The term "private equity" can used to describe many different types of capital pools. Some are institutions managing large sums and have a finite investment period, while others are managing their own personal funds and are investing for future generations. The different categories can be confusing to professionals who are not interacting with this industry on a deal basis. Consequently, in this month's article we outline the multiple types of "private equity" that a business owner might encounter during their sale or recapitalization transaction.
- Committed Funds. This is the most common type. A firm raises a fixed amount (say $300 MM) from various institutional investors, wealthy individuals or family offices. Funds deploy 10-20% of the fund each year and create a portfolio of companies within that fund. The investors get paid when the companies are monetized (i.e. sold), which generally must happen in 5-10 years of an investment date. The benefit is that if the investment committee approves the deal, they can drawdown the funds and complete the investment. The downside is they often have rigid investment parameters due to what they told investors they would pursue, so it can be difficult getting through investment committee.
- Institutional Investors. This category includes pension funds, insurance companies, endowments, and other institutions that make direct investments into a business. Institutional investors have been investors in committed funds for a long time, but many have decided to make direct investments into companies, either alongside another private equity investor or alone. These investors might still seek liquidity but may have. The benefit is having ample liquidity and flexibility based on deal size and industry. The downside is they might not have the same degree of business-building experience as committed funds or other PE investors, and their minimum check size might be much higher than would be a fit for lower middle market companies.
- Family Offices. Similar to institutional investors, many wealthy families have migrated away from investing through committed funds (due to uncertainty of investing into a blind pool, plus the layers of fees upon fees), and instead are opting to make direct investments into companies. This works particularly well when the family's wealth was created by an entrepreneur who understands what portfolio company business owners are going through, and how to mentor and help them grow. This model works best when the family hires someone from a "traditional" private equity background who can help with deal sourcing. The benefit is permanent capital, and the downside is they are not active in new deal origination so they are difficult to find (and often very risk averse).
- High net worth. Similar to a family office, many individuals are making investments directly into lower middle market companies. A family office generally implies infrastructure and personnel, and perhaps an investment thesis, whereas HNW investors can lean in or out as they wish. In some cases they might be the sole investor, but more frequently we see where a club of HNW individuals team up to make a direct investment into businesses as a way to mitigate risk.
- Mezzanine. This category is an offshoot of committed funds. These investors contribute a combination of high-interest subordinated debt and equity capital as part of the same transaction. The interest rate might seem objectionable to a business owner, but when you consider the rate is both tax deductible AND lower than equity returns, the business owner can see how a prudent amount of subordinated debt actually enhances equity returns for remaining equity investors (including rollover equity). Mezzanine funds may co-invest alongside other private equity investors or be the sole investor, and may seek either a minority or majority position. Many mezzanine investors participate in a government sponsored program known as Small Business Investment Company (SBIC) program, which effectively gives them an attractive cost of capital to pursue lower middle market investments through low-interest government-backed loans. The tradeoff is more of their investment has to be structured as debt to repay the loans.
- Independent Sponsors. This category has become quite popular within the private equity world, yet remains scarcely known or understood to those who don't deal with private equity frequently. This structure occurs when an experienced operator or seasoned investment professional joins forces with a capital provider (i.e. any of the aforementioned capital sources) to complete the transaction. The independent sponsor essentially works on the capital provider's behalf to oversee the investment, interact with management, and assist with business-building initiatives. The work is similar to what a committed fund or other majority owner would expect to do, although the independent sponsor might have greater industry expertise than a capital provider, and/or is willing to be more hands-on with a company post-closing than capital providers might be. Some of these professionals choose to remain independent for extended period of time and build a portfolio, whereas others ultimately decide to raise a committed pool of capital down the road. Why would committed funds work with independent sponsors? So they can deploy more capital and let someone else do the work, in exchange for sharing the upside.
- Search Funds. This category describes an entrepreneur (or 2-3) that are committed to investing in one company and joining its leadership team full-time post-closing. Prior to launching their search, the entrepreneurs will have raised a committed pool of capital from an active network of search fund investors, with a specific investment thesis in mind. Those investors often invest in multiple other "searchers" and club up with 10-20 other co-investors, and many are willing to fund search costs along the way for the entrepreneur to ensure success with finding a company. This is common among post-MBA professionals and those earlier in their career, but not necessarily.
The question of "who does what" in private equity to be confusing for business owners not accustomed to dealing with the industry on a regular basis. Each of these categories are viable strategies that help provide support and strength for the private equity asset class overall. A business owner who is speaking with private equity firms would be wise to consider which category those firms are, so they understand the implications of a partnership together. Beyond that, choosing a partner based on experience, character and personality fit can lead to a productive business partnership for the years ahead, regardless of their category.