The earliest or perhaps, the basic layman understanding of market or marketing we know, as far back as our memory can go, is that it is simply the process of buying and selling. But everything about this basic concept has changed greatly indeed over the years, just the same way we have seen and experienced changes in all phases and faces of our human existence. One thing however that did not change so much, is the concept of buying and selling and buying to sell, which eventually led to the creation of an entire new business sector we can say, called private equity investing. Have you ever thought of starting a private equity firm?
Private equity works with the concept of buying to sell companies/businesses, and the concept of private equity has experienced phenomenal growth all over the world, leaving in its trail, arguments and counter-arguments. According to some people, private equity is all about ripping or rather stripping of assets and profiting from them, as private equity investors, partners and managers are perceived, as people who take advantage of loopholes and unfair tax breaks, to make money from commercial practices and activities, while to some others on the other side of the argument, private equity is the perfect and superior strategy for managing a business.
In this practical guide however, we will not be focusing our attention on the arguments or counter arguments with regards to private equity investing, but rather we will be looking at the step by step guide to follow on how to start a private equity firm in 2021 and beyond and profit from it.
Starting a private equity firm is a tough nut to crack, this statement is not to scare you, but the reason why we stated that it is a hard nut to crack, is simply because of the processes involved in starting your own private equity firm, the attendant risks, the strict governance and regulations and not forgetting the unusually high capital needed to get started.
We will however in this write up, be breaking up the processes into easy to understand and simplified requirements and steps on how to get started with your own private equity firm and profit from it.
HOW PRIVATE EQUITY WORKS
The concept behind private equity is buying to sell. An acquisition when done rightly for instance, can quickly increase in value, thereby generating annual returns. So the business model of a private equity firm is to follow this buy-to-sell strategy and then buy a business and sell after a certain period of time and make a return on the investment.
Businesses all over the world are experiencing a buyout boom. In the early years of the current buyout boom, many private equity firms prospered mainly by acquiring the non-core business units of large public companies. Some of these businesses under their previous owners, are those that most times had often suffered from neglect, unsuitable performance targets, or other constraints, thereby giving opportunity to private equity firms to buy them, turn them around and sell them later.
More recently, private equity firms—aiming for greater growth—have shifted their attention to the acquisition of entire public companies. This has created new challenges for private equity firms. For example, when KKR and GS Capital Partners, the private equity arm of Goldman Sachs, acquired the Wincor Nixdorf unit from Siemens in 1999, they were able to work with the incumbent management and follow its plan to grow revenues and margins. In contrast, since taking Toys “R” Us private in 2005, KKR, Bain Capital, and Vornado Realty Trust have had to replace the entire top management team and develop a whole new strategy for the business.
Before we go into the step by step process of getting to start a private equity firm, it is very imperative that you have an understanding of the followings and ensure you have them in place, before proceeding in starting your private equity firm.
- Have a depository account
- Have a salary and compensation structure for all key employees
- A system to identify and manage conflict of interest between managers and investors
- An internal risk management system
- A minimum of 150k of your own capital
The following steps when followed dedicatedly will help you to get started in setting up and successfully running your own private equity firm.
- DEFINE THE BUSINESS STRATEGY
Private equity business is a high risk and competitive field to play in, so it will be foolhardy to go into the pitch of play of private equity business, without first having a foolproof strategy. You must have a business strategy that is remarkably different from that of competitors. How then can you come up with a unique strategy if not through conducting a market research into individual and defined market sectors?
Private equity sector ranges from early stage start-ups, fin-tech, energy development etc., so your strategy will help you identify the area you will focus your funds on, as no investor will be interested in a private equity fund, without knowing the goal for their funds.
So as you tinker on your investment strategy, you should consider if your fund will be geographic, emerging market or industry specific.
Meanwhile, there are several business focuses you could adopt. For instance, will your funds aim be to improve your portfolio companies’ operational or strategic focus, or will it centre entirely on cleaning up their balance sheets?
Remember that with private equity firms, things typically hinges on investment in companies that are not traded on the public market. It’s very important that you determine the purpose of each investment before taking the decision to invest. For example, you have to answer the question, what is the aim of this investment? Is the aim to grow capital for mergers and acquisitions activity? Or is the goal to raise capital that will allow existing owners to sell their positions in the firm?
- WRITE A BUSINESS PLAN
Your private equity firm should be treated as any other business, would you rather start a business without knowing the direction you are headed? It is then expected that you write a comprehensive and detailed business plan. Your Private equity firm will be dealing with a lot of investors, and the investors should be able to know your plan with regards to the funds timeline, time scale for raising funds, cash flow expectations and exit period for each portfolio.
Your business plan should at least on the minimum answer these questions:
- What is your investment strategy? (What is your market? Your industry? Your niche?)
- How will you find deals?
- How will you raise the money for the fund?
- How much will you charge?
- What will your start-up costs be?
- What will your ongoing expenses be?
The business plan will therefore contain your strategy on how the funds will grow over specified time, a marketing plan on how to attract future investors, and the executive summary of the business plan, which will capture the whole essence of your business.
