Finance

What Is Private Equity(PE) And How Do Private Equity Firms Actually Work?

If your business is not financially self-sufficient, you will have to rely upon external sources of financing. Companies can get funding through various external sources, including friends and family, bank loans, new partnerships, leasing, trade credits, shares issue, and many more. One of the most common ways businesses opt is financing through selling their shares. Share selling is done through equity financing. Equity financing means selling your company’s share return of cash investment. Companies open their shares for sale in open public, and any investor can buy the shares for cash. Equity financing does not require repayments; instead, the investors make money through the dividends, which is a share in the company’s profit.

Private equity is an alternative method to equity financing. This method involves funding from investors who directly invest in private companies. Private investors are usually interested in investing in new technologies, expanding working capital, and making new acquisitions.

But how exactly does private equity work? This article breaks down everything you need to know about private equity by elaborating on the foundations of the private equity funds and their functionality,

What is private equity?

Almost everything that you buy in your daily routine is from a company that is backed by private equity. From picking up a pack of chips to getting a security system for your house – private equity is everywhere. Every other company is getting its funding to run the business smoothly from a private equity source.

Private equity is the type of business financing where capital or money is directly invested in the company. In the more extensive and complex financial markets, private equity is one of the most common ways of funding a business. It is an alternative method to equity financing that engages in investing in a company directly or buyouts of public companies, eventually resulting in the delisting of its public equity. Private equity investments are made in a traditional industry and mature businesses in exchange for an ownership stack or equity.

Shareholder loans, preferred shares, CCPPO shares, and ordinary shares are the four components that make up any firm’s equity. In an acquisition, equity typically contributes 30 percent to 40 percent of the funding. Private equity firms usually invest in equity stakes with a four- to seven-year exit strategy. Private equity investments are considered less traditional equity investments as they are hard to access compared to the stocks and bonds in public markets.  It is an alternative asset class similar to distressed securities, venture capital or real estate, and more.

What is a private equity firm?

An investment firm that specializes in private equity is known as a private equity firm. They invest in companies with the intention of raising their net worth over time before selling them for a profit. They usually invest in a company with an exit plan in 4 to 7 years. Like venture capital (VC) firms, private equity firms invest in potential private companies using funds they obtain from their limited partners (LPs).

Private equity firms usually take the majority stake ownership, 50% or more in the company they invest in. They own the majority ownership of multiple companies simultaneously. The collection of the companies a PE firm has invested in is called its portfolio. A more substantial portfolio with more companies establishes the PE firm’s ranking in the private financial market.

Who is a private equity investor?

Financial investors working at private equity firms are known as private equity investors. They play a vital role in raising the capital for the firm by discovering wealthy investors who are interested in making new investments. Private equity investors also identify the latest and potential companies that will drive successful future acquisitions for the firm. As reported in 2017, there were 3953 private equity investors. The number shows an increase of 51% from the numbers recorded a decade ago in 2007.

How does private equity work?

Private equity investors gather the funds by pooling money from the firm’s limited partners and use that money to invest in a company. Limited partners are usually wealthy individuals and institutional investors who are looking for profitable investments. PE investors close the fundraising process once they’ve met their fundraising target and put the money into potential businesses. Sometimes, private equity investors may invest in a company that seems stagnant or in a distressing situation but shows certain signs of growth. They keep their eye on the future outcomes of the company they are investing in. investment structure for such a company may vary from the other prospering companies. The most common system or deal they use for a currently weak company is leveraged buyout (LBO).

In a leveraged buyout, a private equity investor buys a controlling position in a company with a combination of equity and a large amount of debt that the company must eventually repay.

In the meantime, the investor tries to boost the company’s profitability so that loan repayment is less of a financial strain.

When a private equity firm sells any of its portfolio companies to any other company or investor, the firm generates a good profit. The profit is used to distribute returns to the limited partners who had invested in the company’s fund. However, selling the portfolio company is not always the case. Some of the private equity-backed companies may go public as well.

What are private equity funds?

We hear about private equity funds every day, but what actually private equity funds are? Let’s dive deeper to understand the details of private equity funds and how they are different from other types of funds available in financial markets.

Private equity funds are pools of funds and money that are used to invest in businesses that offer a high rate of return. They have a set investment horizon, usually between four and seven years, after which the PE firm aims to exit the investment profitably. IPOs and the sale of the company to another private equity group or a strategic buyer are some of the exit options for a private equity firm.

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Institutional funds and accredited investors are the most common sources of financing for private equity firms, as they can offer large sums of money over long periods.

The funds are raised and managed by a team of investment specialists from a particular PE firm.

Private equity funds vs. mutual funds

Sources of funds generation and getting the investments, the types of firms the fund invests in, and how the firm collects its service fees are the most significant differences between private equity funds and mutual funds. PE funds raise money from limited partners or accredited institutional investors, while mutual funds gather the money from ordinary people and everyday investors. Mutual funds often invest in publicly traded corporations, whereas private equity funds typically invest in private companies. Furthermore, mutual funds are only permitted to collect management fees, but PE funds can collect both management and performance fees, which will be further discussed below.

