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What Is Private Equity
Private equity refers to a type of investment made by investors such as investment funds and retail investors in private companies.
In other words, the investors provide the necessary funds for a private equity investment allowing a private company to fund its business and pursue its strategic growth activities.
Private companies obtaining private equity will general use the funds to:
- Make capital expenditures
- Fund their working capital
- Engage in mergers and acquisitions (M&A)
- Fund their research and development (R&D)
- Fund their product launch and go-to-market activities
To better understand what is private equity, let’s look at some of its main features.
Private Equity Investment
Private equity investments are investments made outside of the public markets by institutional investors and accredited investors.
The main objective of a private equity investment is to invest in a company early on and at low costs betting that the company will substantially grow over time and thus lead to important returns.
Generally, private equity investors do not invest for a short-term gain but are prepared to have their money invested for a long time before seeing any type of profit or return on investment.
For example, if the investors invest in a startup having a lot of growth potential over time, the investors may remain invested between five to ten years before exiting or cashing out their investments.
The ideal scenario for investors is to cash out their private equity investments through a liquidity event such as an initial public offering (IPO) or through buyouts.
Private Equity Firms
Private equity investments are typically handled by private equity firms, venture capital firms, or directly by an angel investor.
In general, private equity capital is concentrated in an investment fund organized as limited partnerships.
Private equity firms have the main objective of providing capital to private companies who need funding to grow their business, expand business operations, or restructure.
What distinguishes private equity firms from venture capital firms is that they invest in mature companies and tend to acquire a majority control.
On the other hand, venture capital firms tend to invest in startups or young companies and will generally have a minority position.
The way private equity firms make money is by charging management fees of a few percentage points to cover their costs and overhead.
In addition to that, they will charge a performance fee based on the investment returns.
Private Equity Investors
Private equity investors are those who invest in companies through private equity channels.
In most cases, private equity investors are institutional investors or accredited investors who meet certain qualification characteristics.
Accredited investors are sophisticated investors that qualify as such under securities laws who tend to have a high net worth or are large corporations.
As accredited investors, they are able to access complex and high-risk investments such as venture capital investing, private equity investing, angel investing, and so on.
Private Company Valuation
Private equity financing is a type of financing that is done outside of the public financial markets.
Entrepreneurs, company founders, startups, and other private companies may find it advantageous to fund their business through private equity firms as they will not have to comply with complicated securities exchange laws and regulations nor will they have to publicly disclose their financial statements.
On the other hand, private equity financing can be quite expensive for private companies.
Since a private company is not listed on a stock market, the company valuation may not accurately establish the true market value of the private company shares.
As a result, a private equity transaction based on a market value below the private company’s true value will not be beneficial for the company shareholders.
Types of Private Equity Funding Strategies
Private equity firms handle the raising of capital needed by a private company by soliciting investments from institutional investors and accredited investors.
There are many types of private equity funding possible giving investors many options to choose from.
The most common types of private equity financing are:
- Distressed funding
- Leveraged buyouts
- Real estate private equity funding
- Fund of funds
- Venture capital funding
Venture Capital Funding
Venture capital funding is a type of private equity investment made to fund startups and entrepreneurs starting a new company in general.
When a company founder or entrepreneur has a great idea but has no money to translate that idea into a functioning business, private equity investors can fund the entrepreneur’s business to move from idea to business product (this is called seed financing).
As the company grows, further investment rounds could be offered to the investors.
Then, to get the company in the market and compete with others, the company can go for another round of investment called Series A financing.
As the company grows and progresses to the ultimate destination of an IPO, other investment rounds can be considered such as Series B, Series C, Series D, etc.
You may have heard of the term “leveraged buyout” in the news or in the media.
This is a very common type of private equity financing.
In many cases, public companies may choose to sell certain business segments or refocus their business strategy by selling off certain business units.
That’s where private equity firms will raise the necessary capital to fund the purchase of a non-core business unit of a public company.
The primary objective of the investors is to acquire a business, have it operate for some time, solidify its financial position, and then sell it for a profit or list it on a stock exchange.
Vulture financing is a type of private equity investment where the investors finance a company in distress.
The objective of vulture funding (or distressed funding) is to find companies that have true growth potential or are undervalued and to turn them around bringing them back to profitability.
If the investors consider that the management is not doing a good job, they will change the management hoping that the new management team will get the job done.
Alternatively, if the company owns assets that are not performing well, they may sell them off or discontinue certain lines of business to focus on the company’s core expertise.
A management buyout is a type of strategy where the company management team raises private equity funds to purchase the company.
The private equity firm will be given a minority position in the company in compensation for its investment.
This type of strategy is seen when public companies want to restructure and prefer to go private before starting the process.
In this fashion, the company shareholders, investors, and various stakeholders can cash out before the company management takes control of the company.
Mezzanine capital investments refers to when investors purchase subordinated debt or preferred equity securities in a company.
The investors will own securities junior to other types of securities in the company’s capital structure but will be senior to the common shares.
This is a good strategy for companies to borrow capital over and above what they could get through traditional lenders or banks.
Fund of Funds
A fund of funds is a type of private equity investment where investors invest in other funds such as mutual funds.
The primary reason why investors may choose to invest in a fund of funds is due to the high minimum capital investment required to directly invest in the funds they are targeting.
As a result, they’ll invest their money in a private equity fund that will, in turn, invest in the desired funds.
Real Estate Private Equity Funding
Real estate private equity investments are those made to purchase commercial real estate properties or real estate investment trusts (or REITs).
Private equity firms pool investor capital to purchase properties that would ordinarily be too expensive or too risky for one single investor or a small group of investors to acquire.
How Does Private Equity Work
Let’s look at how private equity investments work so you can better understand the concept.
Generally, to start the process, a limited partnership is organized to form a private equity fund.
The private equity fund takes charge of the private equity transaction, logistics, and operational requirements.
Then, investors are invited to invest in the private equity fund so it can raise the amount of money it had intended to raise.
Once the fundraising objective and targets are met, the private equity fund is closed and the capital raised through the investors is invested in the targeted company.
The private equity fund will then formally invest in the targeted company (typically for the mid to long term).
The private equity fund’s objective is to eventually sell its investments for a profit through a buyout or initial public offering.
It’s also possible that the private equity fund sells one of its portfolio companies to another investor or private equity firm either to limit losses or realize certain gains.
What Is Private Equity Investment Takeaways
So there you have it folks!
What are private equity investments in simple terms?
What is private equity and how does it wor?
You can consider private equity as a private form of financing performed outside of the public markets.
In essence, private equity is a category of capital investments that investors make in private companies hoping to earn higher than average returns.
Typically, private equity firms and retail investors will engage in providing the private equity capital to companies they believe have the potential to grow.
Many private equity investments are handled through private equity firms whose main mission is to invest in a company that will grow over time allowing them to eventually sell their position for profits.
The primary purpose of a private equity firm or fund is to invest in a private company by purchasing equity securities with the expectation that they will appreciate in price over time.
This type of alternative investment class is available to large institutional investors, large corporations, and sophisticated individual investors who meet certain criteria under the applicable securities laws.
If you want to embark on private equity investing or you are looking to fund your company, it’s best to consult with a business lawyer with experience in corporate financing and M&A to see the pros and cons related to your specific situation.
I hope I was able to answer your question related to what is private equity and how it works.
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What Is Private Equity Summary
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