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Private Equity Firms-the Myths and the realities

Private Equity Firms

Private Equity Firms-the Myths and the realities
Private equity markets are known for high-profile takeovers, big deals, and stake sales. Here are some common myths debunked as well as things to be cautious about.

When the private equity industry is in the headlines, it is typically in the context of high-value deals, high-flying fund managers, fast deals, and big takeovers. It is undeniable that private equity (PE) portfolio companies have shown significantly higher revenue growth rates than those not backed by PE. And with traditional sources of finance becoming somewhat restricted for mid-market companies in the wake of the pandemic, PE is a fund source they are looking toward.

However, skeptics suggest caution when it comes to how private equity firms manage the firms they acquire, particularly those in the middle market. The average person thinks negatively about PE, believing it is so driven to make huge profits that companies are destroyed along the way.

Below are some common myths about private equity markets that one should be concerned about:

• Reports on performance are reliable: PE managers tout outstanding performance results, but these could very well be untrue. The private equity industry is highly secretive and not very closely regulated, and product benefits and value tend to be exaggerated. Internal rate of return (IRR) can easily be manipulated or exaggerated, and there are other methods of boosting returns without improving fundamentals.

• Fund performance can be predicted: This is untrue, as private equity markets are highly cyclical. Past performance is no pointer to future results, and top performers in one quarter could easily crash in the next.

• Private equity firms are resilient: PE has the reputation of being marginally uncorrelated to other asset classes, thus being attractive for institutional investors who want to diversify. However, research has shown that in Europe, PE and the public benchmark had a correlation of 0.8 among surveyed buyout funds. Within the largest individual endowments, PE showed high correlation to public stocks, with no benefits from diversification.

There are also several myths that tend to give the private equity industry a negative reputation, but are in fact untrue. The common ones are below:

• Control of the company will be lost: This is a belief that tends to bog down many business owners and CEOs. This is however not a given, as investors often pick up just a minority stake in the business, with overall control staying with the previous owners. Private equity firms investing in a company do bring in new reporting requirements and they are a key part of the decision-making process, but this most often brings in a wealth of expertise and experience from other portfolio companies. They encourage bigger and wider thinking and help in executing the same.

• PE does not look beyond biotech and technology: This is untrue, even though there are many success stories of companies in high-tech sectors seeing success in private equity markets. Such stories tend to be from smaller companies, while for PE firms looking at larger businesses, the sector focus is pretty wide, encompassing traditional or often struggling sectors too.

• Companies are broken up: This is one of the biggest myths; however, the truth is that the private equity industry actually acquires and merges more companies than it breaks up. If and when a split does happen, it is often of a non-mission-core division that is sold off.

• People do not matter: Human capital is in fact very important to private equity firms, who can create wealth and growth only if they have the right people doing the right jobs in the right roles. Indiscriminate firing is ill-advised, as there would be no one left to keep operations up and running, and there is great value in retaining the expertise people have built up in the course of continued employment with the acquired firm. Additional talent may be brought in to fill skill or knowledge gaps, which adds to an expert network very useful for company owners.

• Asset stripping drives PE returns: It is true that PE firms holding majority stakes can look toward asset stripping, but this approach is not a given and is in fact the exception rather than the norm. Investors look to boost the value of the business in order to sell their stake at a higher value than they bought it for, and asset stripping is not the only way to achieve that. Growth strategies in fact include new territories and products, transformative technology, and business acquisitions.

• PE markets are risky: Private equity markets can be risky, but this depends on individual firms. Businesses who want investors must peruse their return consistency, portfolio, track record, and market conditions. Leveraging is often used to maximize RoI, but it has not commonly been proven to lead firms to distress situations. Overleveraging is in fact avoided and PE firms seek to grow and develop the business with available funds.

• PE is a short-term source: Investors who pick equity stakes try to actively manage the business and later float or sell it at a higher value. This requires a longer horizon especially in the wake of the pandemic, with organic growth and add-on acquisitions becoming important tactics.

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Pradip Mohapatra
See all posts by Pradip Mohapatra