What is Private Equity? | Goals, Working, Types, Pros vs Cons

Investment is one of the crucial things that a start-up requires to take off and continue to be relevant in the market.

Fortunately, the market has a vast range of investment sources. One of them is Private Equity.

However, as an investment capital source, it belongs to the alternative class (others include hedge funds, managed futures, venture capital, and the like) and comprises assets not enlisted on any public exchange.

As it follows, private equity is an alternative mode of investment (comprising of equity debts or securities) made in a company (generally, mature ones) that is not registered on a public exchange for holding equity shares in that company.

Key Takeaways

1. Private equity refers to investments in private companies not listed on a public stock exchange.
2. Private equity firms invest in companies with potential for growth and use their expertise to increase their value.
3. Private equity firms make money by buying and selling companies at a profit, over several years.

Goals of Private Equity

Private Equity mainly comprises two components: Investors and Funds that make direct investments in private enterprises or obtain control of public enterprises to delist them from public exchanges and take them into the private domain.

A private equity investment can be used for a variety of purposes, such as:

1. Funding new technology.
2. Making new acquisitions.
3. Strengthening and solidifying the company balance sheet.
4. And expanding working capital.

By investing in these various aspects of company operations, private equity investors aim to enhance the value of a company so that they can eventually sell it for a vast amount of profit.

How does Private Equity work?

Individuals or business entities interested in investing or owning company shares collectively raise capital to form a private equity fund.

When these entities meet their fundraising objective, the fund is closed, and the accumulated funds are then used for investment in companies with favorable prospects.

Generally, a private equity fund comprises two kinds of partners: General Partners and Limited Partners. The latter holds 99 percent of the fund’s shares and has the advantage of limited liability.

In contrast, the General Partners own only one percent of the fund’s shares and are holders of full liability. They are also responsible for the operation and execution of company investments.

Types of Private Equity Investors

Generally, two types of investors make private equity investments:

1. Institutional Investors: These are organizations or companies that invest on other people’s behalf. For example, insurance companies, mutual funds, and pensions. 
2. Accredited Investors: Business entities or individuals permitted to trade or invest in unregistered securities provided they fulfill one or more conditions concerning the net worth, asset size, income, professional experience, or government status. These entities pool their capital in Large Private Equity Firms, which invest in promising companies.

These investors devote a sizeable amount of money to mid-market companies for longer periods. The reasons why private equity investors prefer longer holding periods are:

1. To ascertain a turnaround (financial recovery) for troubled companies.
2. To facilitate liquidity events like an initial public offering (IPO).
3. To enable a sellout to a public company.

Types of Private Equity Investments

The structure of investments made by private equity investors varies according to the needs of the companies. The following are some of the most preferred types of private equity investments.

1. Leveraged Buyouts: This is the most popular type of private equity investment. It involves acquiring a company, enhancing its financial and business health, and selling it to other investors for vast sums of profit.
2. Distressed Investments: Also known as Vulture Financing, it entails acquiring a distressed company (almost on the verge of bankruptcy) and selling its assets for profit or upgrading its business and financial operations and output for an eventual sale for profit.
3. Fund of Funds: As evident from the appellation, it entails investment in other funds, mutual or hedge funds. 
4. Real Estate Private Equity:  Real estate investment trusts (REITs) and commercial real estate are the primary beneficiaries of this kind of investment.
5. Venture Capital: These are fundings made in budding enterprises.

Advantages of Private Equity

As an investment source, private equity rewards companies with several benefits.

1. Alternative access to liquid assets: Private equity permits companies to obtain liquid assets from an investment source other than the traditional financial mechanisms like enrollment on public exchanges or bank loans (at a high-interest rate).
2. Investment source for start-ups: Specific private equity investments like venture capital help start-ups and budding companies take off.
3. Investment source for de-listed companies: Private Equity is an essential source of investment for companies that have been de-listed from public exchanges.
4. Allows experimentation: Private Equity enables companies to experiment with new ideas and growth strategies, which is otherwise impossible under the pressure of the public markets that drive companies to excel and continuously earn profit.

Disadvantages of Private Equity

Despite providing several benefits to companies, private equity has its share of unique challenges.

1. Difficult to liquidate: Unlike in public exchanges, there is no provision for a ready-made order book that befits sellers with buyers in private equity. Firms must search for a suitable buyer to sell their company or shares.
2. Negotiation-based pricing: Unlike in public exchanges, where the market determines the cost of shares of a company, private equity investments depend on negotiations between sellers and buyers.
3. Agreement-based shareholders’ rights: In Private Equity, shareholders’ rights depend on the agreements made with a company rather than a broad legal framework. Consequently, they tend to vary from company to company.

References

1. https://heinonline.org/hol-cgi-bin/get_pdf.cgi?handle=hein.journals/fedred82&section=7
2. https://www.aeaweb.org/articles?id=10.1257/jep.23.1.121
3. https://www.hbs.edu/faculty/Pages/item.aspx?num=35877

Last Updated : 11 June, 2023