What Is Private Equity, and How Does It Work?
Private equity (PE) involves a group of wealthy individuals coming together to purchase a company. Investopedia says that “private equity investment comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended time periods.”
These investors fit two separate categories: limited partners and general partners. The limited partners receive a smaller percentage of the profits than the general partners since the general partners manage and maintain liability for the fund. Most PE firms, such as Kohlberg Kravis Roberts (KKR & Co.) and Bain Capital, have significant portfolios and are worth billions of dollars.
Another important point is that the private equity exchanges do not occur on public markets. Depending on the situation and the type of private equity, the PE firm can buyout a public company, which takes the public equity off the market, or invest directly into a private company.
When they make the purchase, a private equity firm usually does not intend to keep the company forever. Instead, PE firms will usually have an exit strategy in place at the time of purchase. Their goal is to maintain the company for a designated amount of time, improve its margins, and sell it for a profit.
What Are the Types of Private Equity?
As mentioned in the previous section, there is more than one type of private equity. Each type involves institutional and accredited investors that are raised for different types of companies and can be used for different purposes.
These are not the only types of private equity, but these are some of the most common. Additionally, they are not always mutually exclusive from each other or from other types of financing, such as debt financing.
A leveraged buyout is what most people associate with the term private equity. In this type of transaction, a PE firm identifies a company that they wish to takeover. After selecting a company, they utilize a combination of equity and debt to make the purchase. Their goal is to improve the company over several years, then sell it off to another interested group or conduct an initial public offering (IPO).
Sometimes, the firm will purchase the company in its entirety, while other times it will simply purchase a majority stake. Either way, this allows them to control strategy and direction so that they can improve its current profitability and long-term projections, therefore increasing its value.
Fund of Funds
As you can probably guess from the name, a fund of funds maintains a portfolio that includes a diverse group of equity funds, as opposed to individual companies. This lowers the entry cost, which allows individuals and industrial investors who otherwise could not enter the market to invest. Most often, fund of funds invest into hedge and mutual funds.
Fund of funds are managed management teams of professional investors. This team charges fees to the individual and institutional investors to make informed decisions regarding their assets under management.
While most private equity firms buy mature companies, venture capitalists (VC) seek out promising startups which could grow to yield significant profits. Oftentimes, the portfolio companies that VC firms invest in have significant growth potential, but need outside capital to reach that potential. VC firms rarely, if ever, take majority ownership. Instead, they make a smaller investment, allowing the management team to continue as the primary decision-makers.
Profitability is not a requirement for a VC portfolio company, but a decent cash flow and solid business plan are. Venture capitalists take a significant risk with every portfolio company, since it could crash and burn without ever becoming profitable. As a result, VC firms tend to hold a diverse portfolio consisting of many investments in the $10 million range.
With growth capital, the goal is to provide a mature, proven company with resources to expand even more. The idea is similar to venture capital, but it presents less of a risk since the companies are already profitable. However, this means that the potential reward is also much smaller.
Companies that receive growth capital can use it for a variety of purposes. This includes entering a new marketplace, developing new products, or making a significant sales push.
There is a great deal of variety within real estate private equity, which centers on the exchange of property. Some real estate PE involves small investments that are sure to yield consistent cash flow, such as apartment rental buildings. This approach invokes the more typical PE approach of buying something that is sure.
On the other extreme, real estate PE can look more like venture capital. By making speculative moves on land that is projected to hold more worth later, real estate PE take a risk but also could achieve significant profits down the road.
Distressed funding is a specific version of the leveraged buyout. In this scenario, a mature company is struggling financially. A PE firm swoops in and purchases some or all of the shares for pennies on the dollar. The firm then attempts to restructure and revive the portfolio company, so that they can sell it at a profit later.
A firm could also purchase a company just to dissolve it and sell all of their assets for a profit. Many hedge funds also focus on distressed companies, so the line between these two is not always clear.
What Are the Advantages and Disadvantages of Private Equity
The benefits and drawbacks of private equity vary depending on what stage of growth your company is in, as well as the type of equity. For instance, venture capital benefits young, unproven companies by allowing them to obtain capital, while a leveraged buyout allows a mature company to restructure and improve.
Here are a few of the most important advantages of private equity.
With public companies and companies that are sold on the public markets, there are significant regulations. Any company that conducts an IPO must comply with the myriad of terms of the Security and Exchanges Commission.
However, private equity is available to a much smaller pool. Regarding private equity, Investopedia says, “there is less concern from the SEC regarding participating investors’ level of investment knowledge because more sophisticated investors (such as pension funds, mutual fund companies and insurance companies) purchase the majority of private placement shares.”
Since a private equity firm’s success depends on the success of your company, they will care about your business. Oftentimes, this means that they will want to be involved. With many PE firms having years of knowledge in your industry, their mentorship and opinions should help you improve your business.
Compared with other means of raising capital, private equity usually provides the most. Alternatives such as angel investors and bank loans do not get close to the amount of capital that private equity can provide.
Most private equity investments are upwards of $100 million. While these investments go into companies that are worth much more, this type of capital injection can still produce significant results.
However, there can also be some major disadvantages to private equity.
The entire premise of private equity is giving up a percentage of the ownership in your business for capital resources. However, giving up a majority of your company’s equity is nothing to ignore. Giving up all of our equity makes it difficult for you to obtain additional financing down the line.
While the mentorship provided by the PE firm can be helpful, it can also be frustrating. When the management team and the firm have different ideas about the direction and practices of the company, there can be significant conflicts.
What Types of Companies Use Private Equity
Because of the variety of funding options that fall under the umbrella term of private equity, there is no singular type of company that can utilize it. However, different company types fit different PE types.
To be eligible for leveraged buyouts, distressed funding, or growth capital, your company should be proven and mature. This does not necessarily mean that you are currently profitable. The goal of these investors and firms is to revitalize a company that has already shown what it can do, but is struggling.
To that end, most PE firms invest roughly $100 million into their portfolio companies. This means that businesses worth significantly less are not common targets for leveraged buyouts or distressed funding. It also means that these types of PE firms have a consolidated portfolio, with a few very large companies. However, younger and smaller companies can still get in on private equity through venture capital.
What Does RevTek Offer?
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Our process and terms are simple, allowing you to obtain from $3MM to $30MM in growth capital. You can use the capital to meet any of your business’s needs and improve your sales and marketing, expand your broadband network or broadband development, acquire new equipment through purchase or equipment leasing, or develop new services. Contact Us today.