What is private equity?

Private equity, literally "capital privé" in French, is an asset class that consists of taking stakes in companies not listed on a stock exchange. This form of financing allows companies to accelerate their growth, restructure or change shareholders while benefiting from the financial and strategic expertise of investors who focus on this field. For company managers and investors, understanding how private equity works is becoming essential at a time when these transactions represent several tens of billions of euros a year in France. This article sets out how this industry works in practice, its legal implications and the issues for all stakeholders.

Definition and fundamental principle of private equity

Private equity refers to equity investment in companies that are not listed on public financial markets. Unlike conventional stock market investments, private equity funds generally acquire significant stakes, often majority stakes, in target companies. This approach allows them to influence directly the strategy and management of those companies.

The distinctive feature of private equity lies in its investment philosophy: funds seek to create value by actively supporting companies in their development, and then to realise a substantial capital gain on resale of their stake after a few years. This investment period, generally between three and seven years, clearly distinguishes private equity from short-term financial investments.

The business model rests on raising capital from institutional investors (insurance companies, pension funds, sovereign wealth funds) or wealthy individuals, and then investing those funds in a portfolio of selected companies. Fund managers receive annual management fees, typically 2% of committed capital, and a performance fee called "carried interest", generally representing 20% of the capital gains realised.

The different investment strategies

Private equity comes in several strategies depending on the maturity and needs of the companies targeted. Venture capital (capital-risque) finances start-ups and innovative companies at the creation or start-up stage. These investments, which are particularly risky, aim to identify future technology or industrial unicorns. The legal nature and regulatory regime of the vehicles dedicated to this strategy are presented in our article on venture capital funds.

Growth capital supports growing SMEs and mid-caps (ETI) that need capital to finance geographic expansion, the launch of new products or the acquisition of competitors. This strategy generally involves minority stakes, the founding managers retaining control of their company.

Buyout capital steps in on the acquisition of mature companies, often in the context of family successions or disposals by groups wishing to refocus on their core business. The funds then acquire a majority stake and support the new management team in implementing an ambitious development plan.

Finally, turnaround capital focuses on acquiring companies in financial difficulty in order to restructure and recover them. These transactions, which are particularly complex, require in-depth expertise in corporate restructuring and in negotiation with creditors.

Legal structure and structuring of transactions

Private equity funds generally take the form of partnerships limited by shares (société en commandite par actions, SCA) or venture capital mutual funds (fonds communs de placement à risques, FCPR) in order to benefit from a tax-transparent regime. In an SCA, the institutional investors become limited partners while the management company takes the role of general partner responsible for managing the portfolio.

This structure protects investors by limiting their liability to the amount of their contributions while allowing the management team to receive variable remuneration linked to performance. The fund rules define precisely the investment conditions, the performance criteria and the exit arrangements.

The due diligence process

Before any investment, private equity funds carry out an in-depth analysis called due diligence. This investigation covers the financial, legal, tax, commercial and operational aspects of the target company. Specialist firms are brought in to audit the accounts, check regulatory compliance, analyse commercial contracts and assess legal risks.

Legal due diligence examines in particular the capital structure, the existence of shareholders' agreements, significant contracts, pending disputes, intellectual property and the employment position. This phase may reveal matters capable of causing the transaction to fail or of adjusting the acquisition price. What the audit reveals, in particular about the target's employment liabilities, is analysed in our article on legal due diligence on the acquisition of a company.

Negotiations then turn to the asset and liability warranties (garanties d'actif et de passif) that the sellers must give. These warranties protect the buyer against the later discovery of liabilities not revealed during the audits. Their scope, duration and caps are the subject of hard negotiation between the parties.

Legal documentation of acquisitions

Private equity acquisitions give rise to complex legal documentation built around the memorandum of agreement (LDI, Letter of Intent), and then the final sale and purchase agreement. The memorandum sets out the conditions of the transaction, in particular the price, the conditions precedent (merger control clearance, financing) and exclusivity of negotiation.

The sale and purchase agreement contains the sellers' representations and warranties, the conditions for completion of the sale and the price adjustment mechanisms. A locked box mechanism may fix the company's financial position at a given date, with all subsequent cash flows going to the buyer. Among these mechanisms, the deferred price supplement indexed to future performance is the subject of our article on the earn-out clause in the sale of a business.

At the same time, a shareholders' agreement organises the governance of the company after the acquisition. This document defines the composition of the board of directors, voting rights, investors' information rights and exit mechanisms. It may provide for tag-along and drag-along clauses to facilitate a later sale of all the shareholdings.

Financing and leverage

Private equity transactions rely heavily on debt to amplify returns on equity. This technique, called leverage or LBO (Leveraged Buy-Out), consists of financing the acquisition of a company by combining the equity contributed by the fund and bank borrowings.

Typically, the acquisition of a company valued at €100 million may be financed by €30 to €40 million of equity and €60 to €70 million of debt. This debt is secured on the assets and cash flows of the acquired company, which will therefore have to generate enough cash to meet the repayments.

