Ever heard about seed capital? Early-stage VC? Late-stage VC? Growth equity? Middle-market buyouts? Mega buyouts? Distressed? Mezzanine funds? Real estate funds? Infrastructure funds? Fund of funds?
Yup, the names do get confusing.
And so does deciding which of these PE strategies will earn you the most money.
Truth be told, directly investing in PE might not be an option for you at the moment (unless you happen to already have a lot of money), but working for a PE fund could very well be.
Before you start intensely preparing for interviews though, you might want to spend a bit of time analyzing the different options out there to figure out where you would fit in best and which PE firms have the best prospects.
In this article we’ll do just that, but first we’ll talk about the components of a PE “strategy” and the different categories of PE strategies – from betting all your money on the next Instagram to buying a company, liquidating it, and selling off all its assets, Gordon Gekko-style.
So What is a PE Strategy?
As we’ve seen before, private equity is an umbrella term for different types of investments in private companies or in publicly listed companies that will become private as a result of the investment.
There are many components to a PE firm’s strategy, namely the stage of the companies targeted, the geographies targeted, the investment sectors, the value added by the firm, the entry/exit strategy, etc.
Key Elements of a PE Strategy
1) Stage of Investment
The stage of investment is the main way to classify PE strategies and firms. We’ll cover all the strategies in-depth throughout the article, but here are the 3 main stages:
a) Venture capital is used for investments in early stage companies, including the seed stage (the earliest stage), early stage, late stage, and pre-IPO stage (the latest stage of VC).
b) Growth equity comes next – it represents investments in slightly later stage companies, usually with proven concepts/products that are generating significant revenue and are looking to grow their operations.
c) Buyouts and distressed investing are last, and fall into the “later stage investment” category. These involve “mature” companies (i.e. they are not growing very quickly anymore) that generate significant cash flow already, and many of the deals are focused on using the ideal capital structure rather than operational improvement.
2) Fund’s Target Geography
In terms of geography, a fund can focus on one country (country-specific fund), a few countries or a region (regional fund). A region could be, for example, North America, Southeast Asia, or the Middle East and North Africa (MENA).
A distinction can also be made between funds that invest in emerging markets and those which target developed markets. The US is the largest developed PE market, followed by the UK. China is the largest emerging PE market, followed by India and Brazil.
In any case, the geographic focus will be specified in advance in the fund’s Limited Partnership Agreement (LPA).
3) Fund’s Target Sector
PE investments can be made in a broad range of sectors, such as technology, real estate, energy, manufacturing, healthcare, financial services, retail, media, consumer products, etc.
Some funds will specialize in one specific sector, some will target a few sectors, and others are generalist funds, known as “sector-agnostic funds”. As we’ll see, this also depends on the type of fund – VC funds tend to be more specialized while buyout or growth equity funds can be more diversified.
4) Value Added by the Firm
Every firm adds value to its portfolio companies – or at least, tries to add value.
The firm’s added value could be, for example, its operational expertise, strategic expertise, restructuring/streamlining expertise or its network of contacts in the industry – which might result in new customers, suppliers, partners, or even executives for its portfolio companies.
5) Exit Strategy
Regardless of how promising an investment may be and how much value the PE firm can add to the company, you can’t make money if you can’t exit your investments!
For that reason, the firm will evaluate different scenarios and identify potential exit strategies in terms of exit route (IPO vs. M&A), possible acquirers (Much larger companies, similarly sized companies, or another financial sponsor) and valuation (is there room for multiple expansion?).
For example, the preferred exit route could be an IPO on a domestic or foreign stock exchange, a trade sale to a list of potential buyers, or a secondary sale to another VC/PE firm.
Different Strategies by Stage of Investment
Ever wonder how firms like Blackstone, Summit Partners, Tennenbaum Capital, or Sequoia make money?
The short answer, like everything else in finance, is “Buy low and sell high” – but they each do it in different ways.
Everything You Need to Know About Venture Capital
Sequoia? Kleiner Perkins? Accel? Andreessen Horowitz? Any of those ring a bell? They’re all well-known venture capital (VC) firms.
VC firms invest in promising start-up companies with high growth potential that usually have a new technology/product/concept/business model.
VC firms will generally take a minority position (10 – 30%) and the funding can be used to test a concept, launch a business, for early development, or for the expansion of an early-stage business.
Most VC firms are quite specialized and often focus on a single field. Fields suitable for VC funding are typically the ones with high growth potential, such as cleantech, technology, telecommunications, healthcare, or Internet, but some businesses in other fields might also see VC investment.
