The ABCs of PE (Part 3): Fund Types and Investment Strategies

by: Kay Francoeur

 

At ECA, we primarily work with private equity. More than 85% of our clients are investor owned or backed, and we’re experienced in placing great candidates for PE firms, for portfolio operations leaders, and with portfolio companies.

 

While Part 1 and Part 2 of our series on PE basics covered the fundamentals of what PE firms are and why the size of these funds really matters, Part 3 takes a slightly deeper dive into the nuances among PE fund types and typical investment strategies.

 

VC

The term “venture capital” sometimes gets folded into private equity, but there are important distinctions between VC investing and traditional PE firms. VC usually makes small, minority stake investments to early stage emerging businesses. VC investing is high-risk but also can be high-reward. The companies these investors target typically aren’t generating revenue yet, so their ultimate success is unpredictable. But when these bets pan out, the return on investment can be huge.

 

VC is different from growth equity PE, which is a minority stake investment in an established, growing company.

 

Private Credit / Private Debt

Private credit or “private debt” are umbrella terms that refer to a loan extended to a privately held company, especially when that company might not otherwise be able to access the traditional loan market. Most private credit loans are made to mid-sized companies, although some lenders will extend credit to smaller businesses, distressed businesses, and real estate investors.

 

In contrast to PE funds, private credit funds typically don’t seek ownership in the companies that they lend capital to. A PE firm generates returns by creating value in its portfolio companies whereas a private credit fund achieves returns primarily through interest on loans or the sale/repayment of such loans. PE funds also generally have a limited life span, but many private credit funds do not.

 

Some private equity firms have their own private debt funds that loan money to private equity-backed portfolio companies. These funds may be used as a part of the leveraged debt structure used by PE firms to acquire portfolio companies, provide acquisition financing, or to fund operating lines of credit. But due to the obvious conflict of interest concerns, PE firms with debt funds generally never loan money to their own portfolio companies.

 

In return for taking on the significant risk associated with leveraged deals, private creditors are generally first in line to be paid back, regardless of whether the acquisition succeeds or fails to generate expected returns.

 

Growth Equity

Growth equity is capital investment in an established, growing company. In contrast to venture capital, growth equity becomes relevant further along in a company’s lifecycle, once a company is established but needs an infusion of additional funds in order to continue to grow. Growth equity investments are granted in return for equity in the company, usually a minority stake.

 

The advantage of growth equity investment over VC is that growth equity investors can try before they buy – the diligence process is occurring with an existing, established company, so there are financial track records to examine, clients and other stakeholders to interview, and an opportunity to test the product/service thoroughly before deciding if the company is a sound investment choice.

 

Buyouts

Buyouts are the most common type of PE fund. Like growth equity, PE firms relying on buyout strategies invest in more mature businesses. In contrast to growth equity however, these funds typically take a controlling interest (50%+) in the company they acquire.

 

Buyout funds tend to be much larger than some other types of PE, for example VC investments. They also tend to have greater rates of success than VC funds, but they operate within a tricky dynamic. The entrepreneur who sells their business no longer has control, and frequently is experiencing the constraint of having a new boss for the first time in a long while. There can be friction between company founders and PE investors that needs to be managed carefully. Even still, buyouts are the most common types of PE funds.

 

 

The goal of a buyout is typically to shift the control of a company for a period of time, during which internal improvements will be made and new value created. Those improvements will catalyze a return on the investment it takes for the PE firm to buy out the company. The hope is that this kind of hard reset can provide some breathing room for a struggling or stagnating company, and end up propelling significant growth – and thus, significant return on investment for the PE firm.

 

There are two main types of buyouts:

  • Management buyouts
  • Leveraged buyouts

 

In management buyouts, the existing management team buys the company’s assets and takes the controlling share. These kinds of buyouts might work well when a company needs internal restructuring and wants to go private before undergoing major organizational changes. Management buyouts provide an exit strategy for large corporations that want to sell off divisions that are ancillary to their core business, or for company owners looking to retire.

 

A leveraged buyout is a transaction where a company is acquired using debt as the main source of consideration. A PE firm will often borrow up to 70-80% of the purchase price and fund the balance of the transaction with their own equity.

 

Because there’s so much debt riding on these kinds of acquisitions, leveraging increases risk but also potential reward. The acquisition must realize high returns and cash flows in order to pay the interest on the debt. The target company’s assets are typically provided as collateral for the debt, and buyout firms sometimes sell parts of the target company to pay down the debt.

 

Fund of Funds

A fund of funds (FOF) takes capital in and then invests it in several other PE funds. The advantage of a FOF is it allows a PE investor to diversify, becoming the owner of several different PE funds at the same time.

 

A final fund type that is becoming increasingly common in the PE landscape is the “fundless” or “independent sponsor” model, which have disrupted conventional investing in meaningful ways. The final forthcoming installment of this series will examine these types of funds in their own right.

 

 

Kay Francoeur is a Project Manager at ECA Partners. She can be reached at [email protected]

 

 

Kay Francoeur
Project Manager

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