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What is private equity?

Lucy Mair finds out how private equity works, and about the analyst training programme at Terra Firma
Other finance
Private equity

Madeleine Evans only joined private equity firm Terra Firma 15 months ago, but she already has an in-depth understanding of the business thanks to the huge variety of work she's been involved in since then.

After completing her undergraduate degree in finance and international studies, Madeleine gained a Master in Public Administration from the London School of Economics, when she began considering a career in private equity. "Private equity is incredibly interesting because it's a combination of the deal-making culture of banking and the strategic analysis characteristic of consulting. My work involves understanding financial markets and the capital structure of businesses, as well as thinking about strategies to make businesses more efficient and profitable, plus the responsibility of putting capital at risk," explains Madeleine.

How it works

Terra Firma is one of Europe's leading private equity firms, and the idea behind its business is simple: it manages money on behalf of those who invest in its equity funds. It does so by raising capital to acquire companies, transforming them over a period of around five years, and then selling them at a profit to deliver high returns to investors and earn revenue for the firm.

When deciding whether to acquire a company, the firm has three key criteria. Madeleine explains: "First, businesses must be asset-backed, meaning their value is supported by physical assets, such as property. Second, they must be in essential industries that are well-established and have stable demand. And third, they need to require fundamental change, meaning there's potential for us to improve the strategy, management, operations, investment approach or capital structure so the business can be sold at a higher price than we bought it for."

Private equity firms acquire and transform businesses using two types of finance: equity finance (cash from investors) and debt finance (money borrowed from banks). Madeleine says: "By using debt finance, we invest less of our investors' money in the business upfront. The cost of debt - that is, the interest we have to pay back on the loan - is lower than the cost of our fund's equity. So this strategy means we get to keep more of the business's increased value when we sell it."

The financial crisis has made it more challenging for private equity firms to raise debt finance because banks are less willing to lend. "Expectations for private equity returns may need to come down as we're having to use more equity to finance our investments," admits Madeleine. But the economic climate has also presented opportunities for private equity firms. A growing number of distressed businesses are ripe for private equity firms to acquire and transform into profitable operations.

Life as an analyst

Terra Firma is different to many private equity firms because of its structure. The firm not only has deal teams, which look for businesses to buy, execute transactions, manage the financial side of acquired businesses and then sell them; it also has in-house operational teams. "These teams look after many of the other functions you might need while finding, buying, managing and selling businesses, whether that's strategy consulting or legal and tax services," Madeleine explains.

The three-year analyst programme at Terra Firma lets graduates experience and understand all areas of the business. Madeleine started by rotating through investor relations, fund finance, portfolio business monitoring and operational strategy. "In my first year at Terra Firma I spent time learning about our investors, tracking the performance of our fund, and doing an analysis of pricing strategy for one of the businesses we own. I also got to work directly with Guy Hands, the CIO and founder of the firm, which was a fascinating experience."

This summer Madeleine joined the deal team, where she has been working on the firm's 12-year investment in Germany's largest privately-owned housing company, Deutsche Annington. The business was created in 2001 when Terra Firma acquired 64,000 properties from state-owned German Federal railways. Although that was a decade before Madeleine joined the firm, she's currently involved in preparing the business for a potential sale: "I've made a number of presentations about how the business has developed under our ownership, demonstrating its track record and future potential."

Madeleine says one of the best things about working in private equity is that you get exposure to the inner workings of large companies. "It's fascinating to see how day-to-day decisions are made at senior management level and how long-term strategies are set," she says. The analyst training programme isn't without challenges: "There's a considerable amount of pressure so you have to be very sharp and prepared to pick things up as you go along." But," she adds: "I love the fact that I'm always learning. Terra Firma offers its analysts considerable support and training so we can become better investment professionals."

Case study

Madeleine explains how Terra Firma has transformed a state-owned German housing group into a profitable private business:

Deutsche Annington was acquired by Terra Firma in 2001 because it met the firm's three criteria: it was asset-backed, with a large number of residential properties; the rental and real estate market is considered an essential industry due to stable demand for housing; and the business was under-managed, so there was scope for fundamental change.

Under the firm's ownership, Deutsche Annington has gone through three principal phases of transformation. Madeleine says: "Initially, the properties were managed as a set of ten regional companies, so we centralised the management of the business and installed an excellent IT system to allow management to understand what was happening in the business, which created a platform for further growth."

Terra Firma has also bought more properties to increase the size of the business. "We executed some important add-on acquisitions, which has tripled the size of the company to around 185,000 properties. We now use fewer management resources to look after more assets than when we acquired the business."

The firm has also analysed the balance of insourcing and outsourcing services to improve efficiency. "Most recently we've in-sourced the provision of care-taking services for the homes, which has been profitable for the company and created a better environment for the tenants. We've hired a number of resident caretakers, which creates a sense of investment in the building for the people who live there and builds a better sense of community," says Madeleine.

These improvements to the business have increased Deutsche Annington's value so it can be sold at a profit to a private company, or publicly listed on the stock market.