Private equity funds vs. hedge funds

Private equity and hedge funds only accept investments from accredited investors. The most significant distinctions between PE funds and hedge funds are the fund structure and investment objectives. Hedge funds prefer to invest in publicly traded firms, while PE funds prefer to invest in private enterprises. Unlike other private funds, they can use leverage and are strictly managed by the Security and the Exchange Commission (SEC). There are different strategies and types of funds used under a hedge fund.

Types of private equity funds

Private equity funds generally have two categories; venture capital and leveraged buyout. Both types have different characteristics and functionalities, depending on the nature of the investment and the company invested.

Venture Capital (VC)

Small, early-stage, and developing enterprises that are considered to have excellent development potential but have limited access to other sources of finance are often the focus of venture capital funds. In today’s time, when the economy is shifting to the tech industry, it becomes difficult for most startups to acquire loans because of minimal hard assets. In such a situation, the startups seek money from venture capital firms. Venture capital firms make investments in startups, emerging companies, entrepreneurial projects, and innovative ideas that have huge potential to generate profit in the future.

Venture capital funds are an essential source of finance for tiny start-ups with ambitious value propositions and innovations that do not have access to substantial amounts of debt. Although the risk factor for venture capital firms is huge because any innovative startup may fail due to its technicalities or poor assessment, it is a risk worth taking. Venture capital funds offer tremendous profits despite the dangers of investing in unproven fledgling enterprises with uncertain future outcomes from an investor’s perspective. Venture capital funds usually expect an annual return ranging 25%-35%.

Leveraged buyout (LBO)

A leveraged buyout is a form of acquisition of a company using a massive investment to meet the purchase cost. Compared to venture capital firms, leveraged buyout invests in mature companies and usually takes the controlling interest in the company. The standard debt to equity ratio is 90% debt and 10% equity in the leveraged buyout.

Leveraged buyouts are known for their predatory and ruthless functionality because, in a typical scenario, the other company does not authorize the buyout. They use a large-scale amount of leverage to increase the rate of return. The leveraged buyout investments are considerably more significant than the VC fund.

Leveraged buyouts are made for three primary reasons;

  1. To spin-off a portion of an existing business by selling it
  2. To turn a public company into a private one
  3. To transfer small business ownership (or private property)

Regardless of the scenario, the acquired company must show a considerable margin for growth and profitability.

Mezzanine Financing

Unlike its complicated name, Mezzanine financing is a simple form of debt. Some PE funds offer the services of Mezzanine funds as well. They provide a small amount to companies that may be a separate deal or a part of an existing one. The only downside is that if the company goes bankrupt, mezzanine debt gets paid off later than other debts; hence, the risk factor in mezzanine financing is elevated.

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Growth Capital

Growth capital is a type of deal that comes under the umbrella of private equity. In this kind of deal, the private equity firm focuses more on the business’s growth than the turnarounds. For this purpose, the PE firm takes smaller stakes in the company. Growth capital is similar to venture capital in the matter of taking smaller stakes and different because, unlike venture capital, growth capital only invests in mature companies.

What is the difference between private equity and venture capital?

People often mix private equity and venture capital. Although venture capital lies beneath the umbrella of private equity, they both have their differences in terms and conditions.

Private equity refers to the ownership or investment in private companies. A venture capital fund is a part of private equity investment that focuses more on early-stage companies, startups, and small businesses. So, it is safe to say that venture capital is a form of private equity.

There are distinctive features of both venture capital and private equity. Venture capital focuses on companies early in their lifecycle, while PE invests in slightly more late-stage companies. Using the committed money from limited partners, PE invests in companies with promising growth potential and usually takes the majority share. On the other hand, venture capital uses the limited partners’ investment to take minority shares in the companies they invest in.

When a private equity firm sells a company from its portfolio, the returns are distributed among the private equity investors and limited partners, where the former gets 20% and the last 80%. Whereas selling the company so soon is not the goal of a venture capital firm. The startup takes time to flourish and generate higher returns. The firm makes its profit when the company goes public or gets acquired. Venture Capital firms can also generate profits by selling some of the shares of the company.

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How do private equity firms earn?

A general question that arises in every person’s mind is, how do private equity firms earn? The answer is, they make money by collecting management and performance fees. The amount of fee varies from fund to fund, but a standard fee structure of a private equity firm is based on the rule of 2 – and – 20.

Management fee

Private equity firms earn money by charging a management fee. Following the rule of 2 – and – 20, a private equity firm charges a 2% management fee, which is calculated as a percentage of the total assets under the management of a PE firm. The firm uses these fees to meet the daily expenses and regularly incurred overhead costs.

Performance fee

Along with the management fee, private equity firms also charge a performance fee. Under the rule of 2 – and – 20, a PE firm charges a 20% performance fee, which is calculated as a percentage of the profit generated from the investments. The firm uses this money to stimulate further and boost the profits and reward the employees for their hard work.

Pros and cons of private equity

Weighing the pros and cons of private equity has always been an active discussion in the financial markets and business world. Whether to use PE as a source of financial support for their companies or not, business owners have been hearing all kinds of opinions about how private equity funds work.

