Popular Misconceptions about Private Equity, Part 1


Firstly, what do I mean by “private equity”? The term is used very loosely, often interchangeably with “venture capital”, sometimes to cover both (with venture capital identified as a subset of private equity) and sometimes only to define the top end of the private equity market such as leveraged/management buyouts, etc, and it’s this last definition that I’m using below. This confusion has been one of the great successes of the industry, with the blurred boundary between unleveraged equity financing for small and start-up companies (venture capital) and buyouts of large companies in highly leveraged transactions (private equity) enabling the latter to piggy-back on the former when it comes to the perceptions of the public and governments.

Private equity has been very topical over the last few months as it was noticed how little tax the very highly remunerated fund managers were paying on their income. This seems to lead to a trade off between fairness/equity issues with the issue of some very rich people paying little tax versus the undoubtedly massive impact of private equity on UK productivity. However, the second part of this equation is based on the misconception I most often hear about private equity, i.e. that private equity funds achieve their returns primarily by improving the productivity of the companies they buy. Regarding this misconception, the best source I’ve come across regarding how private equity funds generate returns is a 2004 survey of private equity in the Economist, which lists four methods for generating returns:


- Improve the profitability of the company…
- Buy low, sell high…
- Break it up…
- Use leverage…


Improving profitability/productivity is indeed one method by which private equity funds generate returns, but this is only part of the story and by far the most important method is the use of leverage.

I tend to think of the private equity market as following a very similar business model to the market for buy-to-let housing. With buy-to-let, a property is bought typically in the UK with around 80% debt and only 20% equity, with the debt funded by the property’s tenants and funds equal to only 20% of the purchase price required by the buyer. With rent covering debt service costs, the buy-to-let investor then achieves a magnified return on their equity. For example a £100k house bought 100% with equity that rises to £105k in value earns a 5% return on equity if 100% equity funded, but this equates to a 100% return on equity if the house was originally 95% debt funded.

With private equity, the typical leverage is around 70%, with the companies’ cash flow covering ongoing debt service costs and wiping out all corporation tax liabilities because interest expense is tax deductible. Then if a 10% increase in company value can be achieved each year for (say) 3 years, a £1bn company bought for £300m ends up worth £1.33bn, £630m after repaying the debt and generating a return on equity of over 100%.

It’s true that for this to work the company has to go up in value, but with leverage magnifying the upside, relatively small increases in company value end up generating handsome returns for private equity funds, and if the returns come primarily from leverage then I will leave it to the reader to decide what that means for the trade-off mentioned above.

2 comments:

  1. Andy Says:

    Private Equity = Tax Dodge

    In a mature market, what other kind of business gets that ROI?

    Actually, an Indian friend gave me a good tip - be related to a legislator in a developing country...

    And it works in the UK too. Wouldn't it be nice if mathematics still applied here?

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