One field with a lot of potential (or a lot of hype…) for more VC investment is education – online learning and alternative degree programs are changing the landscape, and there may be a lot of disruption there in the future.
You’re familiar with the big-name companies that raised venture capital fairly early on: Apple, Google, Facebook, Yahoo!, Genentech, FedEx, Microsoft, and countless other tech and biotech companies.
But you might not realize that 1) Plenty of big companies have not received VC funding, so it’s certainly not “necessary”; and 2) Most companies that did receive VC funding you’ve never heard of – because they failed or never went anywhere!
VC is a high risk / high potential reward type of investment and the percentage of failures among VC-backed firms is very high.
A VC fund typically invests in a large number of deals (10-15+) in the hopes that one or two “star investments” will drive the fund’s returns, and that the rest will fail or be written off completely, with some delivering average performance.
Venture investment is usually further sub-divided according to the targeted stage of development, from seed financing to pre-IPO. Keep in mind that there are no universal definitions and that different investors tend to use slightly different classifications.
Seed Stage – The seed stage is the very first stage of funding. Seed-stage funds typically provide a few hundred thousand dollars to entrepreneurs to finance the research and development process and to launch an early version of the product (if it’s a tech company – biotech / pharma / clean-tech all require more funding).
At this stage, the product/technology might not have been proven and the VC firm will assess the feasibility of the proposed idea. This is the riskiest stage of VC investment and also the one with the highest failure rates.
These days, many VC funds don’t even focus on seed stage investments and instead leave it to angel investors, whose ranks have grown in recent years – it no longer requires nearly as much capital to get an idea off the ground, so you could launch at least a version 1.0 of a new website or app with a small team.
Early Stage – Early-stage VC investors target companies that have some sort of management team in place, some level of product / market fit, and which have shown signs of early traction with their product (e.g. they’ve been growing monthly active users by 20-30% each month). The capital will be used for product development and more sales and marketing.
Late Stage – Late-stage venture investors will usually provide a second or third round of financing in order to fund production, sales, marketing, etc. so that the business can start “ramping” its revenue and expand to the next level. By this point the company should already be generating some revenue, and should have serious traction with their product.
The capital invested will generally be higher than in previous rounds, often $2 million – $10 million or more.
Pre-IPO Stage – At the pre-IPO-stage, the PE firm provides a final round of financing to support the company throughout the phase leading to an initial public offering (IPO).
Huge pre-IPO financings have become popular, with firms like Digital Sky Technologies often investing hundreds of millions of dollars in companies to help them grow and provide some liquidity for early investors and employees – so they can stay private longer without making them wait forever to cash out.
There are often more than three rounds of financing; the first round is called seed financing and the subsequent ones might be labeled “Series A Financing”, “Series B Financing”, and so on.
If the company still cannot generate enough cash flow to survive on its own or it can’t be sold, new or existing investors might keep investing… at least, as long as they believe they can actually make their money back.
While some VC-backed companies get acquired at a late stage or after they’ve already gone public, many companies get acquired much earlier than that.
Investors won’t make a fortune on such deals, but they could still get a “decent” return if the firm is acquired in only a few years for tens of millions rather than hundreds of millions or billions of dollars.
Growth Equity 101
What about Summit Partners, JMI or TA Associates? Ever hear about those guys? They’re all growth PE firms.
Growth equity firms invest in quickly growing companies with proven ideas/business models to help support further growth. These firms will not only provide financial capital, but also strategic guidance and operational support, so they can help the company grow and achieve its full potential.
These PE firms will generally make minority equity investments and will let the current management team continue to run the business. The capital injection can be used to scale-up operations, to enhance distribution, to expand geographically, to develop a new product, to finance an acquisition, or anything else.
Growth equity firms differ from VC firms because they target more mature companies. Many, if not most, companies here already generate revenue and are cash flow-positive – but they need additional funding to expand and hire more people.
Growth capital firms differ from buyout firms because they generate their returns by improving and growing businesses, while, as we’ll see very soon, buyout firms emphasize value creation through financial engineering and cost cutting.
Example: A growth equity firm might invest in a $30 million revenue company with $5 million in EBITDA because they see an opportunity to grow it to $60 million in revenue with $15 – $20 million in EBITDA in 3-5 years.
That company would be “too small” for most buyout firms – but “too big” or “too slow-growing” for most VC firms.
Growth equity is a very popular strategy in emerging markets since local businesses don’t always have access to capital from the domestic banking system or capital markets. In addition, the intellectual capital provided by the PE firm is often sought after because it can help companies expand globally and achieve a world-class status.
