The modern private equity business is not so old, as the first leveraged buyout took place in 1955. This was when McLean Industries, run by Malcolm McLean, acquired the Pan-American Steamship Company and the Waterman Steamship Company. He financed these acquisitions with the proceeds of the sale of his trucking company, McLean Trucking. He also did this through bank debt and the issuance of preferred stock. Since then, dealmakers started forming their own investment firms to do similar types of buyouts. The high-profile ones included Warren Buffet and Victor Posner. They were followed by Boone Pickens and Saul Steinberg. A few bankers at Bear Stearns also did leveraged deals. Their success attracted many competitors and led to a segment of the financial services industry we know today as the private equity business.
Effects of Buyouts
There are various impacts of horizontal mergers on the stock prices of competitors. A study by Slovin, Sushka, and Bendeck investigated 128 buyout bids from 1980-1988. 78 of the buyout bids were from managers, while 50 were from outsiders. They found that while target returns were significantly higher when the bids came from buyout firms, this had no impact on rivals. The authors concluded that bids led to positive valuation effects for rivals and that these effects were not that different in outsiders or management bids. These positive valuation effects were due to new information about the industry and firms in it were being created by the buyout, and the price paid to target shareholders.
In another study by Harford, Stanfield, and Zhang, a large sample of 586 LBOs over the years 1991-2006 were studied, and they found that these provide a signal to other firms about M&As and LBO opportunities in the industry. They also concluded that LBOs have the possibility to lead other M&As. one way to interpret this is that potential bidders might believe that other companies in the industry might present good profit opportunities if the firm that underwent the LBO had so much “slack” that it could afford to take on significant debt service obligations.
Leveraged Capitalizations
On the other hand, research conducted by Brown, Fee, and Thomas analyzed a sample of 355 LBOs and 43 leveraged recapitalizations from 1980-2001. Results have shown significant negative returns for suppliers of the LBO firms. Those with significant supply relationships with the LBO firms were more negatively affected. This can be analyzed as maybe, post-deal, the firms that went through a buyout would have more bargaining power. It can also be interpreted as the post-LBO companies being forced to pressure suppliers to handle the higher debt service. The authors also concluded that the companies which supplied companies that went through leveraged recapitalizations have no significant response to the deal. These recapitalization firms, which are larger than LBO companies, might have enjoyed buying power over suppliers.
Private Equity Market
Private equity companies gave a substantial part of the fuel for the M&A boom from 2003 to 2007. It then declined with the fallout from the subprime crisis but bounced back as the recovery took hold.
The private equity market refers to a collection of funds that have raised capital by soliciting investments from different investors where the funds will be invested in equity positions in companies. A going-private transaction then occurs when these investments acquire 100% of the outstanding equity of a public company. When the equity is accumulated through an investment capital of the private equity fund but mainly borrowed funds, this is called a leveraged buyout or an LBO. Many refer to the funds as LBO funds since these deals are such common investments for private equity funds.
These funds may make other investments, such as providing venture capital to nascent businesses. Funds established for this purpose are sometimes called venture capital funds. These kinds of investments may use the fund’s capital exclusively without using borrowed funds. But with this equity investment, the target company may enable itself to have more access to debt markets. This may happen after securing the equity investment from the private equity fund. It is possible for the fund to take a minority or a majority position in the company. Usually, venture capital investments contain incentives, such as stock options. These enable the investor who assumes the risk to enjoy greater profits if the business becomes successful. However, a lot of dissimilarities between private equity funds and venture capital funds happens.
Private Equity Funds vs. Venture Capital Funds
It is necessary to know the difference between private equity funds and venture capital funds since both are users of private equity. equity. Both are organized as limited partnerships, with the general partner making the investment decisions. However, there are plenty of very significant dissimilarities between the two.
Private equity funds look for undervalued investments like whole companies that are not trading at values commensurate with what the fund managers think is possible. These could also be divisions of companies that want to sell the units due to a change in strategy or a need for cash. One example was in 2002 when the international liquor conglomerate Diageo realized that there was not a lot of synergy between its liquor brands and the burgers and fries in its Burger King division. The Texas Pacific Group and Goldman Sachs Group purchased Burger King from Diageo in 2002 for $1.5 billion.
Generally, private equity fund managers raise capital from various institutional investors. Usually, they charge their investors “2 and 20”. This means 2% of invested capital and 20% of profits. 20% of profits is referred to as carried interest.
On the other hand, venture funds often make investments in new companies that may have limited revenues. The companies they invest in are often startups. Private equity firms seek out more established companies that have lengthy revenue, if not a profit, history. They usually invest together in a syndicated manner and undergo have several rounds of funding as a company goes through stages in its development.
Venture funds also go through shorter investment horizons and additional capital is only given if the company meets its milestones.
© Image credits to Anni Roenkae