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The Secret Behind Private Equity Growth and High Rates of Return

By : Ziad K Abdelnour| 28 November 2017
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The Secret Behind Private Equity’s Growth and High Rates of Return

Private equity buyouts have hit the highest level in the past decade with firms accounting for $143.7 billion in the first half of 2017.

According to the Data from Thomson Reuters, the volume of deals involving private equity firms climbed 29 percent to $143.7 billion in the first half of the year, the highest level since 2007. In fact, the largest every pure buyout fund was raised this year by Apollo Global Management with $23.5 billion in commitments, while CVC Capital Partners hauled in €16 billion from investors.

Why does the mere mention of the words “private equity” instantly rouse both excitement and apprehension?

Perhaps it is because of the substantial and often, controversial amounts of money that are involved or that private equity can mean the complete buyout of public companies. And when you recognize the considerably long holding periods that are often required for private equity investments to either enable liquidity events or ensure a turnaround for distressed companies, you realize why private equity has earned its reputation.

But what is the secret strategy of private equity firms to achieve such high returns?

In my personal opinion, and with over 30+ years experience in the space, I believe a number of factors are involved in order to dramatically increase the value of investments:

  • high-powered incentives for both private equity portfolio managers and the business operating managers in the portfolio
  • dynamic use of debt leading to tax and regulatory advantages
  • purposeful focus on cash flow and margin improvement
  • freedom from restrictive public company regulations

But beyond that, the core strategy at the heart of private equity’s success is the firm’s fundamental practice of buying businesses, steering them through a transition of significant improvement, and then selling them.

Private equity firms have shown that this buy-to-sell approach is most suited when buyers take control and outright ownership, an opening that arises when the business has failed to aggressively manage themselves and ultimately, underperform. Opportunities in undervalued businesses are also worth exploring.

Private equity firms and the funds they manage are typically structured as private partnerships. Raising funds from institutions and wealthy individuals, they then invest that money in buying and selling businesses. Once they’ve raised the specified amount, a fund will close to new investors. Each fund is then liquidated, selling all its businesses within a pre-set frame of time which is typically no more than ten years.

Some constraints on the use of the investors’ money do exist for the private equity firm. For example, the fund management contract may limit the size of any single business investment. However, once money has been committed, investors have virtually no power over management.

Private equity managers typically have investment banking or strategy consulting backgrounds along with line experience. They rely on their extensive network of business and financial connections to seek new deals. With skill in predicting cash flows, they have the ability to spot and accurately value businesses with improvement opportunities.

Today, private equity firms have to adopt a more hands-on style and an integrated strategy now more than ever as the world faces economic challenges that make increasing shareholder value more challenging.

The Global Financial Crisis stemming from the decline in oil prices in the Middle East and Africa region had forced private equity firms to develop unique strategies so as not to lose investor’s confidence. Resilience to market challenges and developing close relationships with various stakeholders while maintaining a hands-on approach or the virtue of active ownership to each portfolio company has been key.

Whether to take on private equity investing is a complex decision, requiring in-depth analysis of your personal and business goals, the market environment, and the financing options available. Focusing on these important considerations — rather than on common misperceptions — will help you make the right decision.

Looking forward to continuing being your resource for deals, capital, relationships and advice; whether for corporate or real estate transactions.

Have a great day.

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