Private Equity is an asset class for funds and investors that directly invest in private companies.
It is typically a risky investment for individual retail investors because it is hard, if not impossible for them to conduct a thorough due diligence process.
But successful Private Equity funds, managers and firms are able to shape their target companies into more valuable assets
(note: that is why retail investors want to ‘tag along’ with these big boys because they have the expertise and resources to vet through non-scammy private equity investment opportunities)
That is why, credible Private Equity funds, managers and firms have been able to report spectacular returns, beating the public market returns.
Even CIMB Group Holdings Chairman Nazir Razak, is setting up a private equity fund, targetting to raise $ 1 billion. Source – The Edge
Also, understand that private equity investment is a relatively long-term investment, which has a typical 10+1+1 years of charter life.
Because the underlying portfolio assets are less liquid, the structure of private equity funds is normally a closed-end structure, meaning that the investor has very limited or no ability to withdraw its investment during the investment tenure.
Difference between private equity and public equity investment
Public equity (stocks) – PASSIVE ROLE
- Liquid ownership in a public listed company
- Sole objective is to buy low then sell high
- Profit via dividends & capital gains
Private equity – could be ACTIVE ROLE (depending on nature of investments, see below)
- Illiquid stake in a company or a project
- Objective#1 – Grow the Net Profit
- Objective#2 – Reduce debt
- Objective#3 – Improve valuation
How does Private Equity Manager Add Value
During Buying Process
1) Conduct due diligence on private information such as strategic plans and forecasts
2) Conduct exclusive due diligence on operations & company management
3) Get favourable entry price by means of below market value acquisition
During Holding Period
1) Drive for long-term sustainable value creation, not quarterly performance
2) Drive for operational improvements, revenue growth, profitability & expansion
3) Drive for positive changes and hold company management accountable for KPIs
During Selling Process
1) Execute exit strategy which has been defined during entry, via IPO, convertible bonds, warrants, etc
2) Improved company fetches higher price via higher valuations & earnings multiple (P/E ratio)
3) Ability to source for strategic buyers with best offer price in a well-connected network
How to compute Private Equity Annual Return
Since there is likely be inconsistent cashflows due to capital repatriation and interest income, the return of private equity investment should be computed using Internal Rate of Return (IRR) to compare apple-to-apple with annualized returns of other investments. Refer to the infographics above for illustration on this.
How does Private Equity Generate Abnormal Returns
Buyout a majority stake in companies with consistent cash flow and/or order pipeline.
Profit by: Increase valuation, sell to highest bidder at the end of fund life, or cash out via IPO
Extend loans to profitable companies
Profit by: Regular cash distributions at a premium interest rate
Downside protection: Loan to Net Asset Value discount, with assets as collateral
Take over other P.E portfolio due to mandate change or contractual life end
Profit by: Discount to NAV by motivated seller, IPO/distributions
Downside protection: Assets as collateral
Ringfence profitable products of a company, extend loans to fund capex & opex
Profit by: Regular cash distributions at premium interest rate
Downside protection: Ownership rights
How common are private equity investments?
- Ekuinas, the Malaysian government-linked private equity fund, bought a 85.76% stake at RM 64.7 mil into Revenue Valley Group (Jan 2012). Revenue Valley owns brands like Tony Roma’s and Manhattan Fish Market.
- Ekuinas also bought a 35% stake at RM 68.6 mil into Malaysia’s leading bumiputra sportswear retailer, Al-Ikhsan Sports Sdn Bhd (July 2016)
- CIMB Private Equity bought a 33% stake at RM 33 mil into into R.E.A.L. Education group, a full-fledged education service provider (May 2014)
Private Equity Exit Strategies
Normally a combination of any one or more of the below:
- Return of Capital Plus Profit
- Sell to another company or fund
- Initial Public Offering (IPO)
Private Equity Industry in Malaysia
According to Ekuinas, the private equity industry in Malaysia is still at an infancy stage. However, the expectation is that private equity will be more common & prominent as the country adapts to new realities in the conventional stocks and bond market.
The Malaysian Government strives to construct a new economic model that focuses on innovation and productivity. One way is to achieve this is encouraging the development of Private Equity (PE) and Venture Capital (VC), aiming it to become the next engine of economic growth that will spur Malaysia into the status of high income nations.
The difference between private equity and VC is that VC is for companies that are entering relatively new business or technology (higher risk), while private equity focuses on established companies which are entering the next level of growth (lower risk).
Syed Yasir Arafat Syed Abd Kadir, the CEO of Ekuinas said:
“Malaysia has a vibrant early stage funding ecosystem such as the Cradle Investment programme giving grants to fund ideas and development, as well as Malaysia Venture Capital Management Bhd and Malaysian Technology Development Corp funding the development stage of companies. That’s why we are focused on companies in the growth stage, so there is no overlap”
“Deal flow is there,” he adds, pointing to the examples below:
- Sale of supermarket chain Jaya Grocer for RM300mil to a PE fund managed by CIMB Private Equity and Mitsubishi Corp
- CMS Opus PE Sdn Bhd buying a 31.5% stake in fresh fruit convenient store retailer MBG Fruits Sdn Bhd for RM10mil
- Ekuinas RM68.6mil investment for a 35% stake in retail sports outfit Al-Ikhsan Sports Sdn Bhd, among others.
Besides, retirement Fund Inc (KWAP) reportedly made a US$30mil direct investment into one of the world’s largest “unicorns”, the name attributed to privately owned tech start-ups that have reached valuations of more than US$1bil.
In KWAP’s case, its investment is in car-hailing app company Uber, one of the most valuable unicorns valued at a whopping US$68bil at last count.
KWAP invested in this funding round of Uber alongside Saudi-based Public Investment Fund, which pumped in US$3.5bil, a much higher amount than what KWAP put in.
In fact, KWAP is setting aside more money for riskier investments, including a plan to double its allocation to the Private Equity sector, as the pension fund joins other investment managers globally in embracing higher calculated risks to boost performance.
“With the new normal of low interest rates and the slowdown in economic growth, we have to be realistic. Average yields for Malaysian Government bonds are at 3.5%.
The profits we generate from this would then be reinvested into lower returning assets. That explains our increased allocation into alternative asset classes,” says Datuk Wan Kamaruzaman Wan Ahmad, the CEO of KWAP.
And according to Securities Commission (SC) of Malaysia, under the Capital Markets and Services Act 2007 (CMSA), any person carrying on a business in any regulated activity must be appropriately licensed or registered by the SC. Corporations undertaking venture capital or private equity activity are registered persons under Schedule 4 of the CMSA.
Even Air Asia is setting up its own venture capital fund – RedBeat Ventures, in collaboration with 500 StartUps, to invest in post-seed startups (source: DigitalNews Asia)
Lastly, even billionaire Richard Branson is getting into the private equity game!
(source: Business Insider)
More Private Equity Lessons below for Beginner Retail Investor