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1 July 2015 CFA Institute Journal Review

Private Equity Investment Practices: A Comprehensive Study (Digest Summary)

  1. Marc L. Ross, CFA

Private equity has grown from its humble beginnings into a significant subset of the investment management profession, demanding a specific skill set and entrepreneurial mindset. No longer only a US phenomenon, private equity as an investment practice offers investment opportunities around the globe.

What’s Inside?

The author provides a robust yet succinct overview of the private equity profession. He begins with a brief history and then considers current conditions as well as the mechanics of private equity around the world. He concludes with thoughts about its future.

How Is This Research Useful to Practitioners?

Private equity is a hands-on profession in which investors try to create value without the convenience of a ready near-term exit. Illiquidity is the common thread that binds the primary strategies: venture capital (early-stage investing), growth equity, leveraged buyouts (mature investing and value creation), distressed investments, and mezzanine capital (capital provision in the form of subordinated debt with greater potential yield).

Initially a US phenomenon, private equity investment opportunities now exist around the world. Its original founders were the private investments of 19th-century industry titans’ family offices. The practice began more formally in the post–World War II era when new business ventures lacked ready financing. The first private equity firm, American Research and Development Corporation, sought to address these concerns.

Years later, small business investment companies arose through a federal mandate to provide capital to risky startup ventures. The intent was successful and financed such young companies as Intel and Hewlett-Packard. But lack of oversight in the early years, along with limits on certain investments and a controlling interest in companies, made for unpromising beginnings.

The enactment and subsequent clarification of the prudent man rule provisions of the Employee Retirement Income Security Act enabled asset managers of defined benefit pension plans to invest in private equity. It was a watershed moment—along with the creation and subsequent dominance of limited partnership participation and the creation and successful marketing of high-yield (“junk”) bonds to finance leveraged buyouts prevalent in the 1980s.

Levels of investment in private equity have waxed and waned over time with the entry and exit of less-experienced investors. Their departure, technological innovation, increased institutional participation in alternative investments, and companies’ senior managements’ willingness to sell to private equity players have all made for a more fruitful investment environment.

Changes in the firms themselves also have enabled greater participation. There are more offerings, such as real estate, mezzanine financing, distressed debt, and bond funds. In addition, limited partners do not need to be individuals; family offices, institutional investors, corporations, and funds of funds also qualify. General partners source deals based on their particular expertise and resources and perform due diligence, bearing unlimited liability. Limited partners are the investors who finance these deals, usually of finite duration, and their liability is limited to their outlay in a given venture. The time frame of a particular deal is often a function of the type of investment, which also may dictate the method used to value it. Positive and negative covenants govern the general partners’ obligations and limitations during the course of an investment. Investment performance is a function of macroeconomic conditions: A loose money environment generates increased capital commitment whereas a tight one generates less commitment.

Opportunities outside the United States vary by market environment. Private equity in Western Europe began in earnest in the 1980s. Canada, Japan, Australia, and Israel (a robust venture capital incubator) have had their own systems for some time. Private equity in emerging markets with the convenience of government and donor organizations began to develop and flourish in the early 2000s. In emerging markets, investment types, the anatomy of the deal, pricing, and exit strategies can differ substantially from the Western model.

Private equity industry participants, from the junior analyst to the general partner, will find this a welcome overview from which to gain perspective. Students and practitioners of valuation would similarly glean an important high-level view of the industry’s growth and challenges.

How Did the Author Conduct This Research?

This study is both a historical overview and a discussion of current practice. It draws heavily on and synthesizes the research of respected industry leaders and professional associations. Business academia makes a meaningful contribution to the discussion as do management consultancy firms.

Private equity has evolved markedly over the past 50 years. Although companies may have a broad or narrow focus, the inner workings, for the most part, are the same.

Abstractor’s Viewpoint

Private equity is big business. The number of firms occupying this investment practice and vying for returns has grown significantly over the past decades. Competition has become fierce. The practice is facing the real challenge of direct institutional investment rather than investment through the intermediary of a private equity firm whose fees detract from performance. Global macroeconomic conditions and equity markets will continue to challenge investors during both the life of an investment and their eventual exit. Those aspiring to a career in this corner of the investment world need to embrace change as the one constant.

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