Two minute explainer: Private equity firms and their strategy

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Private equity (PE) firms run unlisted vehicles, usually funds, that take over struggling or nascent businesses, increase their profitability and are sold later at a much greater value.

The targets are often established companies with a good underlying fundamental business going through a rough time, or startups with strong ideas and potential to scale up.

PE funds have a fixed life, usually ten years, and managers always have an exit strategy with the target sold to a new investor or floated on the public market.

Targets usually have a unique selling point, such as a product that distinguishes them from their competitors, and a strong management team to deliver the turnaround strategy.

If the current executives are not deemed suitable, the buyer appoints a new team.

For example, iconic bootmaker Dr Martens PLC (LON:DOCS) was snapped up by PE group Permira for £300mln in 2013, but valued at £3.7bn on its market debut in January.

PE firms can make these huge returns on their investments by overhauling the acquired business and also through their financial structure.

In leveraged deals, the PE buyer only advances a small part of the total offer price and uses the assets of the business being acquired as collateral for debt to cover the rest.

For example, a consortium made up of billionaire Issa brothers and private equity firm TDR Capital agreed to acquire supermarket chain Asda for £6.8bn last October.

The Issas and TDR only had to put up £780mln each, while the rest was borrowed.

The risk is usually calculated based on the business being acquired – and supermarkets are currently among the most stable – while the current low-interest rates make the debt repayment more affordable.

In the case of Asda, the interest will be around £125mln per year, which can be covered comfortably by the £500mln of cash the grocer makes annually.

Private markets are healthy ones: Total money managed at the start of 2021, including private equity and debt funds, was 5% higher than the year before at US$7.4 trillion, based on data from McKinsey & Company.

According to Ragavan Arunachalam, senior associate at law firm Collyer Bristow, PE companies will continue focusing on sectors that have thrived during the pandemic, such as working from home infrastructure and ESG investments.

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