Private equity, Why so exclusive?

What is Private Equity?

A private company could finance its business through various sources. All the sources can be classified as equity and debt. An equity stakerefers to a stake of ownership in a firm. When a firm raises capital for operation of its business through equity, it actually sells a portion of ownership of the firm. In other words, if an individual or organization gives fund to run a business and in returns it gains a share of its ownership, this funding is known as equity finance. On the other hand, debts (also termed as debentures) involve raising funds through taking loans. These loans could be of short term and long term nature.

There are different kinds of structures that a business may adopt such as sole proprietorship, partnership and company. A company is that form of structure where the legal entity of a firm is separate from its owners. Company organization finances its operation through selling shares (equity) and also through acquiring loans. When shares of a company are sold off to the general public at large, such company is termed as public company. These companies sell their shares on a credential market like the New York Stock Exchange. This selling of shares is known as public trading. However, there are firms that are not large enough to sell shares to the public but are able to raise capital through giving ownership to small groups of people or institutions. Such firms are private companies and are not traded publically on market like New York Stock Exchange.

Private equity is what private companies get as capital from private and accredited investors and not from public stock markets. These investors could be individuals or firms and in return get share of ownership into the company in which they have invested. In other words, equity of private companies, not traded on stock markets, raised through selling off ownership to accredited investors is known as private equity.

Private equity fund is different from buying a stock of a company. Merely buying a stock in a company does not give hold on working of the company. But, private equity funds give some degree of control over the operations of a firm to the investors. The funds are of huge amount that is used to buy out large stakes of a company that would allow managing the working of the company. Typically, private funds are used to buy and manage companies before selling them by investors.

What are Private Equity Firms? Introduction and Working

There are firms and institutions which take advantage of this situation where private companies require long term fund and investors are available to get their savings invested but their connection is not met. To remove the gap between such availability of savings and demand of funds, firms have taken birth. These are known as private equity firms. The private equity firms receive funds from various sources and channelize these funds into businesses that cannot go for public trading. These sources include pension funds from individuals, assets of wealthy investors, universities endowments, insurance companies, labor unions etc. It can be said that a group of individuals who work together as an institution to carry out private equity investment is known as private equity firm.

Typically a private equity firm does the following-

• Raising capital from external sources

• Investing the raised fund into series of private equity deals

• Exiting the business through selling off the investment and distributing the proceeds between the external parties (Limited Partners) who sourced the fund and the shareholders (General Partners) of the private equity firm.

A simple example would help understand the business model of private equity firms. A group of five partners formed a limited partnership firm and raises capital from deep pockets investors. The firm uses the huge fund to invest in an established company by buying out the stakes and hence gaining control over some of its operations. The firm exerts some degree of control over management and operation of the company in which investment is made. It is done to improve the health of the company through methods like improving leadership, cutting cost, enhancing distribution and strengthening efficiency of the operations. Based on the stake purchased by the equity firm, the degree of control is decided and exerted. When the company gets stable and healthier, private equity firm decides to exit and sold off its stakes of the company. The proceeds that the firm get from selling off the stakes get distributed among the external source parties and the individuals who form the equity firm. The external source parties are known as limited partners and the five partners that form the firm are known as general partners. Generally 20% proceed is reserved for general partners and rest is shared among the accredited external investors.

From the above discussion, the working of a private equity firm can be pointed out as the following activities-

1. Raising Capital – Capital is raised from internal and external sources. Major share is from external sources. As the firm invest heavily in a company to get part of its decision making, the firm targets sources with deep pockets like wealthy investors, pension funds, labor unions, foundations, endowments etc. These investors are limited partners. The liabilities and earnings are proportional to the contribution of each limited partner. The general partners (who actually form limited partnership and brings the private equity firm into existence) also contributes 1-3% of total investment capital.

2. Sourcing – Now, the raised capital has to be invested somewhere. This is known as sourcing to a company. The firm would analyze several potential companies to invest in. While analyzing the companies number of factors will be evaluated such as nature of the company and industry, financial history and health of the company, company’s valuation, easiness and potential risks in exiting the company, company’s business model etc. After careful analysis, a company is selected in which private equity fund would be invested.

3. Closing Deals – Once a company is selected, due diligence is once again given to various considerations like risk factors, exit potential, company’s strategy. Afterwards, a deal is presented to the company for negotiation. Once agreed upon, deals are finalized officially and closed by lawyers from both sides. Funds then are released from the equity firm to the company.

