Private Equity

What is private equity?

Private equity (German: außerbörsliches Beteiligungskapital) describes equity that funds and other financial investors invest in unlisted companies in order to sell the stake after a few years at a gain in value. In the narrower sense, the term means the acquisition of a majority in established, profitable companies (buy-out), the purchase price of which is financed to a considerable extent with loans. Because of this leverage, it is also called a leveraged buy-out. The principle resembles the debt-financed purchase of an apartment building: the rents cover interest and repayment, and on a sale the buyer is left with the proceeds less the remaining debt.

In the wider sense, private equity also includes venture capital for young companies and growth capital for more mature, still growing companies. In transaction practice, what is usually meant is a financial investor that acquires a company for the return and does not integrate it into a business of its own. It appears as a bidder in company sales, in succession situations or in the carve-out of a corporate division. The entry is regulated in the share purchase agreement, the financing in loan agreements and the relationship of the shareholders in the articles of association and the shareholders' agreement.

Private equity funds: structure and investment logic

Private equity funds are generally closed-end funds with a term of often ten years and an extension option. Insurers, pension schemes, foundations, sovereign wealth funds and family offices commit capital as investors, which the fund manager calls only when it is needed for an investment.

The fund manager, the private equity firm, receives an annual management fee of often 1.5 to 2% of the committed capital. In addition there is a profit share (carried interest) of often 20% once the investors have received back their capital and a minimum return (hurdle rate). Because fees arise immediately and profits arise only with the sales, the investors' return is negative in the first years and rises only later (J-curve). And because the fund is wound up at the end of its term, it acquires every stake with a planned exit.

Mechanics of a buy-out

Acquisition vehicle and debt leverage

The fund generally does not buy the target company itself but through a specially founded acquisition vehicle (Erwerbsgesellschaft) without a business of its own. It pays the purchase price partly with equity from the fund, often supplemented by a reinvestment: the sellers and management invest part of their proceeds again. It also takes up acquisition financing, that is, loans from banks or credit funds for the purchase price. In between there is often mezzanine capital (subordinated, higher-interest funds) or a vendor loan, in which the seller defers part of the purchase price.

This debt leverage increases the return on equity as long as the company earns more than the debt costs. If earnings fall short of the plan, interest and repayment are due nevertheless, and the value of the equity falls disproportionately. The acquisition financing is usually sized as a multiple of EBITDA (earnings before interest, taxes, depreciation and amortisation). The loan agreements contain conditions (Covenants), above all on the debt ratio and on whether cash flow covers interest and repayment.

Legal and tax limits in Germany

The banks demand security from the target company itself as well. If it is a GmbH (German limited liability company), capital maintenance sets limits. Security for debts of the shareholder must not lead to an outflow of assets that are needed to maintain the share capital (Section 30(1) of the German Limited Liability Companies Act, GmbH-Gesetz, GmbHG). Financing agreements contain limitation clauses (limitation language) for this.

For tax purposes, the interest expense of the acquisition vehicle is meant to be offset against the profits of the target company. For this, the two are merged or combined into a fiscal unity (Organschaft), in which the target company transfers its profit to the acquisition vehicle (Sections 14 et seq. of the German Corporate Income Tax Act, Körperschaftsteuergesetz, KStG). The interest barrier rule (Zinsschranke) (Section 4h of the German Income Tax Act, Einkommensteuergesetz, EStG; Section 8a KStG) limits the deduction of high interest expenses. If the fund acquires more than half of the shares within five years, tax loss carry-forwards generally lapse under Section 8c KStG. This means earlier losses that have not yet been offset; exceptions apply, among others, up to the amount of taxable hidden reserves.

Management participation

The managing directors and other executives generally participate in the acquisition vehicle with their own money. They hold mainly ordinary shares, that is, shares without preferential rights. The fund, by contrast, contributes its capital largely as an interest-bearing shareholder loan or as preferred capital. If the enterprise value rises, the value of the ordinary shares therefore grows disproportionately; in the market they are called sweet equity. Whether later proceeds count as a capital gain or as employment income is clarified for tax purposes before entry.

Value creation levers in private equity

Funds plan the value creation of a buy-out stake, already at the review stage, separately by three components:

• Earnings growth: higher EBITDA through revenue growth, better prices, purchasing and processes.
• Higher valuation multiple: a larger, better organised company that depends less on individual people or customers often achieves a higher multiple on its EBITDA at sale than at entry.
• Deleveraging: every euro the company repays during the holding period increases the value of the equity at the same enterprise value.

In a buy-and-build strategy, the fund combines these levers: it adds smaller companies in the sector to a platform company, which can usually be had at lower multiples than the later group.

Private equity in company sales and succession

For sellers, a financial investor is an alternative to a strategic buyer, that is, to a company in the same or an adjacent industry. Without a business of its own, it can hardly factor cost and revenue advantages from a combination (synergies) into the price. Through debt leverage and an acquisition strategy, it nevertheless often offers competitive prices. In succession solutions and in a management buy-out, the fund provides the equity that the management lacks for the acquisition.

At the centre of the review before the purchase (due diligence) is the quality of earnings. Every item of the adjusted EBITDA is recalculated. What is usually offered is an enterprise value without financial debt and cash (cash-free, debt-free). The purchase price for the shares (equity value) results only after deducting net financial debt and debt-like items.

For its own exit, the fund sells to a strategic buyer, to another fund (secondary buy-out) or, more rarely, via the stock exchange. It aims for a fixed purchase price as of a past reference date (Locked Box). It limits warranties tightly and often has them insured (W&I insurance, warranty and indemnity insurance), so as no longer to be liable after the sale.

