This is the best article in understanding Private Equity, an asset class for funds and investors that directly invest in private companies.
What is private equity investment?
It is conventionally considered a high risk, high return investment for individual retail investors (except accredited investor) because it is hard, if not impossible for them to conduct a thorough due diligence process.
However, as financial markets (bond & equity markets) globally turn increasingly volatile, private equity as an alternative asset class has come under the spotlight for generating alpha returns while positively impacting the economy.
In fact, private equity has ‘graduated’ from being a lesser known investment option on the fringes of investment world to the mainstream. Private equity investments are highly specialized and actively managed (there’s no ‘passive private equity investment’).
(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)
Successful Private Equity funds, managers and firms are able to pick from their ‘deal flows’ and then shape their target companies into more valuable assets.
That is why, credible Private Equity firms, institutional investors managers and hedge funds have been able to report spectacular returns, beating the public company (stocks) returns.
Even CIMB Group Holdings Chairman Nazir Razak, is setting up a private equity fund, targeting fund raising of $ 1 billion. Source – The Edge and updated in Jun 2020 (known as Ikhlas Capital Singapore)
Also, understand that private equity investment is a relatively long-term investment, which has a typical 10+1+1 years of charter life.
Portfolio companies are companies or entities in which a venture capital firm, a buyout firm, or a private equity company invests. All companies currently backed by a private equity firm can be spoken of as the company’s portfolio.
Because the underlying portfolio assets or companies are less liquid, the structure of private growth 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.
How do you make money in private equity?
Here’s your info graphics guide to this alternative investments asset class known as private equity.
Difference between private equity and public equity investment
Public equity (stocks or publicly traded company) – 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
In exchange for a management fee, the PE firm (known as the general partner or GP) uses its strategic, operational and financial expertise to create value for the investee company and eventually exits at a premium to its acquisition cost. This is when returns are generated for the investors, known as limited partners (LPs).
The below summarizes common private equity investing strategies:
During Buying Process
1) Conduct due diligence on target company 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 via any feasible capital structure
In other words, private equity investors or fund manager look to back credible entrepreneurs with growth-oriented companies and
capable investment management teams. They add value through their network, experience in and exposure to foreign markets and by participating in strategic matters. Although most private equity fund manager is sector agnostic, they tend to lean towards resilient and/or brick and mortar industries such as food and beverage, healthcare, education and consumer products and services.
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 (at a premium to its acquisition price) which is usually defined during entry, via initial public offering aka IPO, private sale, convertible bonds, warrants, etc (example of pre IPO stake sale, The Holstein Milk Co’s by Khazanah Nasional)
2) Improved company fetches higher price via higher valuations & earnings multiple (P/E ratio)
3) Ability to source for strategic buyers in secondaries market with best offer price in a well-connected network
How to compute Private Equity Investment Annual Return
Since there is likely be inconsistent cash flows 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.
A challenge for private equity fund manager (or the manager for the fund of funds like RHB Pre IPO and Special Situation Fund III or Kenanga Global Unicorn) is to create understanding that the results, although reported yearly, are not based on performance or actions taken within a single year.
By the way, if you are wondering ‘How do you invest in PE?’, then going through Securities Commission vetted PE funds like what’s mentioned above is the safest way.
Type of Private Equity Investment Abnormal Returns
Buyout a majority equity stake (or mezzanine capital) 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 portfolio 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 (Ekuiti Nasional Bhd), the Malaysian government-established 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)
- Permodalan Nasional Bhd (PNB), one of the largest fund manager in Malaysia, with more than RM 300 billion in assets under management (AUM) – private equity investment constitutes 2% of its portfolio, but efforts are underway to raise the allocation to 5%. PNB appointed 13 PE firms globally, and prefers to co-invest with a partner for deals outside Malaysia [source: The Edge Malaysia Special Report Sept 2019]
- EPF mandate to invest in private equity asset class is capped at 2.5%, and that includes sectors like real estate and infrastructure. In 2019, Head of EPF private market department revealed that EPF has been invested in private equity for more than a decade, averaging about U$ 50 million per deal. EPF exposure to Private Equity includes investments in global PE funds and funds-of-funds, co-investments (usually with EPF General Partners) and direct investments into Malaysian companies. It has been generating very healthy returns – in the mid to high teens. [source: The Edge Malaysia Special Report Sept 2019]
Private Equity Investment Exit Strategies
Normally a combination of any one or more of the below:
- Return of Capital Plus Profit
- Sell to another company or fund (divestment) in secondary market
- 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.
How much money do you need to invest in private equity? How much should I invest in equity?
Usually, you need to be an accredited investor and the smallest tranche could be as low as RM 100,000 or USD 25,000.
The difference between private equity vs Venture capital (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 fund for a 35% stake in retail sports outfit Al-Ikhsan Sports Sdn Bhd, among others. This was Ekuinas first investment in the retail sports equipment. Ekuinas optimised its supply chain and ensure that its retail partners received the right goods in a timely manner. How? Ekuinas matched supply with demand, minimised human interaction and leveraged existing systems in the company. The results were impressive as the company made an additional RM8 million in top-line growth within 7 months. The system also generated processing efficiency — what was previously done in a week with 3 employees is now performed in three hours by one person.
Besides, Pension 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 fact, KWAP revealed that it has a relatively long history of private equity investment, namely , its first private equity investment actually took place as early as 2002. In 2019, private equity accounts for 4% of KWAP investment portfolio [source: The Edge Malaysia Special Report Sept 2019]
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 growth 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