Financing structure and bank covenants

Acquisition financing generally combines several tranches of debt with different characteristics. Senior debt, repayable in priority, carries the lowest interest rate but imposes strict financial covenants. These ratios (debt/EBITDA, interest cover) must be complied with on pain of triggering an event of default.

Mezzanine debt, subordinated to senior debt, offers a higher interest rate and may include deferred capitalisation instruments (convertible bonds, subscription warrants). This intermediate tranche makes it possible to optimise the cost of capital while preserving financial flexibility.

Credit agreements also provide for restrictions on dividend distributions, exceptional investments and changes to the structure. These constraints aim to preserve the company's repayment capacity and to protect the lenders' interests.

Impact on the management of the company

Acquisition debt profoundly changes the management of the company by imposing rigorous financial discipline. Managers must optimise cash generation to meet debt service while financing growth. This constraint can stimulate operational efficiency but limits strategic room for manoeuvre.

Early repayment of debt is often a priority objective in order to reduce financial costs and loosen contractual constraints. The disposal of non-strategic assets, improvement of working capital turnover and optimisation of investments help to accelerate deleveraging.

Value creation strategies

Private equity funds do not merely provide capital: they deploy operational expertise to transform the companies in their portfolio. This active approach fundamentally distinguishes private equity from passive financial investments.

Operational optimisation is the first lever of value creation. Investment teams analyse industrial processes, sales organisations and support functions in order to identify areas for improvement. Digitalisation of processes, renegotiation of supplier contracts and optimisation of product ranges often generate substantial gains.

External growth and add-on acquisitions

The buy-and-build strategy consists of acquiring a platform company and then making add-on acquisitions in order to create a sector leader. This approach makes it possible to benefit from economies of scale, commercial synergies and a stronger competitive position.

Add-on acquisitions require controlled integration in order actually to realise the synergies identified. Harmonisation of information systems, consolidation of purchasing and rationalisation of sales networks are the priority post-acquisition workstreams.

This strategy has the advantage of diversifying risks by spreading the investment over several assets while creating value greater than the sum of the parts. The valuation multiples of consolidated groups generally exceed those of stand-alone companies.

Internationalisation and new markets

Support for international development is another major axis of value creation. Funds bring their network of contacts, their knowledge of foreign markets and their financing capacity to accelerate the geographic expansion of portfolio companies.

This strategy involves a prior analysis of the target markets, local competition and the regulatory framework. The choice between organic growth and local acquisitions depends on the maturity of the market, barriers to entry and the resources available.

Internationalisation generates geographic diversification of revenues that reduces dependence on the domestic market. It also gives access to fast-growing markets and the benefit of cost arbitrage in certain functions.

Exit strategies and realisation of capital gains

The exit is the culmination of the private equity investment and largely determines the final performance. Funds plan the likely exit arrangements from the time of acquisition, according to the size of the company, its sector of activity and market prospects.

An initial public offering is the most valuable exit for companies that have reached a critical size and sufficient visibility. This option requires several years of preparation, including professionalisation of governance, improvement of financial communications and compliance with the disclosure obligations of listed companies.

Sale to a trade buyer

A sale to a competitor or to a player in the value chain is often the most natural exit. These trade buyers value the commercial, industrial or technological synergies that they can achieve with the acquired company. Sale multiples frequently exceed those obtained on purely financial sales.

Preparing this exit involves identifying potential buyers and positioning the company to maximise its attractiveness. Building a lasting competitive advantage, developing unique skills and optimising the capital structure all ease negotiations.

The sale process is generally organised as an auction with pre-selection of candidate buyers. This method makes it possible to optimise the terms of sale while preserving the confidentiality of the transaction.

Secondary sale to another fund

A sale to another private equity fund, called a secondary sale, makes it possible to maintain the capital support of the company while offering an exit to the initial investors. This option is particularly suitable for companies that still need several years of development before reaching their full potential.

The acquiring fund generally brings a new development strategy and complementary skills. This transfer is often accompanied by a refinancing that makes it possible to distribute part of the capital invested while keeping a residual stake.

Secondary sales represent a growing share of private equity exits, reflecting the maturity of this industry and the growing sophistication of investment strategies.

Regulatory framework and supervision

The private equity industry operates in an increasingly structured regulatory environment. The European AIFM (Alternative Investment Fund Managers) Directive of 2011, transposed into French law, imposes enhanced obligations on managers of alternative assets in terms of own funds, governance and transparency.

Private equity fund management companies must obtain authorisation from the Autorité des marchés financiers (AMF, the French financial markets authority) and comply with strict rules of conduct. They must in particular separate their investment and control functions, appoint an independent depositary and publish regular information on their activities.

Transparency and reporting obligations

The regulations impose on fund managers an obligation of transparency towards their investors and the supervisory authorities. Periodic reporting must detail the investments made, the performance of the portfolios and the main risks identified.

This enhanced transparency responds to regulators' concerns about the systemic risks that the private equity industry could represent. The authorities pay particular attention to the use of leverage and its potential impact on financial stability.