But generally speaking, almost all business plans have the following elements:
- Cover or Title Page
- Plan Summary
- Operating or Management Plan
- Market Analysis
- Marketing Plan
- Human Resource Management
- Financial Data
- Owner(s)’ Experience and Expertise
- SET UP YOUR BUSINESS STRUCTURE
It is good that you have written your business plan, but a business will not execute itself. Hence you have to now set up a structure that will serve as a vehicle to run your full operations
You can achieve this for instance, by setting up an external team of lawyers, accountants, attorneys and industry consultants who will be providing insight into the industries of the companies that will eventually become part of your portfolio.
You can also set up an advisory board that can help you with disaster recovery strategies in case of cyber-attacks, steep market downturns, or other portfolio-related threats to the individual fund when you are up and running.
You should also decide on the roles and titles of your team members. You can specify roles for the management team, Chief Financial Officer, Chief Information officer, Chief compliance officer, etc.
Your business set up process will also involve setting up the team that will carry out tasks such as handling of rent or purchase of office space, furniture, needed technology equipment, and eventually the hiring of other staff.
There are several things to consider when hiring staff so as to attract the best for a company that is just starting out like yours, you should consider things, such as profit-sharing programs, bonus structures, compensation protocols, health insurance plans, and retirement plans.
- ESTABLISH THE INVESTMENT VEHICLE
Your private equity firm will need an investment vehicle in order to carry out your operations, so it is expected of you to establish your funds legal structure. Depending on the state or country you will be operating from, but it is generally assumed that a private equity firm will naturally adopt the structure of a limited partnership or limited liability company.
As a founder of the fund, you will automatically become a general partner, meaning that you will have the right to decide the investments that will compose the fund.
Depending on how you want to operate your business, but it will be expected that your investors will be limited partners who will not have the right to decide which companies will become part of your fund.
With this structure in place, your Limited partners will only be accountable for losses tied to their individual investment, while your general partners if any, will handle any additional losses within the fund and liabilities to the broader market.
Assuming that everything goes well for any investments the company will make, you should for instance in three to five or seven years, sell the company and make some money. The selling process is full of legal, accounting, and potential regulatory obstacles as well, that is the reason why you should have your consultants, lawyers and accountants set up from the beginning, as you will need them at this stage of selling, especially if you are thinking about an IPO.
The reality is that unless you are already in the industry, with a proven track record, and with a network of industry connections, the odds that you can start your own private-equity fund are next to nothing, hence the reason why you need the team of lawyers, accountants and consultants, so you can leverage on your track records.
It is highly advised that you use the lawyers to draft all necessary partnership and placement agreements with all your partners and consultants.
- DETERMINE A FEE STRUCTURE
Private equity firms, does not necessarily manufacture any products per say, but rather they offer a service, which usually is tied to management fees and commissions. As the fund manager, you should determine provisions related to management fees, carried interest and any hurdle rate for performance.
An unwritten industry law states that, private equity managers, typically receives an annual management fee of 2% of committed capital from investors. As an example to understand how things work, for every $5 million your firm raise from investors, you will collect $100,000 in management fees annually.
This percentage will however depend on your level of experience, as in some cases, you may receive smaller management fees just to attract new capital.
Another key fact to note is that carried interest is commonly set at 20% above an expected return level. Should the hurdle rate be 5% for the fund, you and your investors would split returns at a rate of 20 to 80.
You should set up compliance, risk and valuation guidelines for the fund to help you and your investors in resolving issues of sharing in time of low or high hurdle rates.
- RAISE CAPITAL
The most difficult and exciting part of running a private equity firm is the strenuous task of raising funds. You will need a lot of creative marketing strategy to raise reasonable funds. As a first step towards raising funds, you will have to prepare your offering memorandum, subscription agreement, partnership terms, custodial agreement, and due diligence questionnaires and have them readily in place. You may have to seek the help of professionals in preparing all of this documents and agreements if you cannot prepare them on your own, or you can always fall back to the professionals in your team.
Raising of funds and also getting your new managers to get a severance letter from their former employers, where applicable, are what makes starting a private equity firm very challenging, as it is always very difficult to convince others to invest in your fund.
The easiest way to convince others therefore, is to start by investing in your own fund. You should try as much as you can to convince fund managers who have had successes in their careers, as they are the likely people who be willing to provide at least 2-3% of their money and invest it into your fund.
In addition to your investment track record and investment strategy if well-articulated, your marketing strategy will be central to raising capital. Due to regulations on who can invest and the unregistered nature of private equity investments, the government guidelines says that only institutional investors and accredited investors can provide capital to these funds, thereby making the process of raising funds even harder.
Institutional investors may include insurance firms, sovereign wealth funds, financial institutions, pension programs, and university endowments. Accredited investors are limited to individuals who meet a specified annual income threshold for two years or maintain a net worth (less the value of their primary residence) of $1 million or more.
Once a private equity fund has been established, you as a portfolio manager will then have the capacity to begin building the portfolio. At this point, your other managers will then start to select the companies and assets that fit their investment strategy.
From available data, private equity investments have outperformed the broader U.S. markets over the last few decades. This has led to increased demand from investors seeking new ways to generate superior returns. It then implies that there are so much opportunities you can take advantage of and profit from by starting your own private equity firm. But the question is, are you willing to take the bold step? Do you have what it takes to use this information provided here? Will you be comfortable in just reading this and not take any action? The ball is in your court now, what you do with it is entirely up to you.
What are your thoughts with regards to this practical guide and do you have any business idea you want us to write about? Let us know in the comment section.