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In simple terms private equity represents equity shares that are held privately and not openly traded on stock exchanges. These shares represent ownership or interest in a company which is not publicly listed or traded on stock exchanges. Private equity is a source of investment capital which is derived primarily from high net worth individuals and firms that purchase shares of private companies or acquire control of companies. Such individuals and companies often purchase stake in these private companies and improve their profitability etc. in order to take them public at a later date. A majority of private equity industry is made up of large institutional investors such as pension funds and large private equity firms that are funded by accredited investors.
A large capital outlay is required to gain a significant level of influence over a firm’s operations as the basis of private equity investment is direct investment into a firm. This is why larger funds with deep pockets currently dominate the private equity industry. The required minimum capital amount required by such investors may vary depending on the firm and private equity fund being considered.
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The underlying motivation for such huge financial commitments is the pursuit of achieving high positive returns on investment in the future. Partners at private equity firms raise funds and manage the money obtained from various accredited investors to yield favourable returns for their shareholder clients. The investment horizon for such commitments may range between 4 to 7 years.
Private Equity Firm Operational Styles
The investing preferences of private equity firms vary across thousands of private-equity firms in existence. This dictates the type of private equity. Some investors are strictly financiers i.e. only passive investors. The passive investors depend on the private equity firm’s management to grow and increase profitability and supply owners with appropriate returns. On the other hand, other private equity firms consider themselves active investors because sellers typically see this method as a commoditised approach. In this type of partnership, they provide operational support to management so that they can build and grow the company.
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Some private equity firms may have an extensive contact list and ‘C-level’ relationships such as CEOs and CFOs within a given industry or they may have expertise in realising operational efficiencies and synergies. This can help increase revenue for the company with private equity investments in the long term. An investor is more likely to be viewed favourably by sellers if they can bring in special skills that feature the potential to enhance the company’s value over time.
Investment banks also compete with private equity firms using funds from various sources to buy up private companies and financing the promising ones. In the case of traditional private-equity firms, only accredited investors can investment their money and usually these firms tend to have a limited number of investors. As these firms have grown, some of the largest and most prestigious private equity funds trade their shares publicly.
How Private Equity Investments Work:
Private equity firms sometimes buy out a company outright. In such a scenario, the company’s founder often stays on to run the business but this is usually only for a short time till new management takes over. Other private equity investment strategies include buying out the founder(s), cashing out existing investors of a private company, providing expansion capital and/or providing recapitalisation for a struggling privately-held business.
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Private equity is also linked to the process of a leveraged buyout. In this strategy the firm borrows additional money from other sources/investor to enhance its buying power and uses the assets of the acquisition target as collateral.
Another type of this fund has been gaining popularity recently. This is called a “Search Fund”. Instead of pooling money to invest in a business, the investors channel their money to support an entrepreneur who searches for suitable private business to acquire and run. When the future CEO finds a suitable company, then the investors pitch in their money to make the purchase and receive a stake in the company.
Benefits of Private Equity Investments
The upside of private equity is that it is the perfect tool for the owners/founders to get access to additional funds/skills that can help the business develop further. These funds also take care of their investors by rewarding them with returns that are in line with the performance of their acquisitions. Another possible requirement for private equity is that it can help out a business that is in need of a cash infusion and/or overhaul. Private equity funds can also introduce new ideas and even new administrators who might improve the condition of a business.
Downside of Private Equity Investments:
Like every other financial tool private equity has its downsides too. Companies in their early stages of development are often not a good fit for private equity investment strategy. In addition, the ultimate goal of a private equity fund is to make the company worth more than it was before so that it can produce adequate returns for investors. With such an approach, the workforce, the role of the founders in the business, and even the business’ long-term success can be secondary to the goal of profits in the short term.
Oversight and Management:
Oversight and support of the acquired companies and their management is the second most important function of private-equity professionals. These firms can introduce various best practices in strategic planning and financial management to aid the acquired company’s growth. In addition, they can help institutionalise new accounting, procurement and IT systems to increase the value of their investment.
For more established companies, private equity firms proceed with a leadership approach. This allows them to work with the ability and expertise to acquire underperforming businesses and turn them into stronger ones by increasing operational efficiencies which in turn increases earnings.
Private Equity Investment Strategies
There are numerous private equity investment strategies opted by the investors. However, two strategies that are most common and popularly preferred by investors are leveraged buyouts and venture capital investments.
- Leverage Buyouts:In this strategy, a target firm is bought out by a private equity firm or as a part of a larger group of firms. This purchase is financed/leveraged through debt which is collateralised by the target firm’s operations and assets. The private equity firm seeks to purchase the target with funds acquired through the use of the target as a sort of collateral.
In simple words, in a leveraged buyout, the private equity firm is able to purchase companies while having put up only a fraction of the purchase price. The acquiring firm’s aim is to maximise their potential return by leveraging the investment which is always of utmost importance for such firms in the industry.
- Venture Capital:This is more of a general term often used in relation to taking an equity investment in a relatively new firm. Private equity firms often see the existing potential in the industry and target the company itself. Acquiring firms are often easily able to acquire significant stakes in a new company due to cash flow and debt financing requirements of the acquisition Acquiring firms perform such activities in the hope that the target will evolve into a powerhouse in the acquisition target’s growing industry. Private equity firms add value to the firm by guiding the target firm’s often-inexperienced management towards the path of long term growth.
Investing in Private Equity:
Private equity is often ruled out of a portfolio where investors who are not in a position to put forth huge amounts of money. At present private equity investment opportunities in India require steep initial investments, hence, they almost exclusively cater to high net worth individuals.
Mutual funds have their restrictions in terms of buying private equity due to SEBI rules regarding illiquid securities holdings but they can also invest indirectly in unlisted companies by buying these publicly listed private equity companies. These mutual funds typically follow a Fund of Funds style of investing. In addition, average investors can purchase shares of an Exchange-Traded Fund (ETF) that holds shares of private equity companies.
With the potential of providing high returns, private-equity firms have become attractive investment mediums for wealthy individuals and institutions leading to a significant increase in their AUM over the years. Understanding the aspects of private equity and how its value is created in such investments are the first steps towards entering this upcoming asset class which is set to become more accessible to individual investors in the near future.