Leveraged Buyouts Explained
Let’s be honest: you’ve probably dreamed about working for KKR, Blackstone, or TPG (keep dreaming – it’s almost impossible to get in, even coming from a top bulge bracket bank). Those are some of the biggest and most prestigious players in the leveraged buyout industry.
Unlike VC or growth capital, which both involve minority investments in early-stage or growing companies, buyout firms acquire majority control – almost always 100% ownership – of mature firms, using financial leverage.
The acquisitions are made using both debt and equity, but the proportions can vary depending on the acquisition target, the market conditions, and the ability of the buyout firm to raise debt. The debt portion typically accounts for 50-85% of the purchase price.
The companies targeted by those firms must therefore generate stable operating cash flows which will be used to make interest and principal payments.
The buyout firm will use capital from one of the funds it has raised to provide the equity contribution, and will raise new debt to fund the rest of the purchase price.
- Bank Debt: 50% of funding
- High-Yield Bonds and Mezzanine Debt: 20%
- Equity (Cash from the PE firm): 30%
Returns are therefore generated mostly with financial leverage (i.e. the PE firm pays way less right now because they raise debt, which makes it easier for them to earn a higher percentage return later on), but also by adding value to the company acquired. This can be done through restructuring, cost-cutting measures, growing sales, acquiring a related business, and so on.
LBOs can be further sub-divided according to the size of the buyout: the two main categories are mega LBOs and middle market LBOs.
Mega LBOs – The mega LBO segment includes buyouts of at least several billion dollars and is the largest sub-sector of private equity in dollar terms.
The rise of the mega LBO segment was made possible because of the access to abundant and cheap debt prior to the financial crisis. You don’t see as many mega buyouts these days because high-yield debt is less accessible and more expensive.
In frothy markets where credit is easy to come by, it’s not uncommon to see massive deals worth $10 billion+ USD – but when things take a turn for the worst, even the biggest PE funds around are lucky to do deals a fraction of that size.
Middle Market LBOs – This segment includes the buyouts of mature, but smaller businesses known as “middle market companies.”
Some say companies with revenues of $10 million – $250 million are considered “middle market,” while others say it’s the $50 million – $1 billion range – and you can find many other definitions online. The idea is that middle-market companies are bigger than early-stage start-ups, but smaller than brand-name multi-billion dollar companies.
This segment has a lot of potential because middle market firms are generally less risky than very small companies, but are also cheaper than well-known large-cap companies.
And it’s much easier to get debt financing in place for a $1 billion deal than it is for a $10 or $15 billion deal.
Also, it might be easier to exit a middle-market buyout because the exit price will be lower and therefore more exit options exist – hundreds or thousands of companies might be able to do a $100 million acquisition, but only a handful can complete a $10 billion acquisition.
Ever Heard of Distressed or Turnaround PE?
The distressed debt market has grown in popularity over the last two decades – partially because various financial crises have created so many opportunities! PE firms and hedge funds are the main players in this space.
The PE firms in the segment rescue distressed firms which are fundamentally good but are currently undergoing challenges – for example, maybe their expenses are out of control, they’re facing a dangerous competitor, or their capital structure is completely unsound.
Major players include WL Ross & Co., Tennenbaum Capital, and the turnaround arms of Apollo and Cerberus.
Distressed PE firms can use two possible approaches to investing: control-oriented strategies and restructuring strategies.
Control-oriented approach – In the case of control-oriented investing, the PE firm acquires a large position in the debt securities of a distressed company in order to secure a control position in bankruptcy proceedings.
After obtaining the control position, the PE firms will take an active role in the restructuring by changing around the operations and management team of the firm.
Restructuring/turnaround approach – If it’s using a restructuring strategy, the PE firm will invest in a financially distressed company, but will do so by investing new equity to take control of and restructure the company.
Different strategies can be used and distressed companies can sometimes be acquired for very low multiples, which creates good investment opportunities.
One approach is to target quality companies that are currently over-leveraged or that are going through a bankruptcy process and need financial restructuring. In this case, the PE firm will be responsible for reorganizing the company’s capital structure.
Another approach is to target fundamentally good, but currently “operationally challenged” businesses. The PE firm here will be responsible for implementing an operational reorganization to restore profitability.
Yet another strategy is to target companies with distressed or non-performing assets and to implement an asset restructuring strategy to maximize asset returns.
