Relying on outdated perceptions: Big mistake. Big. HugeCameron McCormack, Manager - Investments03 December 2021
By the end of the 80s, exemplified by the 1987 Wall Street Crash, people were recoiling from the ‘age of excess’ and what was seen as excessive capitalism. Private equity somehow became the poster child for everything that was wrong with corporate America. Hollywood birthed some infamous ‘corporate raiders’ including Richard Gere’s and George Costanza’s (sorry, Jason Alexander’s) characters in Pretty Woman.
Edward Lewis (played by Richard Gere) started the movie as a ‘baddie’ with worse morals than his hustler leading lady. Edward is CEO of a company that focuses on leveraged buy-outs, which is one form of private equity, whereby he buys, then dismantles companies to sell the assets for a profit. Edward’s business is a plot point and central to the evolution of his romantic relationship with Vivian, Julia Robert’s character as well as his own personal redemption.
The film paints a negative picture of Edward’s business: endless hostile take-overs, where profits trump everything and ‘winning’ is the only option, irrespective of who gets hurt or how many people lose their job.
The reality is private equity investing is not the ‘baddie’ Hollywood simplistically fashioned. It’s the ‘goodie’.
What does private equity do?
“It's clear to me when you do private equity well, you're making companies more efficient and helping them grow and become more profitable. That success means our investors benefit.”
- - David Rubenstein
The Carlyle Group
Put simply, private equity is investing directly in or with companies that are not publicly traded.
There are three main private equity investing strategies.
- Venture capital
This involves providing capital to early-stage private small sized companies or start-ups. The investment is provided in exchange for a share of the company and used to help the company develop their business idea. This investment is considered high risk as most start-ups are ideas that have yet to be proven. However, the rewards are high for investing in the start-up which turns into a unicorn, the term applied to a privately held start-up company with a valuation over $1 billion.
Almost all start-ups seek venture capital to get the business off the proverbial ground. Tech mega caps Facebook (now Meta) and Netflix both succeeded off the back of venture capital. In many cases, the support is not only financial, the business also benefits from the support network and expertise of the private equity firm. A great example of this is Kinnevik, one of Europe’s largest investment companies, and Zalando, now Europe’s largest online fashion retailer. Kinnevik first invested in Zalando in 2010 and has consistently supported Zalando’s strategy as it evolved from an online fashion catalogue retailer to an online platform connecting all the major players in the fashion industry. Zalando’s strong execution has created significant value for Kinnevik’s shareholders – from a total investment of SEK 7.9 billion (AUD$1.22 billion), Kinnevik’s stake is today worth SEK 55.1 billion (AUS$8.53 billion) and is now intended to be distributed to shareholders1.
- Growth capital
As the name suggests, this refers to funding aimed at private mid-sized companies that are in a growth phase and need additional capital to develop and expand. Similar to venture capital, the funding is granted in return for equity. This is considered lower risk than venture capital as the investment is in an established company which can be more readily researched and assessed.
While private equity is most often associated with investing in tech companies, investment focus can span across all sectors. In 2017, private equity firm Carlyle Group made headlines for securing an approximately 50% stake in an American underground streetwear brand Supreme which relied on product scarcity and word-of-mouth to generate hype (and clothing ranges that sell-out in seconds)2. The investment valued the company at US$1 billion and challenged the traditional view that retail brands requiring mass marketing and distribution to generate adequate growth and profits. Just three years later, Supreme was acquired by apparel conglomerate VF in a deal that valued the business at US$2.1 billion3.
Buy-outs occur when a mature, typically public company is taken private and purchased by either a private equity firm or its existing management team. This type of investment makes up the largest portion of funds in the private equity space4. It is in buy-outs that Richard Gere’s Edward Lewis operated.
Buy-outs can take two forms:
- Management buyouts, where the existing management team buys the company’s assets and takes the controlling share; and
- Leveraged buyouts, where funds are borrowed to facilitate the buy-out.
Virgin Australia was one of the biggest corporate casualties of COVID. Australia’s second largest Airline went into voluntary administration on 21 April 2020, with debts close to $7 billion, thousands of staff and investors left stranded and leaving the country facing a future with only one major airline. However, the airline was saved with the buy-out by private equity firm Bain Capital after creditors agree to a $3.5 billion deal5delisting Virgin Australia from ASX and making it a private company.
This deal provided certainty of the airline continuing – a ‘win’ for Australia’s aviation industry; the protection of creditors including Virgin's employees; and the $600 million in credits owed to customers5.
From Bain Capital’s perspective, the focus is building as Bain Capital PE Managing Director, Mike Murphy has said, “We will continue to take a partnership approach as we go about rebuilding the business for a brighter future over the next few years. We all want a strong, more profitable and competitive Virgin Australia.”
For the most part, private equity investing is about helping companies grow and become more profitable. While private equity’s ultimate objective is to generate high returns on investments, it’s far less of the ruthless ‘smash n grab’ typified in the 80s and and more like the ‘new’ reformed Edward at the end of Pretty Woman: a giver not a taker who now wants to save companies rather than raid them.
Accessing private equity is now easier for Australian investors with the launch of the first listed private equity ETF on the ASX. GPEQ will track the LPX50 Index which includes the 50 largest and most liquid private equity companies with exposure to venture, growth and buy-out opportunities.
Any views expressed are opinions of the author at the time of writing and is not a recommendation to act.
VanEck Investments Limited (ACN 146 596 116 AFSL 416755) (‘VanEck’) is the issuer and responsible entity of all VanEck exchange trades funds (Funds) listed on the ASX. This is general advice only and does not take into account any person’s financial objectives, situation or needs. The product disclosure statement (PDS) and the target market determination (TMD) for all Funds are available at vaneck.com.au. You should consider whether or not an investment in any Fund is appropriate for you. Investments in a Fund involve risks associated with financial markets. These risks vary depending on a Fund’s investment objective. Refer to the applicable PDS and TMD for more details on risks. Investment returns and capital are not guaranteed.
- - David Rubenstein