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Buyout Fund: Definition, How it Works, Process

Research conducted by global consulting firm, Bain and Company, shows that buyout funds enjoyed a bumper year in 2021, touching historical records in investments, exits, and fund-raising.

DealRoom's deal process management software helps many acquirers extract more value from their deals. As an addition to our article on buyouts, this is the guide to buyout funds.

What is a Buyout Fund?

A buyout fund is a fund created by a private equity company with the specific purpose of executing buyouts. The buyout fund will typically be given a specific name (e.g. ‘BlackRock Asia Buyout Fund’), and a type of target investment, usually but not always, defined by geography, industry, company size, and some other operational or financial characteristics.

Increasingly these characteristics include some recurring revenue and unique in-house technology or IP.

How Does a Buyout Fund Work?

Below, we can see how this works graphically.

When investors such as banks, pension funds, HNWI (high net worth individuals) and insurance companies make investment in private equity, they don’t take a share of the private equity firm themselves, but in their buyout funds.

In the example, these are shown as ‘Fund 1’ and ‘Fund 2.’

Each fund has its own management in place with the idea of executing the fund’s investment strategy effectively.

How Does a Buyout Fund Work?

Disclaimer: This is nearly always the case. However, over the past decade or so, private equity firms have begun to list publicly, enabling people to invest in them through secondary markets.

In addition to its overarching strategy, each fund will have a predefined set of financial parameters, so that outside investors (Limited Partners or “LPs”) know what they’re investing in, with the private equity company (the “General Partner” or “GP”).

At the very least, this will include the size of the funds being collected, the target returns, how returns are distributed, management fees, performance fees, and exit fees.

As one might expect from funds developed by private equity partners - among which cohort you can find some of the most highly regarded financiers in the world - the structures can become complex quite quickly. The track record of the most successful private equity firms has allowed them to charge high management fees, delivered across a myriad of clauses related to the financial performance of the funds over time.

Buyout Fund Value Drivers

As the previous article on buyouts noted, buyout funds typically generate value by acquiring assets or companies, which they believe to be undervalued.

They then make operational changes and financial changes to the companies that enable them to achieve the value targets set by the fund managers.

The drivers, as outlined in the buyout article and repeated here, are operational improvements, financial engineering, and changes in strategy:

Operational improvements

This could be anything from better use of spare capacity at the company, more efficient use of its resources, stopping lines which are unprofitable, and any other number of levers which allow the company to improve its financial position in the short-term.

Financial engineering

It could be that the company in its current state is paying too much interest (for example). The buyer could pay off this interest and use lower interest debt, enabling it to enjoy higher operating margins with the higher interest payments that previously weighed down the income statement.

Strategy changes

A company could be primed for value generation and simply focusing on the wrong areas with its strategy. A famous example is Netflix, which changed from posting a random selection of DVDs to its users to the now ubiquitous streaming model. The same company went from being nearly bankrupt to being a unicorn in less than five years.

Buyout Fund Investment Process

Buyout Fund Investment Process

To illustrate the buyout fund investment process, a theoretical (and completely fictional) example is instructive. We have chosen a retail company for the example.

Let’s suppose there’s a private equity company (the GP in our example), DRM, which has created a buyout fund called ‘Physical Retail Capital Fund I.’ Its express goals, which it markets to investors (LPs) it has previously worked with, are as follows:

  • Acquire undervalued retail assets in North America
  • Assets much has strong brand potential
  • In lines such as clothing, homeware, or sporting goods
  • Strong balance sheet positions (to enable them to leverage the investment)
  • Price range: $250M-$500M
  • Multiple range: 4x-5x EBITDA

Shortly after launching this $2 billion buyout fund, which is oversubscribed, the team in charge of the fund (all of whom have experience in retail investments, which made the fund more attractive to the LPs) identify a company ripe for restructuring, a clothes retailer - Beautify LLC.

Its characteristics, as the GPs see it, are:

  • Management with no clear long-term strategy
  • Low online sales revenues made through third-party sites
  • Some of their retail units are performing well, but many are performing poorly
  • Market research shows most people don’t know who the store’s target market is
  • The company has near zero debt, but its EBITDA has fallen for five years in a row.

DRM approaches the management of Beautify LLC and having spotted a few issues in the due diligence process (which ran at a record time of 3 weeks, thanks to using DealRoom), the deal closes for $100M, which is composed of $50M of Limited Partners’ funds, with the remaining $50M being leveraged.

DRM begins making operational, financial and strategic changes that begin creating value for Beautify LLC, and by extension, the Physical Retail Capital Fund I. The chronological steps of the buyout fund, can be seen in the table below:

chronological steps of the buyout fund

Now, if we recall that Beautify was initially acquired for $100M at an EBITDA multiple of 5x (i.e. EBITDA was $20M at the time of the acquisition), we can see that the operational changes and strategy changes have increased the EBITDA at Beautify to $80M.

Now, if it were to sell the business for the same 5x multiple, it would achieve a sales price of $400M,  $300M more than the initial price. And given that the investors only put $50M into the initial transaction, their return on equity is multiplied by an even bigger factor.

The buyout fund, DRM, has provided an outstanding return to the limited partners

Its work in due diligence with DealRoom set it on a good path, enabling it to spot the value drivers early in the process, and execute strategic changes straight after the transaction closed.

How DealRoom Can Help

The example provided is hypothetical and yet, reflective of many of the deals that buyout funds work through on DealRoom on a daily basis.

Whether it’s a buyout fund focused on retail, oil&gas, services, manufacturing or anything else, DealRoom’s M&A project management solution is designed to help the acquirer to extract value. The DealRoom solution can help buyout funds in areas such as:

  • Fund and deal marketing
  • Acquisition due diligence
  • Restructuring/financing
  • Deal marketing
  • Exits
Learn More

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