Like every other thing in the world, private equity also has its pros and cons. Let’s have a look at them.

Pros of private equity

Private equity offers numerous benefits and advantages. Some of them are listed below.

  1. Companies prefer private equity funds because PE enables them to access liquidity as an alternative to the mainstream and traditional financial supports, such as bank loans.
  2. A form of private equity, such as venture capital, also provides funds to startups, innovative ideas, and early-stage businesses.
  3. In the case of delisted companies, private equity financing can encourage the firm to try unusual growth strategies hidden from the market. This support is only possible because the companies do not have the pressure to publish their quarterly earnings.
  4. There are proven returns for the limited partners in private equity investments. A study from Boston Consulting Group shows more than 50% return for more than half of the PE funds.
  5. Private equity has deeper money resources and can finance the companies to renovate, maximize firm’s value, buy new equipment and meet new business objectives.

Disadvantages of private equity

Private equity firms face public scrutiny for years, but lately, they have been making more headlines. Where private equity comes in handy for the majority of the companies in turbulent financial times, it is known to be associated with a variety of disadvantages since the beginning of time. Private equity faces a lot of criticism on how it functions and takes over the companies they invest in. Let’s get into the details of some of the critical phenomena related to private equity.

  1. The attachment strings are too tight with private equity. It may help you get millions to support your business, but you may end up losing control over your company.
  2. Private equity is notorious for causing employee turnover. Their focus is on profit only, which sometimes means laying off talented personnel. This may be damaging to the community and the local economy.
  3. By design, private equity’s business model revolves around a considerable amount of debts while making deals in private financial markets, which can be damaging for the firm acquired and financial markets as well. It also increases the chances of bankruptcy.
  4. Transparency of private equity firms in money-related matters is also a critical question by authorities and attorneys. After the financial crisis of 2008, oversight of the PE market has increased, and it enjoys less stringent rules than most financial institutions.
  5. Private equity firms and business owners may have a conflict over their definition of ‘value.’ Where ‘value’ means only profits for PE firms, a business owner may have long-term values and concerns for relationships with customers, employees, and reputation.

Exit strategies for private equity fund

A private equity firm invests in a company with an exit plan in 4 to 7 years. After four years, the PE firm starts setting the basis for an exit strategy and takes an exit at an appropriate time.

Things to consider for exiting a private equity

There are many factors a private equity firm should consider while looking for an exit strategy. Some of the most critical questions a PE firm should ask before they exist are listed below.

  1. When is the right time to take an exit?
  2. What is the investment horizon?
  3. What internal rate of return will be achieved?
  4. Are the business strategy and firm’s current capital structure appropriate?
  5. Is the management team compliant and ready for the exit?
  6. What are the available exit routes?

Exit routes

PE companies have two options when it comes to exiting: a whole exit or a partial exit.

A trade sale to another buyer, an LBO by another private equity company, or a share repurchase are all options for a wholesale exit from the business.

A private placement, where another investor buys a stake in the business, could be used as a partial exit strategy. Another option is corporate restructuring, in which external investors become involved and gain a stake in the company by partially buying out the private equity firm’s investment. Finally, corporate venturing is a scenario in which management grows its stake in the company.

Lastly, a flotation, often known as an initial public offering (IPO), is a hybrid plan that involves the company being listed on a public stock exchange. In most cases, only a portion of a firm is sold in an IPO, ranging from 25% to 50% of the company. Private equity companies exit a company after it is listed and traded publicly by gradually unwinding their remaining ownership position in the company.

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Conclusion

The theoretical idea behind private equity is that the undertaking will be worth it for both the PE firm and the company being acquired. If private equity doesn’t exist, there are many companies that would have no means to access such massive capital sources to fund and transform their businesses.

The objective of private equity firms is to invest in companies, enable the company to make money, and make money faster enough to pay down the debts soon. They often take out more debts through their leveraged companies to pay for dividends or even faster growth. If a company can retain its resources and still make a vital investment, private equity funds are not bad. With more significant control over the company acquired and a debt-revolving design, when private equity fails, it fails badly.

This doesn’t mean that all private equity deals and investments go wrong. Many more prominent firms have split their structure vertically in the hope of lending their expertise to the firms they acquire. There are several smaller private equity firms that specialize in some specific fields and invest in relatively smaller companies to make their profitable growth smoother. In short, private equity can be risky and tricky, but with proper management, it is a risk worth taking.

John Otero

John Otero is an industry practitioner with more than 15 years of experience in the insurance industry. He has held various senior management roles both in the insurance companies and insurance brokers during this span of time. He began his insurance career in 2004 as an office assistant at an agency in her hometown of Duluth, MN. He got licensed as a producer while working at that agency and progressed to serve as an office manager. Working in the agency is how he fell in love with the industry. He saw firsthand the good that insurance consumers experienced by having the proper protection. John has diverse experience in corporate & consumer insurance services, across a range of vocations. His specialties include Major Corporate risk management and insurance programs, and Financial Lines He has been instrumental in making his firm as one of the leading organizations in the country in generating sustainable rapid growth of the company while maintaining service excellence to clients.

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