Private equity – how does it work?

Private equity simply explained

The term private equity originally comes from the English language and means “private equity capital“. A private equity company therefore invests capital in companies that are exclusively privately held and consequently not listed on the stock exchange. In order to invest in other companies, a private equity company will ideally first engage in “fundraising”. This involves raising money from institutional, private and industrial investors and pooling it in a fund. Once the previously targeted amount of capital has been collected from the investors, who are also called “limited partners” in this context, the fund does not raise any more capital.

The term of a fund determines how long a private equity company has to invest in companies, increase their value and ultimately sell the shares at a profit. The term of a fund is often between ten and twelve years. This period is in turn divided into three phases: In the first phase, private equity companies search for potential investments that match the previously defined investment focus. The investment strategy can, for example, consist of concentrating on certain regions, investing only in selected phases of a company or specialising in certain industries.

The participation

As soon as a potential investment is found that meets the fund’s criteria, the private equity company begins an intensive review of the company. If the initial analysis confirms the private equity company’s decision to invest, the examination continues after a so-called “Letter of Intent” (LOI) has been drawn up. This summarises the essential contents of the subsequent investment contract.

Often, the private equity company hires external service providers to carry out a “due diligence”, a detailed examination of the company, in certain areas of the company (e.g. technology or intellectual property). Accordingly, depending on the size of the investment, several due diligence reports may be available at the end of the due diligence phase, which present the economic, legal, financial, tax and technical aspects of the company.

On the basis of these reports, the private equity company can form a holistic picture of the company and thus recognise at an early stage circumstances that would preclude an investment. Assuming that the private equity company continues to seek an investment after the review process, negotiations on the purchase price of the investment now begin with the seller on the basis of the LOI. It should be noted here that private equity companies can make both minority and majority investments. Furthermore, a fund consists of several investments in different companies in order to enable a certain risk diversification.

The increase in value

After the investment, the second phase in the life of a fund begins – value enhancement. In cooperation with the company’s management, various measures are initiated for the successful further development of the company.

In order to offer the greatest possible added value, the private equity company uses its network and contributes its expertise from many years of experience, for example to enable international market entry, to generate new customer orders or to establish more efficient workflows. However, the private equity company usually does not act in an operational capacity, but in an advisory capacity, for example on the basis of a seat on the company’s supervisory board.

The Exit

Since a private equity company is always only a partner for a limited period of time, i.e. an investment within the fund term works towards optimising a company and selling it profitably, the third phase of the fund term now occurs – the exit, i.e. the sale of the company, is prepared.

After the minority or majority shareholding has been completed and the enterprise value has been increased, the private equity company is now looking for a worthwhile exit opportunity. There are basically four possible strategies. The first possibility is an IPO of the company. The prerequisite, however, is that the necessary conditions are met. In the so-called “Initial Public Offering” (IPO), the shares, which were previously traded privately, are offered publicly on the capital market.

The second possibility is a “buy back”. This means that founders or co-partners of the company buy back the company shares and thus increase their own stake in the company.

In a “trade sale”, the third exit variant, the stake is sold to a strategic buyer, such as a competitor. Finally, in a “secondary buy-out” there is also the possibility of selling the stake to another private equity company.

The distribution of profits

The proceeds of the respective exit are then paid out to the fund’s investors. It should be noted that all costs incurred during the life of a fund outside of the investments are also paid out of the fund.

This so-called “management fee” is a certain percentage of the fund volume and covers the administrative costs of the fund. In addition, the fund manager is granted a share in the investment performance, provided that the investors have achieved a predefined target return.

What is the difference between private equity and venture capital?

Both the term private equity and venture capital refer to equity investments in companies that are not publicly traded. The difference here always lies in the phase in which the target company finds itself. Private equity companies usually acquire minority or majority stakes in companies that already have stable cash flows and thus represent a lower risk. In addition, private equity companies may use debt capital when purchasing the shares. The debt capital, which is often provided by banks, can then be repaid from the company’s income.

