Private equity involves capital investment in companies and organizations outside of a public exchange. Through private equity transactions, an investor can invest directly in companies or engage in buyouts that lead to the delisting of a formerly public entity. Institutional investors and accredited investors account for most private equity transactions, since these deals typically involve a great deal of money over an extended period of time.
The private equity market has several benefits for both investors and entrepreneurs. Investors can get involved with early-stage companies and fund truly revolutionary ideas from the ground up, while companies can gain access to liquidity without turning to high-interest bank loans or listing on public markets, which introduces several constraints on the business.
Of course, there are also drawbacks to private equity. Unlike with public markets, no order book exists to match buyers and sellers, so these investments can prove difficult to execute and potentially illiquid for investors. Moreover, the pricing of shares in private equity is the result of negotiations between buyer and seller, rather than market forces. This dynamic can add uncertainty to these investments.
Furthermore, the rights of private equity shareholders are not always clearly dictated. Investors need to understand the pros and cons of private equity before they consider investing and use this knowledge as a lens for vetting different deals. In addition, investors should have a clear sense of the major types of private equity transactions, which include:
While people usually consider venture capital and private equity as distinct, venture capital involves investing in private companies and is technically a type of private equity. Venture capital is directed to early-stage companies and startups rather than established, mature companies; the exact type of venture capital usually depends on the stage of the company. For example, some investors may engage in seed financing, which means providing capital to scale an idea for the market after the creation of some sort of prototype. Early-stage capital helps entrepreneurs grow a company once the product or service is developed enough to bring to market. Investors may also hear the term Series A financing. Through Series A funding, entrepreneurs begin to compete actively in the market. Series B, C, and D funding rounds may follow.
The leveraged buyout has become one of the most popular forms of private equity investments in the United States outside of venture capital. In a leveraged buyout, investors purchase a company outright, generally with the intention of improving operations and reestablishing financial wellbeing to later resell it for a profit. Sometimes, investors engage in a leveraged buyout with the intention of conducting an initial public offering (IPO) once the company has been turned around. Not long ago, private equity leveraged buyouts focused primarily on the non-core business entities associated with publicly listed companies, but the practice has taken on a much broader scope.
For the typical leveraged buyout transaction, a private equity firm will create a special purpose vehicle and then use both debt and equity to finance the transaction. Overall, debt financing can account for the vast majority of funds in the transaction. This debt financing is transferred to the acquired company’s balance sheet, which has tax benefits. Then, the purchasing firm enacts a strategy for turning around the company, such as installing new management teams or streamlining the workforce.
Fund of Funds
The name of this private equity approach gives away the strategy. Investors pool money in a fund and then focus on investing in other funds, such as hedge or mutual funds. The primary benefit of a fund of funds is that it gives investors who are unable to afford the minimum capital requirements for certain funds a backdoor entry to them. However, the fund of funds can have some drawbacks. One thing that investors need to investigate before investing in a fund of funds is the management fees. Since the fees from several funds are rolled together, the resulting charges can be quite high. Additionally, a fund of funds may not fit well into an investor’s investment strategy depending on his or her goals and expectations.
Sometimes called by the pejorative name “vulture financing,” distressed funding means investing in a troubled company that is not performing well. With this type of funding, investors hope to turn the company around by making key changes to operations and management, or by selling certain assets, which can range from intellectual property to real estate. Investors often target companies that have filed for Chapter 11 bankruptcy in the United States when engaging in this type of private equity transaction. Distressed funding has been a fairly popular approach to private equity since the financial crisis of 2008.
Real estate is another type of private equity investment that experienced a surge after the 2007-2008 crisis. After 2008, the prices of properties fell precipitously, although many markets have since recovered. From a private equity perspective, investors can get involved through commercial real estate, as well as real estate investments trusts (REITs). Private equity funds focused on real estate often have higher minimum capital requirements for investments, and investors’ money is often locked away for several years at a time. However, the private equity real estate market is expected to reach $1.2 trillion by 2023.