Worked example: private equity buy-out

A fund takes over all the shares in a provider of industrial software, which so far belong solely to the founder. The company has a sustainable EBITDA of EUR 5 million and is valued at a multiple of 8; it is handed over without financial debt and without excess cash, so that the purchase price equals the enterprise value. Transaction costs are disregarded, and cash flow after interest and taxes is used entirely for repayment. For simplicity, the founder's reinvestment consists of the same instruments as the fund's.

• Enterprise value at entry: EUR 5 million × 8 = EUR 40 million
• Financing: acquisition loan of EUR 20 million (4.0 times EBITDA) and equity of EUR 20 million, of which EUR 16 million from the fund and EUR 4 million from the founder's reinvestment
• Founder's share in the acquisition vehicle: EUR 4 million / EUR 20 million = 20%; on entry he receives EUR 40 million minus EUR 4 million = EUR 36 million
• After five years: EBITDA of EUR 7.5 million, sale at a multiple of 9, enterprise value EUR 7.5 million × 9 = EUR 67.5 million
• Remaining debt after repayment EUR 8 million, value of the equity: EUR 67.5 million minus EUR 8 million = EUR 59.5 million
• Multiple on equity: EUR 59.5 million / EUR 20 million = 2.975; this corresponds to an internal rate of return of around 24% per year
• The founder's second payout: 20% × EUR 59.5 million = EUR 11.9 million, in total EUR 36 million + EUR 11.9 million = EUR 47.9 million before tax

The increase in the value of the equity of EUR 39.5 million is distributed across the three levers: earnings growth (7.5 minus EUR 5 million) × 8 = EUR 20 million, higher multiple (9 minus 8) × EUR 7.5 million = EUR 7.5 million and deleveraging 20 minus EUR 8 million = EUR 12 million, together EUR 39.5 million.

The counter-calculation shows the risk of leverage. If EBITDA falls to EUR 4 million, the multiple at sale to 7 and the repayment to EUR 4 million, the enterprise value is EUR 28 million. After deducting the remaining debt of EUR 16 million, EUR 12 million remains. The equity has thus lost 40% of its value although the enterprise value has fallen by only 30%. For the founder, the second payout in this case shrinks from EUR 11.9 million to 20% × EUR 12 million = EUR 2.4 million.

Distinctions: private equity, venture capital and growth capital

• Venture capital: minority stakes in young, mostly still loss-making companies. The money flows into the company through capital increases; loans for the acquisition play no role.
• Growth capital: minority stakes in more mature companies with a proven business model, usually without acquisition financing. The funds mainly serve growth; in a buy-out they go to the sellers as the purchase price.

Common mistakes

• Unsupported adjustments. One-off effects that are removed from EBITDA without evidence are struck out by the financial due diligence. Through the valuation multiple, each item struck out costs a multiple of its amount.
• Enterprise value confused with proceeds. Besides debt, working capital that is too low (the capital tied up in day-to-day business) reduces the purchase price. Retentions, earn-out and reinvestment shift further parts of the proceeds into the future.
• Reinvestment without a look at instruments and leverage. The seller's ordinary shares rank behind the fund's shareholder loans and preferred capital, and the leverage works on them in both directions. Their value should be calculated through, even in the cautious case.
• Holding company set up too late. If a holding company sells shares that were contributed to it tax-neutrally in the last seven years, the contribution is taxed retroactively. The taxable amount falls by one seventh for each year elapsed (Section 22(2) of the German Reorganisation Tax Act, Umwandlungssteuergesetz, UmwStG).

Frequently asked questions

From what level of earnings is a company interesting for private equity funds?

What matters is a sustainable, positive EBITDA, less so revenue. Funds for the lower mid-market often start at an EBITDA in the low single-digit millions, larger funds well above. Smaller companies are more likely to be considered as add-on acquisitions for an existing platform.

Do founders stay on as managing directors after a majority sale?

Often yes, at least for several years, because funds want to keep the management that built the company. In succession cases, by contrast, the aim is an orderly withdrawal. If founders stay, as managing directors they are bound by instructions of the shareholders' meeting (Section 37(1) GmbHG) and can be removed (Section 38(1) GmbHG). The shareholders' agreement usually sets out transactions requiring consent and monthly reporting, often also an advisory board.

How long does a private equity fund hold a stake?

Often four to seven years. The outer limit is set by the fund term of usually ten years; by then the fund must have sold.

Does the company have to repay the purchase price financing itself?

Economically yes. The borrower is formally the acquisition vehicle, but interest and repayment come from profit transfers, distributions or, after a merger, directly from the cash flow of the target company. Banks therefore examine the debt service capacity of the acquired company, and the acquisition financing limits its room for investment.

The Roemer Capital view

Roemer Capital meets financial investors mainly in sale and succession mandates, as bidders alongside strategic buyers. Sale processes usually take 6 to 12 months. For this, Roemer Capital prepares the adjusted EBITDA with documented adjustments and builds the purchase price bridge from the enterprise value to the amount that reaches the shareholders. In this way offers with different reinvestment and earn-out can be compared on one basis.

For reinvestments, Roemer Capital calculates the financial investor's instrument structure through before negotiations take place, because that is where the value of the second payout is decided. The client's law firm and tax adviser are responsible for the holding structure, tax consequences and contract documentation. Roemer Capital coordinates the timeline so that these questions are clarified before the sale process starts.