In this respect, venture capital companies often finance an entrepreneurial endeavour that is still in the start-up or growth phase. Companies that raise capital from venture capital companies usually divide their financing into several rounds with different investors, who in turn contribute capital by subscribing to new shares. Debt capital is not raised by venture capital companies here, as target companies are in an earlier phase and are thus far riskier.

The history of private equity

The origins of the private equity business can be traced back to Georges Doriot, who founded the American Research and Development Corporation (ARCD) after the end of the Second World War. This promoted private sector investment in companies run by returned soldiers.

The first major success story of an investor in the private equity sector can also be traced back to the ARCD: In 1957, an investment of 70,000 dollars was made in the Digital Equipment Corporation, one of the first computer companies ever. The investment was worth over 355 million dollars after the company’s successful IPO.

The first start-up in the modern private equity market is Fairchild Semiconductor, which originated in America and was the first company to produce a commercially viable integrated circuit in 1959. This was made possible by capital inflows from a company that later called itself Venrock Associates.

From these beginnings, an important area of the modern economy gradually developed, which today provides capital to young companies that are not yet able to obtain outside capital due to their early stage. In 2018, for example, 2168 deals with a volume of €262.1 billion were concluded in Europe alone. Worldwide, the figures are even more impressive, with a buyout volume of almost 600 billion dollars, and underline the importance of equity capital.

In Germany, the first private equity company was founded in 1965 with today’s Deutsche Beteiligungs AG. Difficulties arose in the German capital market, however, because the risk appetite of investors in this country is less pronounced than in international comparison and important investors in this industry were missing. In addition, many companies maintain close contact with their house bank, which means that external capital providers are often viewed critically and are not the first port of call for liquidity requests. In the 1970s, for example, the invested capital in the private equity market in Germany amounted to just DM 560 million. Driven by the boom and the spirit of optimism in the 1990s, the volume of the private equity market in Germany multiplied to 4.5 billion at the turn of the century. In 2020, the investment volume in Germany amounted to 12.5 billion euros and will continue to play an important role in economic development in the future.

What does SHS do in terms of private equity?

Like other private equity firms, SHS raises capital from outside investors, limited partners, through “fundraising”. After the fund is “closed”, SHS invests in privately traded companies. Through SHS’s expertise and network, measures are then initiated in consultation with management to increase the value of the company. After the sale of the investment, proceeds are paid out to the limited partners.

SHS invests and participates in healthcare companies in Europe, with a focus on the DACH, BeNeLux and Nordics regions. Due to this strategic orientation and the maintenance of a track record since the company was founded in 1993, investors rely on the expertise of SHS. In the meantime, the company can look back on five fund generations.

Who are the investors in a fund?

Private equity funds are largely subscribed by institutional, private and industrial investors. The share of the “general partners”, or the managers of the fund, is therefore only a fraction of what external limited partners invest. There must be a strong trust between limited partners and general partners, which is based on the investment strategy, the track record, i.e. the success of previous funds and investments, and the expertise of the investment team.

A large number of different investors invest in SHS funds. Family offices, pension funds, provident funds, fund of funds, banks and savings banks, wealthy private individuals, health insurance companies, industrial companies and church investors, among others, attach importance to sustainable investments in the healthcare sector.

Conclusion on private equity

The business model underlying most private equity companies is to generate profits for the investors of the private equity fund by investing in companies. Through the intensive examination of the investments, the management of the private equity company can exclude risks, but market or sector risks still exist. Thus, not every investment in a fund necessarily develops as desired. In the end, however, the less well performing investments can ideally be compensated for, since a very high increase in value can be realised with other investments in the fund.

In addition to the investors of the private equity fund, the national economy also benefits from private equity companies, of course. Within the holdings, the measures to increase the value of the private equity company enable, for example, the development of new products or entry into new markets. Ultimately, therefore, these measures create or secure jobs within an economy and at the same time enable companies to develop their full potential.