It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation (ARDC) and J.H. Whitney & Company.
Private equity companies manage funds, which typically invest in unlisted companies. There are several stages in the private equity investment process starting from collecting capital for the fund and ending with returning committed capital and realized returns to fund investors.
Establishing a fund
Private equity fund managers raise capital from institutional investors to establish private equity funds. Typically, investors include both private and state pension funds, funds of funds, life insurance companies, foundations and other institutions. Often the fund manager also commits capital to the newly established fund. Private equity funds are typically organized as limited partnerships with a life cycle of approximately ten years. Capital is called from investors when the investments are made into portfolio companies. The fund manager acts as an advisor to the fund and is responsible for the decision making process, such as making investment and exit proposals and developing the investment targets during the ownership period.
Mapping potential investments
The private equity fund manager maps potential investment targets for the fund. Typically, the targets need to fulfill certain criteria in terms of size, industry and life cycle phase in accordance with the fund’s strategy. Additionally, the fund manager evaluates the attractiveness of each target based on its value creation and exit potential. Investment targets are usually sourced either through proprietary networks or by participating in auction processes. Efficient deal sourcing therefore calls for strong business networks across the fund’s target geography.
Making an investment
After a fund manager identifies an investment target, a more detailed analysis of the business is performed. This due diligence analysis usually involves going through the company’s financial and legal documents, as well as evaluating its commercial attractiveness. Negotiations with banks to arrange financing are also initiated at this stage. Provided that bank financing is available and due diligence findings support the investment, final negotiations regarding the transaction are initiated.
Developing the target company
Once the investment is made, the private equity fund manager starts developing the company based on a detailed value creation plan. In addition to financial capital, the manager supports the target company by providing sector knowledge, operational experience and access to a wider business/industry network. This usually involves taking a seat on the target company’s board.
Private equity investors are temporary owners. Therefore, a portfolio company is usually held between 4 to 6 years, during which the value creation plan is being implemented in cooperation with the management team. There are several alternatives available for the private equity fund to exit the investment. Most commonly exits take place through:
- Trade sale to an industrial buyer
- Secondary sale to another private equity fund
- Listing through initial public offering (IPO)
- Sale to the management group
Once the exit is finalized, the initial capital and proceeds from the investment are returned to the fund investors.