What is Private Equity? And how does it work?
Whether its buying ice-cream at Cold Stone or filling gas at a Shell petrol station, a large proportion of companies that we consume goods and services from is backed by a private-equity firm. This makes private equity a favorable investment option for many people. In this article, we will explore how private equities work and how they can benefit private companies.
What is a private equity firm?
To put it into simple terms, private equity is a part of the much larger finance sector known as private markets. It is a type of financing, whereby, capital is invested by the investor, usually into a large business in return for equity in the company. They are termed private because the stocks in the company are not traded in a public equity market (i.e. stock exchanges).
The private equity firm will then raise capital for the private companies they buy equity in, to fund the new projects, pay off existing private debt or raise capital for mergers and acquisitions. The funding for private equity firms comes from institutional investors such as large banks or insurance companies. For example, in 2017, during Lyft’s series G funding, they raised $600 million from private equity firms. This increased the company’s valuation from $5.5 billion to $7.5 billion.
Private equity firms are funded by pension funds, labor unions, foundations and many other powerful organizations who invest large sums of money in the hopes of receiving a large return on their big investment. Due to the hefty investments, private equities often have a large control over the industry of the companies they invest in. They invest in companies and manage and improve their operations and revenue over a period of time. Once the private equity has improved the investment value of the company, it can do one of two things. The company can issue an Initial Public Offering (IPO) to go public or it can be sold to a larger corporation at a profitable price.
Between 2000 and 2006, all private equity buyouts worth over $1 billion rose from $28 billion to $502 billion and has been at a steady upward growth since. There is no denying that is an incredibly prosperous business in the finance sector.
Here is the list of the largest private equity firms by PE capital raised:
What do private equity investors do?
Private equity investors have a versatile and powerful job and it is a profession that attracts the brightest and smartest people in the corporate world. The job of a private equity investor can be focused on three important tasks:
— Raise capital from large entities
Just as private companies raise money from private equity firms, private equity firms also go through rounds of funding to raise capital from large institutional investors. Sometimes, the owners of the private equity put in their own capital but this is no more than 1-5%. When raising capital, private equity firms prefer large companies that invest 10-100 million dollars each vs. many small companies that invest money in the thousands.
There are two time periods when a private equity raises funding. ‘First close’ means that the company has raised the required amount of money but new investors can still join the equity for a short period of time. The ‘Final close’ is when the private equity is done raising capital and no new investors can join.
— Buying out private companies
The main function of a private equity is to invest in private companies in both single or multiple sectors. Therefore, a large part of a private equity investor’s job is to source out potential companies, perform extensive research on why the company would be a good investment and finally implement a plan of action to acquire the company.
Prospective deals on companies usually come as a result of a partner’s reputation in the industry or from the in an auction conducted by investment banks where equity firms raise bids for a company and in each round of bidding, companies are rejected from the race. The bidding process happens for companies that have a very high potential for growth.
Once the potential companies are sourced, the private equity investor will perform the due diligence to acquire the company.
— Improve the investment value of the acquired company
Once equity in the company has been acquired, it is the duty of the private equity investors to improve operations and increase revenue in the company. The investors are not in charge of the day-to-day running of the company, rather, they take seats on the company’s board and provide advice and support on the strategies and operations management of the company.
The level of involvement by the investor can vary depending on how big their stake in the company is. If they own a large stake, they will have a significant influence on how the company is run and will be more involved in improving the workflow of the company.
The end goal of the investor is to exit the portfolio company once the investment value of the company has improved. This exit may happen 3-7 years after the company has been bought. The investors gain value in holding this investment through the revenue gained during the investment period, the reduction in costs as a result of streamlining the process and the revenue earned from selling the company which is used to pay off the debt incurred when the company was originally purchased.
Once the company’s revenue has been optimized the investors will either issue an IPO or sell it to a larger corporation.
Private Equity Strategies
Here are three commonly used private equity strategies:
— Growth capital
These are investments made in well-established companies who are looking for capital to expand their current operations or to expand their target markets. These investments are usually a minority investment by the private equity firm. The mature companies they invest in are looking to expand operations without affecting the ownership in the business.
— Leveraged buyouts
This is when a private equity firm borrows a large amount of capital to buyout other companies because they believe that they will get a significant return when they hold and eventually sell the company. Almost 90% of the LBO is financed through debt. Once the company is acquired, the private equity will either sell parts of the company or will improve the investment value of the company and exit at a profit.
— Fund of funds
A FOF strategy is when the private equity invests in various other funds and not directly into stocks and securities. Using this strategy provides a more diversified portfolio for the private equity and the ability to hedge the risk during the different stages of funding. On the downside, investing in funds of funds is expensive as there are additional fees involved such as the management fee and the performance fee.
A private equity investment is great 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 company’s value and revenue and help leverage its position in both local or international markets.