LBO Funding and Exit

Who funds private equity transactions?

Private equity funds raise their money from institutional investors, including pension funds and insurance companies. These institutional investors allocate money to alternative assets, and private equity is considered a very important alternative asset class. Investors generally allocate 1.5% to 5% or more of their portfolios to private equity, by investing across several private equity funds. Institutional investors are keen to participate in this high-return asset class that has low correlation with many traditional asset classes.

What are the target companies of an LBO?

The targets for LBO transactions can emerge through the sale of a private company or division of a public company, or alternatively and more visibly, through a public-to-private transaction involving a listed company. The former could involve, for example, the sale of a family-owned business or the sale of a division of a larger listed company. Of course, it could involve the sale of a company by one private equity firm to another, referred to in the industry as a secondary buyout. Public-to-private transactions, on the other hand, tend to be much more visible and complex. Such transactions can be friendly, meaning that the existing board has a favourable view of the transaction and purchase price, or they can be hostile, meaning that the board believes that the price proposed is too low. As you might guess, when markets are buoyant and companies are “fully valued”, there is significantly less scope for public-to-public transactions, and new LBO transactions mainly involve acquisitions of private companies, especially secondary buyouts. In such cases, the selling private equity firm has achieved its desired return over an appropriate holding period, and needs to realise a return. Concurrently, the private equity firm buying the company believes that there is substantially more upside left that can be realised in a new LBO.

How does a private equity firm exit a company?

Private equity firms need to exit their investments from time to time, to demonstrate actual (realised) gains and create a track record for their investment case as a private equity firm. With a good track record, they can then re-approach the institutional investor base - consisting of insurance companies, pension funds, asset managers and family offices, to name a few - to raise new funds. Private equity firms normally begin their life with a modest sized LBO fund of say $300 million to $500 million, but with a track record in hand, especially through a few business cycles, and with subsequent successful rounds of fundraising, they can grow their profile to the point that they can raise multi-billion dollar funds from supportive institutional investors. Private equity firms exit their investments in several ways. Exits can involve an initial public offering, or IPO, which means listing the company on a public stock exchange. An exit can occur via the sale of the company to a strategic buyer or to another private equity firm. In fact, before undertaking an LBO, you can rest assured that the private equity firm has contemplated its likely exit scenario within three to five years.