Last week we learnt that private equity investing is, among other things, a strategy that involves the purchase of an ownership stake in a target company with a view to increasing the value of that company, and then selling back a stronger, more valuable entity.

Private equity is an attractive source of returns because of the capital gains realised upon exit/sale of the investment. From the viewpoint of the private equity investor, private equity is wealth-building. The returns can be enormous. Returns of five times one’s initial investment over a five-year investment period are not unheard of.

The key items to consider when making a private equity investment are: the target company (that is, the company in which you are taking an equity position), and the efficiency and expertise of the private equity firm responsible for executing the investment/turnaround strategy.

This level and format of equity investing is little recognised in Jamaica. Most persons would be familiar with private equity investing mainly in the form of venture capital or angel financing. In many cases it may be just a situation where your favourite uncle lends you some money to help you fund a worthwhile idea that you cannot afford to finance on your own.

In more developed markets, private equity investors typically invest in a private equity fund run by a private equity firm. The firm usually manages a portfolio of numerous target companies and has several deals going at once. The relationship between the investor and the firm usually takes the form of a “general/limited partnership”. The private equity firm acts as the “general partner” who is responsible for finding target companies, purchasing them and turning them around, and of course most importantly, selling them after sufficient value has been created. In other words, the general partner does all the leg-work, while the limited partners/investors typically play a passive role.

For all this work, the general partners can receive compensation in two ways. The private equity firm is usually paid a modest annual management fee during the investment period. This provides the firm with cash flow and expertise to hunt and execute the deals. However the bulk of the general partner’s compensation comes at the end of the investment period when the company is sold.

Usually, a part of the profits realised on sale are split between the general partner and the limited partners. For example the limited partners may receive 80 per cent of the profits on sale and the general partner 20 per cent. However, there is also usually a “hurdle rate/priority return” for the limited partners. This means that before the general partner receives any share of the profits on sale, the limited partners must receive the hurdle rate or priority return. This means that only the profits above the hurdle rate are split. Even after these fees are considered, select private equity deals can offer individuals double digit returns in US$ terms.

As mentioned above, an important point to consider when making private equity investments is the expertise and capacity of the team involved in executing the turnaround strategy. The turnaround strategy generally involves big bucks; this is the big league; this is serious investing; but if effectively executed, this strategy will return big bucks to the investors. Of course, the converse is true; if the business is not properly financed and managed, one could also lose big bucks. But, as we all know, this is true of any investment in which one gets involved.

A well-known private equity entrepreneur in the US describes his private equity firm as one which helps businesses achieve their full potential by investing in enterprises with solid developmental prospects and, by partnering with their management team, helps them to stabilise, strengthen and expand. This is the essence of private equity investing.

It is important to remember of course, that all of this takes time. It is common for firms to adopt a 5 to 7 year investment horizon for each portfolio company. However, this may vary depending on the industry, strategy and objective of the firms. The life of the overall private equity fund usually extends far beyond the duration of any one deal.

By investing with a private equity firm and sharing in the gains on sale, you may very well be able to finance your own future business expansion; or you may be able to purchase your dream house without going to a mortgage company; or purchase that luxury car you always wanted, without taking out a loan. Whatever your needs are, private equity investing may be worth your while.

Pamela Lewis is Vice President, Investments and Client Services at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm