Private Equity (PE) monitors and manages the portfolio of investments made.
Its funds are mixed: on one hand, they are considered “Distribution Funds” as any dividends received are distributed to the investor; on the other hand, they are “Accumulation Funds” in case it is more efficient to reinvest the free cash flows generated by its investees instead of distributing them via dividends to the Fund and consequently distributing them to its shareholders.
However, it should be noted that the main objective of a PE fund manager is to generate capital gains and, therefore, to maximise the value of the companies in the medium and long run, in order to obtain significant capital gains for the investors when exiting the companies, i.e., disinvestment.
Unlike investment in listed markets of fund managers operating through “SGEICs” (closed-end type fund managers), PE investments do not enjoy the same liquidity, which is a handicap to attract capital from investors seeking low dividend and pay back.
Differences between the management of a fund of an SGEIIC that invests in listed companies and the management of a PE fund of an SGEIC.
The PE manager, unlike the Value Investing manager of an SGEIIC who invests in listed companies and therefore does not have to negotiate an entry price, strict sense, must gather a great negotiating talent in two areas:
- It must reach a reasonable closing price of the transaction, although there are often no clear market references as there are no comparable multiples as is the case with listed companies.
- It must provide liquidity to the investment with the formalization of a SPA (Shareholder Purchase Agreement) that favors the divestment (exit) at market prices that will be based on the intrinsic value, that is, the fundamental aspects of the company’s business.
The Value Investing manager who invests in listed companies evaluates, invests and divests, usually except for taking control shares, without the formalization of commercial agreements that regulate the investment, management and exit, that is, the terms of the transaction.
The PE must identify companies that have the capacity to generate distributable profits, that is, generation of free Cash Flow and, to limit it more, an Equity Free Cash Flow that allows creating value for shareholders from an efficient management of the company. The basic investment metric is not based so much on the well-known ROCE (Return on Invested Capital, that is, EBIT / Permanent Capital) but on business fundamentals that demonstrate a recurring and historical and sustainable Free Cash Flow Capital over time with which to attend first to debt service (interest and principal) and second to shareholder remuneration (via dividends and capital gains on divestment).
The PE does not seek to invest in companies whose share price is below the estimated value but in companies that have a market value based on the critical business variables (their fundamentals or drivers of value, creators of profits and therefore of value of the company) that allows entry at a reasonable price so that the pre-existing shareholder who becomes a member of the PE is benefited from its financial and professional alliance with it to develop a business plan that maximizes the value of the company within a period of time agreed in advance. This approximation therefore pursues the reciprocal benefit, both of the pre-existing shareholder and of the new investor.
Value Investing unwinds its positions when the price reaches the target value of the company in order to make cash with which to reinvest in new business opportunities.
The PE has a priced investment horizon, therefore, it must identify in advance the value drivers and act systematically and procedurally to achieve the business objectives in order to divest in a timely manner to achieve the desired capital gain that will immediately revert to its investors.
The time horizon of Value Investing is much higher than the time horizon of the PE because the former can afford it by having the investor the possibility of selling his shares in open vehicles (whose shares in the Fund can be bought and sold) while the PE manages closed-end vehicles, that is, investors are participants in a Fund from its inception to its end, distinguishing two periods, one of investment where the EP manager has to identify, evaluate, negotiate and invest and another of divestment where the monetization of the investment previously made has to materialize. Typically, the Funds have a fixed duration of 10 years divided into two periods of 5 years each to invest and divest so that what was invested in year 1 is disinvested in year 6 and so on.
The value investing manager has no time restrictions (it can exceed 10 years even) and its participants are from the moment they make the disbursements, in the PE, investors assume a commitment of a volume of money to invest whose disbursement is regulated in a Regulation of the Fund, but it may be the case, and it is not uncommon for the participant in a Fund not to make the entire committed disbursement.
In summary, the management of the PE is more intense, closer to the invested company, requires greater negotiating skills and a strong involvement of the management team against the Value Investor of a manager that invests in listed companies. Additionally, the partner of an PE manager assumes a personal investment commitment with which he indisputably aligns with the interests of the participants (investors) of the Fund he manages.