Funds must also comply with concentration limits to avoid excessive exposure to a sector or a geographic region. These diversification constraints aim to protect investors against the risk of significant losses.

Taxation of investments and capital gains

The tax regime of private equity funds benefits from tax transparency, which avoids double taxation of income. The capital gains realised by the fund are taxed directly in the hands of the investors according to their own tax status.

For French individual investors, capital gains on the disposal of fund units are subject to the single flat-rate levy (prélèvement forfaitaire unique) of 30% (12.8% income tax and 17.2% social charges). Institutional investors generally benefit from exemptions or preferential regimes depending on their status.

Managers benefiting from incentive mechanisms (carried interest) may, under certain conditions, benefit from the tax regime for capital gains on the disposal of securities rather than that for salaries. This favourable regime is the subject of recurring debate on its appropriateness and fairness.

Economic impact and societal issues

The private equity industry plays a growing role in financing the French economy. According to the Association française des investisseurs pour la croissance (AFIC, the French association of growth investors), funds invest several billion euros each year in thousands of French companies, contributing to the financing of their growth and innovation.

These investments are concentrated in particular on the SMEs and mid-caps that make up the French economic fabric. Private equity partly fills the gaps in traditional bank financing to support ambitious development projects or the transfer of family businesses.

Job creation and transformation of companies

Economic studies show that companies backed by private equity funds generally create more jobs than their counterparts without such backing. This performance is explained by the acceleration of their growth, their investment in innovation and their international development.

However, this job creation may be accompanied by restructurings aimed at improving operational efficiency. Funds generally prefer productivity gains to headcount reductions, but some transactions may lead to job losses in non-strategic activities.

Backing by a private equity fund profoundly transforms company culture by introducing more rigorous management methods, sophisticated reporting systems and a stronger customer focus. This professionalisation benefits the company lastingly even after the fund exits.

Criticisms and limits of the model

Private equity is the subject of criticism concerning certain practices regarded as excessive. The intensive use of leverage can weaken the acquired companies and limit their capacity to invest. Some observers denounce an excessive financialisation of the economy to the detriment of industrial considerations.

The tax optimisation strategies deployed by some funds also raise questions about their contribution to the national tax effort. Structures involving low-tax jurisdictions can significantly reduce the tax paid on capital gains realised.

Finally, the growing concentration of this industry in the hands of a few major players raises questions of competition and diversity of investment approaches. This development could limit innovation in private equity strategies and reduce opportunities for mid-sized funds.

Frequently asked questions

What is the difference between private equity and venture capital? Venture capital is a branch of private equity that concentrates on companies in the creation or start-up phase. Unlike other private equity strategies that target mature companies with established revenues, venture capital invests in innovative projects with exceptional growth potential but high risks. The amounts invested are generally smaller and failure rates higher.

Can companies with turnover below €10 million be of interest to private equity funds? Traditional private equity funds generally concentrate on companies with turnover above €10 to €20 million because of transaction and monitoring costs. However, funds focused on small-caps or growth capital support smaller companies. These funds adapt their approach with smaller investment amounts, between €1 and €10 million, and strategies that involve less intensive support.

How long does a private equity investment last? The typical duration of a private equity investment extends from four to seven years, with an average of around five years. This period allows funds to implement their value creation strategy and to optimise the exit conditions. Some investments may be held longer if the company needs further development, while others may be sold more quickly if attractive exit opportunities arise.

Do company managers keep their autonomy after a buyout by a fund? The managers' autonomy depends largely on the fund's strategy and on their shareholding. In growth capital transactions with a minority stake, managers generally keep their freedom of day-to-day management. By contrast, in majority buyouts, funds exercise closer control through the composition of the board of directors and the setting of precise strategic objectives, while leaving operational autonomy to the management teams.

What level of return do private equity funds expect? Private equity funds generally aim for internal rates of return (IRR) of between 15 and 25% a year over the life of their investments. These targets vary according to the strategy adopted: venture capital aims for the highest returns (25% and above) because of the significant risks, while buyout capital is content with more moderate returns (12 to 18%) on mature companies. These returns must compensate for the illiquidity of the investments and the risks specific to unlisted companies.

How can family businesses prepare a sale to a private equity fund? Preparing a sale requires several years of anticipation. Family businesses must first professionalise their governance by separating ownership and management, formalise their procedures and put in place rigorous financial management tools. A full audit of the legal, tax and employment aspects makes it possible to identify points of attention to be dealt with in advance. Finally, defining a credible, quantified strategic plan reassures investors about post-acquisition development prospects.

Can private equity funds step in at companies in difficulty? Some funds focus on turnaround capital (capital-retournement) and acquire companies in financial distress. These interventions require specific restructuring expertise and close relationships with the commercial courts. Funds may also take part in safeguard plans or in judicial reorganisation proceedings (redressement judiciaire) in order to take over assets. This strategy, which is riskier, offers acquisition opportunities at attractive valuations for experienced investors.