Steps to Successful Private Equity Investing

Private Equity Investing- How to Get Started, Pros & Cons

We all know that publicly listed companies raise capital by offering shares to interested investors. However, have you ever wondered how companies not listed on stock exchanges raise funds? The simple concept behind this question is private equity. If you want to delve deep into what private equity is and how it generates money, don't stop scrolling down!

What is Private Equity in Simple Terms? 

Private equity is a bundle of investment funds dedicated to investing or acquiring private companies not present on stock exchanges. It is a financing mechanism where both public and private companies receive investments from a PE fund. Private equity aims at established businesses in more traditional industries to secure equity stake in return for their investment. PE fund is also engaged in acquiring public companies, making them private entities and subsequently restructuring them to expand for future potentials.

Key Highlights

  1. Private equity means investing in companies not listed on the stock exchanges.
  2. Private equity investment enhances a company's growth to a level that makes it eligible for either an IPO or acquisition by a larger equity.
  3. In return for private equity investments, the investors receive fees and profits where investors assume the role of shareholders in the company.

How Does Private Equity Make Money?

Private equity makes money through investments. These investments are further categorised into five categories.

1. Leveraged buyout (IBO)

It is the most preferred strategy in private equity investment. In a leveraged buyout, the private equity firm acquires a controlling interest in a company by deploying a combination of equity and the amount of debt, which is added to the company's balance sheet. The company under the private equity firm’s ownership assumes the responsibility of repaying this debt. A portfolio company repays these debts using the cash generated from operational developments that are done during the tenure of a private equity firm. 

In a leveraged buyout strategy, more emphasis is given to restructuring and operational improvement to increase the company's value and facilitate the repayment of leveraged debt.

2. Growth equity

It is again a private equity strategy that focuses on investing in mature private companies that are growing revenues but are not yet profitable. The investors, through growth equity, do not acquire a majority stake in the company; instead, they typically purchase a minority stake. 

Growth equity and venture capital are often used interchangeably but have key differences, such as investment sizes, where growth equity investments are associated with larger deals than typical venture capital investments. Growth equity investments are made in those companies that have already shown substantial revenue growth. The company targets positive revenue in growth equity; profit is not an immediate requirement.

3. Venture capital

Venture capital plays a vital role in supporting startups and small emerging businesses that face challenges due to lack of funds. Venture capital provides the necessary funds when the companies demonstrate high growth potential and better business plans. These funds help small businesses and startups to fuel at the early stage of development, which enables them to pursue innovations to scale up their operation and manage the initial hurdles of establishing a business.

In addition, venture capitalists contribute their expertise and strategic guidance to assist startups to realise their full potential and achieve long-term success.

4. Secondary investments

In secondary investments, the stakes are acquired in a private company from another private investor. The main objective is to offer liquidity for existing limited partners. This also allows investors to purchase a stake in the portfolio companies closer to realising an exit. 

Secondary investment experienced significant growth from 2012 to 2022. The global deal market expanded from $13 billion to $60 billion during this period, highlighting the increasing importance of secondary investment for investors navigating the private market.

5. Fund of funds

In this strategy, the private equity firm pools money from investors using mutual funds or hedge funds as vehicles. This approach benefits retail investors who need more financial capacity to invest significant amounts directly into individual funds or companies. The fund-of-funds firms invest in a diversified portfolio of external funds. This offers diversification, which also comes with fees for fund-of-fund investors; however, the potential benefits are comparatively more than the associated cost.

Pros and Cons of Private Equity 

Pros of Private Equity

For  Business: 

  1. Alternative funding source:  Private equity provides alternative means to reach capital to many businesses without going for traditional bank loans or public stock market offerings. This also connects private equity firms with professionals with industry expertise to expand the business.

  2. Fulfills long-term objective:  Private equity structure helps businesses to focus on long-term growth rather than meeting short-term objectives. 

For Individual

  • High Return: Private equity funds offer investors the potential for high returns. Sometimes, the fund structure even offers incentives to private investors. 

  • Tax advantage: Investors may benefit from private equity investments' financial and tax advantages.

  • No market restrictions: Private equity investments do not restrict the investors they may face with trading on the security market. It helps them make flexible decisions.

Cons of Private Equity
For Business

  1. Lengthy process: The process of acquiring private equity funds often becomes lengthy, which requires companies to show the worthiness of the investment.

  2. Changes in management and business structure: Private equity investments often involve business management or structure changes. Investors want to implement strategic changes to enhance the company's performance, which can be challenging for the existing management.

For individual investors

  1. Limited accessibility: Private equity is limited to institutional and accredited investors, which restricts the access of individual or small investors.

  2. Longer gain on returns:  Private equity investments may take several years to earn a return. Due to their lower liquidity, investors must wait until the end of the fund's life or exit events to see substantial returns.

How much does the average person in private equity make? 

Average investors need direct access to private equity investing. They must fulfil accredited investor criteria to invest in private equity; however, there are other alternative options for investors who want exposure to private equity.

  1. Publicly traded private equity firms: Some of the largest private equity firms, like Carlyle Group, Kohlberg Kravis Robert and Blackstone Group, are publicly traded. Average investors can buy shares of these companies on a stock exchange, which provides them with indirect exposure to private equity investments.

  2. Exchange-traded funds in mutual funds: There are exchange-traded funds and mutual funds that only focus on investing in publicly traded shares of private equity firms. By investing in these assets, the average investor gains access to a diversified approach and a range of private equity investments.

Final words

Private equity is a financial strategy in which companies secure funds directly from firms or accredited investors. Private equity firms make direct investments in companies, which comes with a commitment, as many companies are not publicly traded. The main objective of private equity investment is to facilitate a company's growth and make it eligible for public offering or acquisition by a larger entity.

Also Read:

  1. What is Asset Management

  2. Fiduciary Surety Bonds

  3. How to invest in Commodities

28 Jan, 2024


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