What are Private Equity Investments?
Private equity is classed as an alternative type of investment. It takes the form of private financing, not investment in companies that are registered on a public exchange.
Individuals, companies, and funds participate in direct private equity investment of non-public companies and allow such things as buyouts of the businesses involved.
It should be noted that in terms of companies that are already public, private equity investors can also be engaged in buyouts. When this happens it results in the delisting of public equity.
The required capital for private equity investment deals comes from institutional, accredited, and retail investors. These investors have the means and ability to dedicate substantial amounts of money over extended periods of time.
The importance of this type of investor cannot be underestimated because in the majority of cases a substantially long holding period is often a requirement for private equity investments. Examples are to enable liquidity events such as an IPO (Initial Public Offering), sale to a public company, or to increase the chances of a gradual turnaround for a company that is currently in distress.
It is this capital that companies receive and use for such things as funding new technology, expanding a company’s working capital, and making acquisitions to strengthen their market presence and expand their target audience. Such initiatives intend to strengthen and solidify a company’s balance sheet.
A private equity fund consists of LPs (Limited Partners) who would normally own 99% of the shares in the fund. LPs have limited liability. The remaining 1% of shares are owned by GPs (General Partners) who have full liability. It is GPs who are responsible for the execution and operation of the investment.
When it comes to the management and performance monitoring of these investments on behalf of investors in a fund this is where a private equity firm steps in. For their role and services, these private equity firms charge fees.
Later in the piece, there will be a more detailed explanation of how private equity firms make their money. But before that, let’s take a look at….
What are Private Equity Firms and how do They Operate?
Private equity firms are classed as one type of investment firm. Their mission is to invest in businesses with the aim of increasing that company’s value over time. The end game is to sell the invested-in companies for a profit.
In one sense Private Equity (PE) firms are similar to Venture Capital (VC) firms. This is because they utilize raised capital from Limited Partners to invest in private companies that they feel have promising prospects. Founders of startups with promise are particular targets.
However, when it comes to taking shares in these companies, PE firms differ from VC firms. This is because it is common for PE firms to take a majority (50% ownership or more) stake when they decide to invest in a company.
They also have this majority ownership in multiple companies at the same time. This is termed a PE firm’s portfolio and this leads to the businesses brought under their majority-ownership umbrella being known as portfolio companies.
What is the Role of a Private Equity Firm and its Employees?
Investors who work at PE (Private Equity) firms are known as PE (Private Equity) investors. Their role is crucial in terms of identifying companies that will make for good investment opportunities and for raising the needed capital to take a stake in such companies.
This means that PE investors will look for investment opportunities in companies with a certain type of profile. Two examples here would be a company that has become stagnant and those that are in potential distress but still show signs that potential growth is possible.
By their very nature, the structure of these investments can vary. However, the most common deal type is classed as an LBO (Leveraged Buyout).
Here’s a brief explanation of what an LBO is:
In an LBO an investor will purchase a controlling stake in a company. To do this a combination of equity plus a significant amount of debt is used. This must eventually be repaid by the company. But before this, the PE investor works to improve the company’s profitability with the intention being that the debt repayment becomes less of a financial strain on the company in question.
It is usual that when a PE firm sells a portfolio company to another investor or company it makes a profit. If that is the case this profit is then returned to the LE (Limited Partners) that invested in the related fund.
How do Private Equity Firms Make Their Money?
As was touched on earlier, private equity funds are developed by private equity investors who work for private equity firms. These firms make their money by collecting 2 types of fees; Management fees and performance fees.
While the fee structure can vary from fund to fund there is typically a Two and Twenty (“2 and 20”) rule. This rule is also the standard in the Hedge Fund world and is common in Venture Capital circles.
Let’s take a look at each in turn:
Management fees – That’s the 2!
These are calculated as AUM (Assets Under Management) and are typically around 2%. Management fees are seen as being the bread and butter of Private Equity firms. The reasoning behind management fees is they are intended to cover regular expenses such as overheads and daily expenses.
Performance fees – That’s the 20!
These fees are calculated as a percentage of profits made by the fund that comes in above a given and predefined benchmark. The typical percentage paid comes in at around 20%. These fees are paid to employees and are offered to incentivize greater returns on investments.
The Pros & Potential Cons of Private Equity Investments
As with all types of investment, equity investments have their advantages and potential disadvantages. Let’s take a look at both, starting with:
The benefits of private equity investments
Companies and startups can take advantage of private equity in a variety of ways. In the first instance, it gives companies seeking liquidity an alternative to conventional financial mechanisms (e.g. bank loans with high interest or listing on public markets).
Some forms of private equity fit very well for early-stage startup companies and for financing/progressing ventures that are at the ‘ideas’ stage. A good example here is venture capital.
Looking at companies that have been delisted through a private equity exercise can also prove to be beneficial. This is because they are then out of the public spotlight and can look to turn their fortunes around through a variety of different growth strategies.
In this respect, senior management then has the consistent pressure of producing healthy quarterly earnings taken off them. This then allows them to look at new ways to reduce losses and from there look at ways to turn the business into profit.
The potential disadvantages of private equity investments
The unique make-up of private equity also means that potential disadvantages come in a variety of different ways.
First, it can be challenging to liquidate holdings in private equity. This is because unlike public markets there is no established order book to match potential buyers with sellers. This means a search must be undertaken for the company to find the right type of buyer for the sale of its investment or the company as a whole.
You then have the fact that the pricing of shares for a company in private equity is not subject to market forces. They can only be determined through buyer and seller negotiations.
The final challenge comes with the rights of private equity shareholders. These are usually decided on an individual case-by-case negotiation basis rather than the typically broad governance framework which dictates such rights in public markets.
Anyone interested in Private Equity investment management whether from an early-stage founder’s angle, a more established company, or those seeking profitable investments should look to maximize their opportunities.
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