its profits.

This entire span takes as much as five to ten years to translate. As you would see, art is picking the right target firm. Acquire, Optimise, Profit, and then Exit- this is the lifecycle of a PE investment.

The Fund Structure

PE funds have a two-centered structure. One is the investors, who provide capital to this fund; the other is the management of the fund. Sometimes, this management is outsourced to asset management companies as well.

The capital of investors is invested; it is taken care of by the management of the fund. The management is involved in running the company.

There is a much popular 2-20 Compensation structure when it comes to profit sharing. Irrespective of the profits, management takes 2% as the fee, and 20% of the rest of the profit. The other chunk goes to the investors.

Say, the profit in this year reached ₹1000. Now, ₹20 from this profit goes to the management as their fee. Out of the rest ₹980, 20% or ₹196 go to the management; and 80% or ₹784 goes to the investors. Remember, the management will have its fee even if the company makes losses.

The Hedge Funds

There is some similarity between Hedge funds and those PE funds, which invest in distressed companies. Hedge funds also invest in distressed companies. However, they are not there to run a business.
 
They buy the stake in the hope that prices would move up in some time. They exit the company with suitable profits. Their span is around 2-3 months, unlike PE funds who stay there running the business with active involvement for as long as ten years.

Winding Down

The PE funds show us how vibrant finance is. There are so many business models, which have now evolved as specialized funds. PE funds seem to be one of those.

The Carlyle Group exit from SBI Cards is the most significant PE exit ever in India. Nevertheless, it is no different from the nature of PE funds. It will be great if more such funds come and invest in Indian companies, and help them grow big.