4. Improving Operations – As the purpose of the equity firm is to improve the working of the company in which the investment is made, it starts improving the operations of the business. Depending upon the stakes and the deals, the equity firm get itself involved in the management and improves the health of the company.

5. Exiting Company – Once it is realized that the company is stable now or is able to go public, the equity firm decides to exit the company. It is ensured that maximum return is received on original investment at this point of time. Generally, within five to seven years, private equity firms leave.

What are Types of Private Equity Fund?

Private equity could be invested into a company into several ways. Numerous options are available to the general partners of a private equity firm to decide upon. The decision in selecting the type of investment for private equity fund depends upon number of factors like amount to invest, risk factor, condition of market etc. These options are known as investment strategies which are given below-

1. Buyouts or Leveraged Buyouts: In simple terms, buying out a company on leverage by private equity firm is known as leveraged buyout where leverage implies the purchase is financed through debt using the purchased company as collateral. Generally a combination of equity and debt both are engaged in such kind of purchase. In other words, a equity firm would invest a sum to buy equity in the portfolio company and a huge sum would be raised as loan from lending institutions to finance the buyout.

When such buyouts happen, majority stake in a company is acquired by private equity firm that is investing into it. This gives great control over the operations of the business of the company. With such control, new strategies could be implanted and even members of management team could also be replaced. Because of this ability to exert control to this extent, the private equity firm could be deemed as active investors.

2. Venture Capital: Venture Capital is capital that gets invested in form of private equity to a young company or a company in less mature market. The company in which investment is made typically has much potential but lacks cash flows or may not have proven business structure. Private equity firms perceiving potentials existing in the industry and in the firm invest heavily to make the company evolve.

The main objective is to turn an inexperienced company into a powerhouse in its growing industry through offering management expertise. This surely takes the private equity investors to buy significant stakes into the company.

3. Growth Capital: As the name suggests, growth capital is fund provided to a company in order to grow further. In contrast to venture capital, private equity is raised for nurturing a mature company. There are companies that have growth potential and have management expertise but lack funds to grow. Thus, they seek finance in order to expand their business. Strategies like restructuring, entering into new market, product development etc are employed for achieving such growth.

Generally minority stakes are acquired through growth capital and hence less involvement is made into management practice by the private equity firm.

4. Turnaround Investing: Also known as distressed investing, such capital is employed in companies that are facing financial trouble. Private equity firm invests heavily in these firms to get major stakes at a deep discount. This is the main merit of such financing. However, there is huge risk involved as if the troubled company does not turn around as expected, even after getting much fund through private equity, the company may go bankrupt. It would make the investors’ money and private equity firms’ efforts go in vain.

In crux, private equity funds when invested into any financial trouble company to turn around its condition; such financing is known as turnaround investing.

5. Real Estate Private Equity: Investment in real estate or property when done through private equity funds, it is called as real estate private equity. Such financing provides opportunity to high net worth investors to invest a considerable amount in property.

How Private Equity Deals are structured?

Private equity firms when invest into a company, they together make private equity deals. Negotiators from both sides (investors and investee) negotiate terms and finalize agreed upon deals which get written as final clauses in a term sheet. There are several structures through which the funds could be provided from private equity firm to the investee company. Deciding upon the structure is commonly known as private equity deal structuring. Followings are the various ways through which such deals get structured.

1. Common Stock- Both the investor and investee decide upon a certain sum of amount that would be given as funds and also the percentage of stock that the investors will gain.

2. Preferred Stock- Ownership is also gained through acquiring preferred stock of companies by private equity firms. It is always desirable for the private equity investors to fund in form of preferred stock as they can be converted into common stock when they choose to do so.

3. Debt financing with an Equity Kicker- Such financing is a mixture of both equity and debt. Funds are provided in form of debentures with lower interest rates in exchange of ownership position in the investee company.

4. Reverse Mergers- When company amalgamation takes place between existing ongoing private company with a public company, it is known as reverse mergers.

5. Warrants- These are securities that give rights of its holder to buy shares of a company at a pre determined price.

6. Options- Similar to warrants, these securities give rights of its holder not to only purchase but to sell also the shares of a company at specific rate in a given period of time.