WHAT IS PRIVATE EQUITY?
What’s Private Equity?
Private equity includes
– Investing in a private company
– Investing in a public company, and bringing that public company private.
An example of this was the management buyout where Michael Dell combined with the private equity company, Silver Lake Partners, to buy Dell off the stock market for $24.9 billion.
Technically, by definition, venture capital would be a subset of private equity, but, here in North America, we look at private equity and venture capital as two distinct things. Of course, at the University of Waterloo we have a course titled Private Equity and Venture Capital. Private equity represents
– Buyouts – investments in larger, more mature companies that use significant amount of debt.
– Venture capital – investments in smaller companies, younger companies that use little or no debt.
“In between” buyouts and venture capital is growth capital. Growth capital are minority investments that are usually made in more mature companies. You can classify growth capital more as private equity, but it could also be classified as venture capital. For example, Georgian Partners invest minority stakes in growing companies that have revenues between $10 and $80 million (Georgian is referred to as a late-stage venture capital firm).
So we looked at buyouts, growth capital, and venture capital. Let’s look at a detailed example of buyouts.
So let’s say we buy a business for $40 million that has $5 million in EBITDA. Let’s say that the bank will give us a loan for four times EBITDA.
So 4 times $5 million: that’s a $20 million loan. Now, let’s assume an interest rate of 5% per year. 5% of $20 million is $1 million a year.
Let’s look at the difference between doing this deal without leverage or with leverage.
We’re paying $40 million for $5 million in EBITDA, That’s a 12.5% return.
We’re only paying $20 million (because the bank is paying the other $20 million). We’re not getting $5 million (because we still have to pay that $1 million in interest), so we’re getting $4 million. $4 million on your $20 million is a 20% return.
By adding leverage to this deal we’re increasing the return from 12.5% to 20%. That’s a simple example of how a leveraged buyout works.