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Lesson 1 of 6 · 14 min
Private equity: buyouts, growth equity and PIPEs
Private equity buys large or controlling stakes in companies outside the public market, then uses control, operating changes and often heavy leverage to raise the company's value before selling it.
In short
- Private capital is funding not raised in public markets or from banks and governments; it covers private equity (ownership) and private debt (loans), so it spans the whole capital structure.
- Main private equity strategies: leveraged buyouts (LBOs), venture capital (VC) and growth capital (minority stakes).
- In an LBO most of the price is borrowed, secured on the target's assets and repaid from its cash flows; a listed target is usually taken private. An MBO keeps the existing managers; an MBI brings in a new team.
- Like public shareholders, private equity owners vote and have a proportional residual claim, but their large stakes give far more direct control, which demands industry-specific expertise.
- Access can be direct (a single asset, sometimes as a co-investment beside a lead sponsor), through a fund, or indirect through a fund of funds.
- A PIPE sells shares or convertibles of a listed company privately to a few investors: fast and cheap to arrange, but dilutive and usually priced at a discount.
Private capital, private equity and private debt
Most companies fund themselves either in public markets (issuing shares or bonds on exchanges) or through traditional institutions such as banks. Private capital is everything else: money that comes from specialised private investors instead.
When that money buys ownership it is private equity; when it is lent it is private debt. Because one investor can supply both the shares and the loans of a company, private capital covers the entire capital structure.
A private equity manager usually runs several funds, each holding a handful of businesses. The companies a fund owns are called its portfolio companies.
| Public equity | Private equity | |
|---|---|---|
| Ownership and votes | Yes: shareholders elect the board | Yes: same rights |
| Claim on residual cash flows | Proportional (dividends) | Proportional (dividends) |
| Size of stake and control | Usually small, little direct influence | Large or controlling, direct say in strategy |
| Main return driver | Price changes and dividends | Capital gains at exit, helped by free cash flow |
| Liquidity | Trades daily | Illiquid until an exit |
Equity of either kind has the same basic payoff shape: losses are capped at the amount invested, gains are unlimited. That is why equity has historically earned more than debt, with more risk.
Leveraged buyouts: MBO and MBI
In a leveraged buyout (LBO) a buyout fund acquires a listed company or an established private one and pays for a large share of the price with borrowed money. The target's assets are pledged as collateral and its cash flows are expected to service the debt, which then sits on the target's own balance sheet. If the target was listed, its shares stop trading, so LBOs are also called going-private transactions.
Two variants depend on who runs the company afterwards. In a management buyout (MBO) the current managers join the buyers. In a management buy-in (MBI) the buyer replaces them with its own team.
Buyout managers try to raise profits and cash flow. In order of typical importance, the extra cash flow comes from organic revenue growth, then cost cuts and restructuring, then acquisitions, then everything else. But the return to the fund depends heavily on leverage: when debt is scarce or expensive, fewer buyouts happen and managers shift focus.
Ways in: direct, fund, fund of funds and co-investment
An investor can hold private equity directly in one specific company, or through a private equity fund that owns several companies. A fund of funds goes one step further and buys stakes in many private equity funds, which spreads risk but adds a second layer of fees.
A co-investment is a direct stake taken alongside a lead sponsor. The sponsor finds, structures and runs the deal; the co-investor simply joins with extra capital in that single company.
- Direct / co-investment: one asset, most concentrated, needs the most expertise.
- Single fund: several portfolio companies picked by one manager.
- Fund of funds (indirect): many funds, broadest spread, extra fees.
Growth equity and PIPEs
Not every deal seeks control. In growth equity (also called growth capital or minority equity investing) a private equity firm buys a minority stake in a more mature company that needs money to expand, restructure, enter new markets or fund a large acquisition. The deal is often initiated by the company's own managers, who want to cash in part of their holding before any IPO while keeping control.
A listed company can raise private equity too, through a PIPE (private investment in public equity). New shares, existing holders' shares or both are sold privately to a few institutions that sign a purchase agreement at a fixed price. Compared with a public offering, a PIPE needs fewer disclosures, costs less and closes faster, so it is common in rescue or work-out situations when the market price and the investors' view of value are far apart.
The catch: PIPE investors want a discount to the market price, and the new shares dilute existing owners, which can set new and old shareholders against each other. Some PIPEs use convertible debt or convertible preferred shares, often with warrants, which can make the true cost to the issuer high.
A PIPE can also send a positive signal: sophisticated investors are putting fresh money into the company, often taking board seats to influence strategy.
Formulas
- Equity value at exit (LBO)
Equity gains come from a higher enterprise value and from paying down debt with the company's cash flow.
- Multiple of invested capital
n = holding period in years; the annualised figure assumes a single entry and a single exit cash flow.
Worked examples
Example 1 How leverage drives a buyout return
Nordhavn Partners buys Kestrel Tools for EUR 500m, funding 60% with debt. Five years later it sells Kestrel for EUR 650m; debt has been paid down to EUR 200m. What multiple and annual return does the fund earn on its equity, and what would an all-equity buyer have earned?
Example 2 The cost of a rescue PIPE
During a slump, listed airline Solvik Air sells EUR 400m of preferred shares privately to two buyout firms. The shares carry an 8% annual dividend and can be redeemed at 103% of face value during the second year. Assume Solvik redeems at the end of that second year and has paid no dividends until then. What does it pay in total, and how much more than it raised?
Example 3 Classifying private equity deals
Classify each deal: (1) a fund buys a listed packaging firm with 65% debt and the existing CEO stays on as part-owner; (2) a fund buys a family-owned hotel chain and installs its own managers; (3) a fund buys a 25% stake in a profitable software company to fund its expansion into Asia; (4) a listed biotech sells new shares at a discount to three institutions in a private placement.
On the exam
Expect definitions (private capital vs private equity vs private debt, LBO, MBO vs MBI, growth equity, PIPE), the similarities and differences between public and private equity, and why leverage matters for buyout returns.
- Confusing MBO and MBI: in an MBO the existing managers buy in; in an MBI an outside team replaces them.
- Thinking an LBO leaves the target listed. A listed target is usually taken private, so its traded equity largely disappears.
- Calling growth equity a control deal. It is a minority stake, often requested by management, who keep control.
- Assuming a PIPE is cheap financing. It is quick and light on disclosure, but involves a discount, dilution and often costly preferred terms.
Check yourself
Q1After a leveraged buyout of a listed company is completed, the amount of the target's equity trading on an exchange is most likely:
Q2A buyout in which the acquiring firm replaces the existing management team with its own managers is best described as a:
Q3A fund buys a company for EUR 300m using 70% debt. It sells for EUR 360m when debt has fallen to EUR 150m. The multiple on the fund's equity is closest to:
Q4A listed company sells EUR 200m of preferred shares in a PIPE with a 9% dividend, redeemable at 102%. If redeemed after three years with no dividends paid, the total payment (EUR millions) is closest to:
Q5A private equity firm buys a 30% stake in a profitable family company, at the owners' request, to fund an acquisition. This is most likely:
Q6An investor that joins a single private equity deal alongside a lead sponsor, which sources and executes the transaction, is making:
Answer the 6 questions: +10 XP for each one you get right first time.
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