Private Equity Transactions – Deal Flow Process
For each fund under management, private equity firms cycle through a multi-staged process consisting of:
- Fund raising from limited partners
- Portfolio acquisition search
- Dispersal of capital gains (or losses) back to the limited partners
Most private equity firms raise capital for a fund through investments made by limited partners – typically pensions, endowments, institutional funds, and high net worth individuals – with the private equity firm serving as the general partner.
During a capital raise, private equity firms normally have a targeted fund size to achieve. Depending on the firm’s track record and the general economic climate, fund raising efforts may either be under- or over-subscribed. New funds for historically successful private equity firms are commonly over-subscribed and therefore close with capital in excess of the target fund size.
Once fund raising is complete, private equity firms begin scouting for potential portfolio investments. While private equity firms enjoy meeting directly with companies interested in selling, often the introduction between a company and a private equity firm is made through an investment banker.
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Investment in Portfolio Companies
As private equity firms identify potential portfolio companies in which to invest, they go through a merger & acquisition transaction process to acquire these new portfolio companies.
Private equity firms will often have a fairly aggressive growth strategy – for both organic growth and growth by add-on acquisitions as a means to create value and therefore enhance the valuation of their portfolio.
Divestment – Liquidity Event
A divestment could occur in the form of a buyout, initial public offering (IPO), strategic acquisition, or another private equity firm buying the portfolio company. Regardless of how it transpires, the divestment of a portfolio company creates a liquidity event for the private equity firm, essentially converting equity into cash or more cash-like equivalents.
Private equity firms make money both from the cash flow that a portfolio company produces while it is owned by the private equity firm as well as from the capital gains realized upon exit. The liquidity event at exit produces and finalizes a capital gain (or loss) that effectively returns funds from equity investments back into the fund of the partnership.
Dispersal of Funds
Because limited partners do not have an infinite investment horizon, private equity firms must eventually convert equity value back to cash by liquidating portfolio holdings and then disperse the money from the fund to the limited partners. This provides the limited partners with a return on investment over the life of the fund.
Long before a private equity firm finalizes its dealings with a particular fund, the PE firm begins the process of raising money for the next fund. In fact, it’s not uncommon for a successor fund to purchase some lingering holdings from a prior fund within the same private equity firm.