What is Private Equity Funding?
Private equity provides funding for new or existing companies with the potential to generate significant returns. Private equity is different than venture capital, so it is not subject to SEC regulation and follows a different tax structure. With private equity investment, the investor gets an ownership stake in the company rather than just an interest-bearing loan of cash. Generally speaking, private equity investments are long-term investments that require more risk/higher return on investment (ROI) situations that take years to realize returns.
For companies looking for funds outside of public markets where securities are sold on exchanges like the NYSE (NYSE), Venture Capital (VC) Corporations must look into seeking out funding through private funds. These funds can be considered an alternative when VCs can’t provide the capital when and where it is needed. Private equity generally refers to the entire pool of funds made available by private equity firms, which can be used to acquire or invest in companies. The main difference between venture capital and private equity is that venture capital funds are generally focused on early-stage startups and small- to medium-sized businesses, while private equity funds target larger, more established organizations.
Private Equity Investment Process
Investors in a private equity firm (called limited partners or LPs) receive shares (called limited partnership interests or LPIs) in the fund that they purchase in exchange for their investment. Some investors, known as general partners (GPs), also buy shares in the fund and receive a portion of any profits earned by the fund. GPs manage the fund and select which companies to invest in using the funds raised from LPs.
The primary goal of private equity investing is to generate returns through profitable exits (by selling the company) or internal growth strategies (by increasing revenue and cash flow). Private equity funds typically close to new investors and then seek out appropriate investments for those already invested. However, there are now open-ended private equity funds available for those seeking funds now because the prospect of returns now outweighs waiting for future investment opportunities.
Types of Private Equity Investments
The types of private equity investments a firm can make vary greatly. However, the general types of private equity investments include: buyouts or takeovers, venture capital, mezzanine financing, leveraged finance and recapitalizations. In a buyout deal , investors purchase all or a majority ownership interest in a company from the company’s existing owners. In venture capital , private equity firms invest in startup companies that already have collateral from another source such as grants or angel investors. In mezzanine financing, limited partners provide financing at middle stages between start-up and maturity (such as when the company is established). In leveraged finance or L/F, investors provide financing or acquisitions in at least 40% debt.
Recapitalization refers to the acquisition of a company through stock swaps when there is no significant change in ownership. Some private equity firms sometimes use these types of transactions for tax advantages and to maintain the company’s listing status with a stock exchange. Private equity investments can be attractive to both GPs and LPs because they offer an opportunity for high returns through the use of leverage and other techniques that can increase value and ROI at a greater rate than traditional asset classes such as stocks and bonds.
Private equity funds are typically structured with a 10-year lifespan after which they expire. While this may mean that some LPs may be unable to exit their investment during the fund’s lifespan, it also means that investors can get in early on the fund without having to wait for the fund to reach maturity like in traditional VC investing.
The most common type of fund is a leveraged buyout (LBO). In a leveraged buyout an investor purchases a company with money borrowed from banks, usually in exchange for stock in the target company. The basic idea is that the buyer will use this additional capital to help improve their operations or take advantage of opportunities, whichever comes first.
LBOs come in two basic flavors: hostile (where the target company is not willing to deal with the acquisition, and the acquirer will therefore use force or coercion to take control of it) and friendly (where the target company is open to selling). The majority of LBOs are friendly.
Most fund advisory firms encourage investors to participate in LBOs because of their potential for returns. The average private equity fund has returned around 15% per year since 1996, while most mutual funds return around 2% per year over the same time period.
Most private equity funds are formed by investment banking firms like Goldman Sachs, Carlyle Group, Blackstone Group, KKR Partners or Warburg Pincus. These groups acquire companies and then resell them to other investors after a few years to make even more profit.
They’re able to do this because their primary concern is the return on investment and not the well-being of the company. This can devastate a company if too much debt is acquired or if management makes poor decisions, but there’s no guarantee that they won’t be successful either. It all depends on market conditions and how good the manager is at making the right calls for his or her businesses.
The most important thing for small businesses seeking to attract investors is knowing how to attract them and just how much to give up. For investors, it is knowing where to invest, how and how much to invest. Fintalent, the hiring and collaborative platform for tier-1 Strategy and M&A professionals has a pool of professionals that can meet both the needs of the investor as well as a firm seeking investment. Fintalent’s Debt and Equity Consultants can advise businesses on the course to take to finance its aspirations while Fintalent’s Research Experts can help investors identfy and choose what businesses to consider for their investments.