Private equity refers to an alternative investment class composed of capital not listed on a public exchange. It consists of investors and funds that directly invest in private companies, or engage in buyouts of public companies, resulting in the delisting of public equity.
Investors in private equity typically include institutional and accredited investors, who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as a sale to a public company or an Initial Public Offering (IPO).
Private equity firms raise funds and manage these monies to yield favorable returns for their shareholder clients, typically with an investment horizon between 4 and 7 years. The four main investment strategies in private equity are: leveraged buyouts (LBOs), venture capital, growth capital, and mezzanine capital.
- Leveraged Buyouts (LBOs): LBOs represent most private equity deals. An LBO occurs when an investor acquires a controlling interest in a company’s equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, along with the assets of the acquiring company.
- Venture Capital: Venture capital is a type of private equity investment strategy that is used primarily for investing in young, high growth companies that need capital to scale their operations. These companies are often tech companies, but can be in any industry.
- Growth Capital: These investments are also known as minority investments, where a private equity firm invests in a company for a minority equity stake. The company might be a growth-oriented business which is cash flow positive, profitable, and looking for more capital to expand operations or enter new markets.
- Mezzanine Capital: This strategy involves the use of subordinated debt, or preferred equity, which is a layer of financing that ranks lower than senior debt but higher than common equity. If a company goes bankrupt, mezzanine capital providers get paid after senior debtholders and before equity holders.
Remember that investing in private equity requires a high risk tolerance, as investments are illiquid and require a long-term commitment. However, it can potentially lead to substantial returns. As with any investment strategy, potential investors should consult with financial advisors and conduct thorough due diligence.
Example of Private Equity
Let’s look at a hypothetical example of a private equity (PE) transaction:
Suppose we have a private equity firm named “Capital Growth Partners” (CGP). CGP is interested in “TechABC”, a tech company that has developed a promising software product but has been struggling with scaling operations and managing cash flow. TechABC is privately owned, and its valuation is estimated to be around $100 million.
CGP believes that with an infusion of capital and management expertise, TechABC can significantly increase its profitability and market value. Therefore, CGP decides to acquire TechABC.
To finance the acquisition, CGP raises $40 million in equity from its investors, which include pension funds, endowment funds, wealthy individuals, and its own partners. It borrows the remaining $60 million needed for the acquisition from a bank, using TechABC’s assets and future cash flows as collateral for the loan. This is a typical Leveraged Buyout (LBO) structure.
After the acquisition, CGP implements various strategies to improve TechABC’s operations and profitability. These strategies might include cost-cutting measures, expansion into new markets, restructuring of the company, or improvements to the management team or business processes. CGP’s goal is to increase TechABC’s cash flow and growth rate, thereby increasing its market value.
After five years, having improved the operations and profitability of TechABC, CGP decides it’s time to exit the investment. It sells TechABC to a large tech company for $200 million.
From the sale proceeds, CGP first repays the $60 million debt it took on for the acquisition, leaving it with $140 million. After subtracting the initial $40 million of equity it invested, CGP is left with a profit of $100 million.
The return on equity for the investors is then ($100 million profit / $40 million initial equity) = 250%. This represents a highly successful private equity deal, although it’s important to remember that not all deals are this successful, and the process involves significant risk and effort.
This example simplifies many aspects of a private equity transaction, but it gives a basic idea of how a PE firm operates: by buying, improving, and then selling companies.