Other PE Strategies
We’ve covered the main PE strategies, but a number of other options also exist if you’re still contemplating what the quickest path to a billion dollars is. Here are a few examples:
Mezzanine Funds – Mezzanine funds provide high-yield debt to reasonably mature companies that generally have positive earnings and cash flow, but that need additional risk capital.
Mezzanine debt is a hybrid instrument which usually has an equity component (e.g. a warrant) attached. It can be used by a company for various purposes such as expansion, as well as for financing in an LBO.
Real Estate Funds – Real Estate PE funds invest exclusively in properties, using debt and equity. They will typically focus on the riskier real estate investments (e.g. value-added funds and opportunistic funds) and are therefore more similar to LBO funds than regular real estate investment firms.
Infrastructure Funds – Infrastructure PE funds invest in public infrastructure (e.g. roads, bridges, airports, public transportation, etc.). They are particularly popular in emerging markets, since the demand for new infrastructure is so high there.
Fund of Funds – A PE fund of funds invests in various other PE funds. This allows for diversification since a fund of funds can invest in funds managed by the top PE firms across various sectors and geographies.
So You Still Haven’t Told Me Which Strategy is the Most Profitable!!!
The answer, as you might already have guessed, is that it depends on a few factors:
On one hand, it depends on the firm’s strategy as well as on the people working there and on how good they are at sourcing good deals, adding value, and exiting at an opportune time.
On the other hand, a lot of factors at the macro and industry level, which are beyond the control of PE firms, can have a huge impact on returns – but that impact might be different depending on the PE firm’s strategy.
For example, high economic growth is usually conducive to PE activity, but an economic downturn can create opportunities for distressed PE investors.
Also, the availability of abundant and cheap debt is very beneficial to leveraged buyout firms, but has a limited impact on VC and growth capital firms.
Some firms – particularly VC firms focusing on a single industry – might also be affected by the cyclicality in a given industry (e.g. technology).
But Historically, What Has Worked Best?
In the past, the different strategies have all seen ups and downs at different times.
In the 1980s, the first major boom in the industry took place with the rise of LBOs, financed by junk bonds.
The LBO industry, however, almost collapsed in the late 1980s and early 1990s because of the bankruptcy of a number of large buyouts and because the high-yield debt market experienced a slowdown.
The second major wave took place in the 1990s, from 1992 onwards. Over the course of the decade, a number of brand-name PE firms were created and both VC and LBOs experienced a boom.
The cycle ended when the dot-com bubble burst at the end of the decade, causing major losses, mostly for investments in telecom and tech companies.
The third cycle took place from 2003 through 2007. The loose credit markets, low interest rates, and regulatory changes set the stage for the wave sometimes referred to as the “golden age of PE”.
A number of mega buyouts were undertaken during this period, which ended in the wake of the financial crisis – debt investors no longer had an appetite for massive deals, and similar to what happened in the late 80s and early 90s, many companies that had been bought out started struggling.
You should also keep in mind that different types of strategies have different risk/return profiles.
In the case of a large leveraged buyout, you could make good money, or lose a bit, but the chances of losing everything are pretty low. On the other hand, you also won’t get a 100x return on capital like some early-stage VC firms might with their investments.
In the case of early-stage VC, it is very possible to lose everything you invest in a company – this is why diversification is so crucial and why these firms have dozens or hundreds of portfolio companies. Or you could find the next Google, Facebook, or Instagram, and make a massive amount of money in a few years.
So Who Should You Work For?
The truth is that you can make a lot of money in any of these segments, but PE firms tend to pay more, on average, than VC firms, simply because there’s more money to go around and fund sizes are bigger.
And within PE, you generally get paid more at bigger firms – at least until you reach the Partner level and your pay becomes more dependent on investment performance.
These days, there seems to be plenty of opportunities for distressed/turnaround PE investments because of the global financial crisis.
Mega buyouts don’t seem quite as lucrative because high-yield debt is not as cheap and available as it used to be, but middle market buyouts could still be attractive.
There are opportunities for growth equity in developed markets, but probably even more in emerging markets.
So, bottom-line: if you’re set on making the most amount of money possible, stick with PE and go to a large firm (at least $1 billion+ in AUM). There will be both growth equity firms and buyout shops in that range.
Beyond that, you’d need a crystal ball to tell you exactly what will happen in the market for the next few years to see which specific firm will perform best.
So unless you have a highly accurate crystal ball, you might as well pick what you think is most interesting.
The truth is that if you break into any of the firms discussed here, you’ll be guaranteed a more than generous payday – enough to make bankers and consultants jealous, anyway.