Private Equity as an Asset Class

Historical Background

The antecedent of private equity as an asset class can be traced to the various waves of mergers that have occurred in history, predominantly in the developing nations. In the US, early mergers, at the end of the 19th century and beginning of the 20th century, mainly involved amalgamations of firms in an industry to result into fewer larger firms (Cheffins and Armour 15). In the second phase of mergers, the 1920s, the mergers particularly involved acquisitions of individual firms, mainly firms in the same business – horizontal mergers, not an amalgamation of firms (Cheffins and Armour 16). It was also during such a period that mergers where firms bought firms in complementary business occurred, but rarely did the mergers involve acquisitions of entities in a variety of unrelated businesses.

It was however not until the 1960s where the third wave of mergers occasioned a trend towards the antecedent of private equity business models. During this era, the rise of conglomerates, firms that have achieved a great deal of diversification through acquisitions across diverse industries, emerged as strong force in the US. For instance, as cited by Cheffins and Armour, The Fortune magazine identified six of the largest 500 corporations being conglomerates, 33 being first generation conglomerates that had risen into prominence in the 1960s, and 21 being established entities transforming into conglomerates in 1969 (16-17). However, the transit to private equity arose in the late 1970s, when, in 1978, KKR established a private equity fund whose specific focus was to fund the acquisition of public companies through private funding in (Cheffins and Armour 18).

Private Equity Delineation

Private equity as a form of an asset class differs from the public equity, due to its illiquid nature, which affords investors the required time to establish transformational change in the firms invested in, thus offering higher changes of growth. Depending on the transactions characterizing the private equity investment, the nature of the private equity can broadly be considered into two categories: venture or buyout.

Venture capital, especially in Europe, will mostly involve transactions with a small enterprise value. Such transactions are mainly targeted at financing young entities, including start-up companies, which are rarely making profits (Fraser-Sampson 9). Traditionally, most of the venture capitalist were targeted to entities developing or using a new technology. Venture capital financing was particularly a core part of technological companies that have since become major public entities in the US including Microsoft, Apple, Yahoo, Google and Facebook. However, other entities such as the logistic giant, FedEx, also achieved growth through funding from venture capital. In such ventures, the investing fund will usually hold a minority shareholding, but control could arise either by default (due to the extent of initial financing) or through refinancing (Fraser-Sampson 9). Additional characteristics of venture capital is that rarely does it involve bank debt and valuation of the potential targets is usually not be based on complex financial modelling but more on instinct and experience (Fraser-Sampson 9). Accordingly, venture capitalists are likely to be entrepreneurs who have developed successful start-ups before rather than investment specialists.

Buyout private-equity transactions, in contrast to ventures, usually involve large-value, complete takeover of mature enterprises. Such buyout will most likely have significant funding from bank debt, hence the term leveraged buyouts (Fraser-Sampson 9). The profit record of the investee firm is usually an important factor in establishing potential firms for buyout and identification of buyout target is usually an exercise that requires a lot of analysis, which involves rules of financial theory (Fraser-Sampson 9). As such, the managers of buyout-targeted funds (“private equity) usually have the requisite professional qualifications in disciplines such as accountancy and finance, and are likely to have an investment-banking background. Such equity funds will also not focus on technology considerations, but target firms in a wide range of industries. However, irrespective of such delineations, some cases, e.g. a leveraged funding of an early-stage technology company, may prove challenging to delineate as being in the venture capital or the buyout category. Accordingly, this review evaluates private capital to be inclusive of both formats of transactions.

The principle of investment in the private equity is that investors in the private equity firms will earn their return after the private equity firm exits its investment. Exiting the investment implies that the fund will sell its stake in the company to a strategic buyer (most common route), to another private equity fund (secondary leveraged buyout), or to the public by listing in the stock markets in an initial public offering (IPO) (Kaplan and Strömberg 11). The general partner, i.e. the manager of the fund, receives compensation in three ways. Firstly, the general partner (GP) receives an annual fee for management responsibilities calculated as a proportion of the capital committed, and, when the investments are realized, a proportion of employed capital (Kaplan and Strömberg 5). Secondly, the GP will earn a carried interest, a proportion of the fund’s profits, usually 20 per cent (Kaplan and Strömberg 5). Thirdly, GPs could obtain their earnings by charging deal and monitoring fees to the investee entity (Kaplan and Strömberg 5). Variations could exist in the rates that management fees are accrued and the carried interest could also be subject to fulfilling certain conditions concerning a present return to the limited partners (carry hurdle) and the timing for carry distributions (Carry timing) (Metrick and Yasuda 2310). Such aspects are reviewed subsequently in the section that considers the private equity in developed countries.

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