Private Equity Faces Structural Challenges

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6 min read
The Great Recession and the turbulent years that followed represented hard times for private equity. Capital liquidity disappeared, and fundraising opportunities collapsed under the weight of uncertain financial conditions. The future of many fund managers looked bleak. The convergence of these conditions called into question the viability of the industry as a whole. At that point, no one would have predicted such a strong rebound for private equity investments, but to the surprise of many analysts, that's precisely what has happened.

In fact, a recent survey of over 200 industry participants revealed that assets invested via private equity are anticipated to grow at a median annual rate of 5.8 percent during the next decade. This stems in part from the more numerous fundraising opportunities firm managers foresee as they recruit from a wider range of investor groups. This uptick in assets also reflects the willingness of institutional investors to allocate more of their capital to private equity options. According to the survey, 64 percent of the participants reported that they planned to increase their stake in private equity. This marks a dramatic rise in investor engagement from the level of only 26 percent five years ago.

With the industry facing an apparently rosy future, and the opportunities and challenges presented by the 2017 tax law, it has reached an inflection point regarding business structures. Like many other types of firms, private equity firms were structured based on the prevailing wisdom of the time. However, what made sense when these entities were created 10, 20 or more years ago may no longer make sense.

Private Equity Primer

Private equity refers to the direct purchase or investment in companies by a group of private investors. These companies may be private or public. In the case of public companies, the purchasers will withdraw the company from all public exchanges in a move known as 'going private' or 'taking the company private.' The goal of the purchase is to increase the companies' profitability in the short term with the hopes of a lucrative resale. The initial capital required to purchase the companies is managed by an entity called a private equity firm.

Private equity firms employ different strategies to generate profits. One popular strategy private equity firms use to gain returns on their investments is targeting underperforming companies for acquisition and increasing their profitability in the short term. Once the firm has acquired the company in question, these transformations toward profitability can happen in a number of ways. Perhaps the firm uses its managerial expertise to achieve operational efficiencies in the company. Or perhaps the firm takes a relatively regional company and uses investments to open the company to an international market. Investments and company restructuring are part of a process that typically takes from three to seven years. Once the firm feels that the company in question has increased in value, the firm will seek to sell the company off, either to another private investment firm or to a larger corporation.

Other strategies include investing in young, start-up companies; providing financing to growing companies; and investing in other private equity firms. The universe of private equity firms is diverse, offering many investment opportunities for institutional and high net worth investors.

Firm Structures

Private equity firms represent a marriage of two types of investors, the Limited Partners (LPs) and the General Partners (GPs). The limited partners provide the capital for the investment. Typically, limited partners are large institutional investors, such as university endowment funds, insurance companies, retirement or pension funds, and family investment offices. In other instances, a private individual may be part of a limited partnership if he or she has substantial available funds to invest. Investment requirements will vary from firm to firm, but it is not uncommon for minimum investments to exceed $1 million. Limited partners have no control of or influence in the investment decisions of the firm. These decisions are entrusted to the general partners. Limited partners are known as 'limited' because their liability extends only to their initial investments.

General partners are professional investors who serve as managers for the private equity firm. As such, GPs handle all of the financial decisions concerning the pool of accumulated capital. The GPs direct transactions through all stages of the investment cycle, including fundraising, deal-sourcing, additional investments, portfolio management and final sales and exit strategies. Unlike limited partners, who are liable only for their contribution to the investment, GPs are fully liable to the market. So, if an investment crashes and the account turns negative, GPs are responsible for any ensuing debts or obligations. Over the course of the private equity lifecycle investment process, the private equity firm charges the limited partners a fee for managing the investments. This fee covers the firm's salaries, deal-sourcing services, data and research costs, and office leases and administrative expenses. Although these fees may change from firm to firm, they have typically run at a rate of 2% of the total investment fund annually.

In addition to the annual fees, the private equity firm has a right to a share of the profits from the sale of the companies. Once the investors have been paid back their initial investments, the proceeds are split between the LPs and the GPs. The exact split will be governed by a pre-existing agreement between the two parties, but typically, 80% of the profits will go to the investment group and 20% will remain with the GPs.

Structural Evolution

As private equity evolves, the legal, tax and compliance teams involved are re-examining organizational structures. The 2017 tax law, which restricts the amount of net interest expense that firms can write off, puts debt-based financing such as leveraged buyouts at a disadvantage. Private equity firms that focused on debt-based financing are considering their options in light of this change.

The tax law advantages investment in the United States through the cut in the overall tax rate, as well as the immediate expensing of asset purchases and the treatment of certain types of acquisitions. Private equity legal, tax and compliance teams need to analyze the new tax law carefully with their current and future business needs in mind.

A well-considered, planned-out restructuring provides many advantages for private equity firms. Pivoting to a more advantageous structure can save money, create efficiencies and support bottom-line business growth. Not only does such a switch make sense from the tax and business points of view, but it stands to help from the compliance perspective. Regulators in many jurisdictions seek a higher level of transparency from private equity firms, which certain types of restructuring can facilitate.

Leveraging technology for help in deciding the type and timeline involved in restructuring is critical. Restructuring requires a platform that facilitates appropriate data governance and custody, as well as helping the board and executives envision what the organization can be. Such a platform empowers the legal, compliance, tax and executive teams, as well as the board, to collaborate on deciding the best structure for your private equity firm going forward and how to get there.