Private equity (PE) has been an attractive investment class stemming from strong returns and diversification. For simplicity, private equity buys businesses, grows businesses, and sells businesses. The difference between the price paid and sold for the businesses is how private equity makes money and generates a return.
Private equity typically takes a controlling interest in a company via a mix of debt and equity while creating a range of incentives to align the acquired business interests with its own. The focus is to grow EBITDA which can be achieved via 1. Organic growth, 2. Increasing margins, or 3. Buy-and-build.
As with any investment, private equity is driven by expectations as to how much and how soon the acquired company will grow. Deviations between expectations and actual results impacts the internal rate of return (IRR) and Multiple on Invested Capital (MOIC). This is why due diligence is imperative to assess expectations which drives the price paid, expected exit value, and expected IRR.
Overpaying can result from too lofty of expectations, poor performance, or too much money chasing too few deals. A lower exit multiple can result from lower growth expectations and margins or declining equity markets all of which impacts the IRR. Many private equity portfolios are skewed with more losing investments than winners, although this can be offset with the winning investments generating higher returns – frequency vs. magnitude. However, such a dynamic can cause private equity to only seek out “unicorn” investments which are few and far between.