The Fresher’s Guide to Private Equity

You’ve most likely heard the term private equity (PE) quite a bit in past few years. But it’s not actually a new idea. In fact, investments in private equity as we know them presently go as far back as the 1940s. But it wasn’t until the 1980s to 1990s that the industry started to see a boom thanks to the availability of credit—including private credit—as well as debt with high yields.Fintech News

What is Private Equity?

Private equity is a general term used to describe all types of funds that pool money from a bunch of investors in order to gather millions or even billions of dollars that are then used to acquire stakes in companies.

Basically, venture capital is private equity. But private equity is often associated with the funds trolling for mature, revenue generating firms in need of some revitalization, perhaps some tough choices, in order to become worth much more.

While venture capital often goes into younger organizations involved in unproven, cutting-edge technologies, funds described as private equity are more attracted to established companies. Think manufacturing, service businesses and franchise firms.

Types of private equity

Private equity firms generally fall into three main categories,

1. Venture Capital (VC)

Venture capital funds are pools of capital that normally invest in small, early-stage and emerging businesses that are expected to have high growth potential but have limited access to other types of capital. From the point of view of small start-ups with ambitious value propositions and innovations, venture capital funds are an essential source to raise capital as they lack access to large amounts of debt. From the perspective of an investor, although venture capital funds carry risks from investing in unconfirmed emerging businesses, they can generate extraordinary returns.

2. Buyout or Leveraged Buyout

Contrary to venture capital funds, leveraged buyout funds invest in more mature businesses, usually taking a controlling interest. Leveraged buyout funds use extensive amounts of leverage to enhance the rate of return. Buyout finds tend to be fundamentally larger in size than venture capital funds.

3. Growth Funds

Growth funds also invest in businesses with high growth potential.

However, unlike venture capital firms, they invest in organizations with established business models.

Such companies might need investment to launch a new product, start a new plant, enter unique geography, etc.

Growth equity funds make their money by growing the business, helping it realize its complete market potential, and then selling off their share at a higher valuation.

Funds might also be formed to invest in a particular geography or a specific sector.

The past few years have also seen the rise of private equity firms that invest only in social sector enterprises.

How does private equity works?

Private equity companies raise money from institutional investors and accredited investors for funds that invest in various types of assets. The most popular methods of private equity funding based on their type are listed below.

•       Distressed Funding

Also popular as vulture financing, money in this type of funding is invested in troubled companies with underperforming business units or assets. The intention is to turn them around by making required changes to their management or operations or make a sale of their assets for a profit. Assets in the latter case can range from physical machinery and real estate to intellectual property, for example, patents. Businesses that have filed under Chapter 11 bankruptcy in the United States are often candidates for this type of financing. There was an increase in distressed funding by private equity companies after the 2008 financial crisis.

•       Leveraged Buyouts

This is the most well-known type of private equity funding and includes buying out a company completely with the intention of improving its business and financial health and reselling it for a profit to an interested party or conducting an Initial Public Offering (IPO). Up until 2004, sale of non-core business units of publicly listed firms comprised the largest category of leveraged buyouts for private equity. The leveraged buyout process works as follows. A private equity firm identifies a potential target and builds a special purpose vehicle (SPV) for funding the takeover. Normally, companies utilize a combination of debt and equity to finance the transaction. Debt financing might account for as much as 90% of the overall funds and is transferred to the acquired company’s balance sheet for tax benefits. Private equity firms employ a variety of strategies, from slashing employee count to replacing entire management teams, to turn around an organization.

•       Fund of Funds

As the name denotes, this type of funding basically focuses on investing in other funds, primarily mutual funds and hedge funds. They offer a secondary entry to an investor who cannot afford minimum capital requirements in such funds. But critics of such funds point to their higher management fees because they are rolled up from multiple funds and the fact that unfettered diversification might not generally result in an optimal strategy to multiply returns.

•       Real Estate Private Equity

There was a surge in this kind of funding after the 2008 financial crisis slashed real estate prices. Typical territories where funds are conveyed are commercial real estate and real estate investment trusts (REIT). Real estate funds require higher minimum capital for investment as compared to other categories of funding in private equity. Investor funds are also locked away for several years at a time in this kind of funding. As per the research firm, Preqin, real estate funds in private equity are expected to clock in a 50% growth by 2023 to reach a market size of $1.2 trillion.

•       Venture Capital

Venture capital funding is a type of private equity, in which investors also known as angels, provide capital to entrepreneurs. Depending upon the stage at which it is provided, venture capital can take numerous forms. Seed financing alludes to the capital provided by an investor to scale an idea from a model to a product or service. On the other hand, early-stage financing can enable an entrepreneur to grow firms further while a Series A financing empowers them to actively compete in a market or build one.

Conclusion

A private equity investment is extraordinary for businesses that are looking to grow and expand their operations. The investors bring a lot of knowledge and experience to the table that can improve the value and revenue of the company and help leverage its position in both local or international markets.