The term private equity can often be hidden by a cloud of mystery, but it is just a different form of investment that does not get listed on the stock exchange. Instead, the company is financed by funds or private equity investors. Private equities are often seen as a way to accumulate larger amounts of investment capital. and it usually arrives from high net worth individuals or similar firms.
Who Invests in Private Equity: Types of Private Investors
Since they are not listed on the publicly traded, private businesses look to individuals, firms, and funds to finance their ventures. There are some key types of investors who look to profit from investing in companies with a lot of potential. They are:
Angel investment is usually executed by high net worth individuals or accredited investors, who focus on entrepreneurs and small start-ups. Often times, the angel investor comes from a family of entrepreneurs or they may have a close circle of friends who are into entrepreneurship.
Many professionals and investors may ask themselves the question, ‘why should I invest in private equity?’ The funds provided by these investors are extremely helpful in order to get the business up and running. However, their contribution may be diminished once the business grows becomes larger. A typical holding portfolio of a company does not include more than 10% contribution from angel investors.
Venture capitalists usually invest in young companies and start-ups that do not have a profitable record. The investment is made with the view of improving the outsized returns and helping the companies flourish. Since this space offers a lot of growth opportunities, it has become a growing asset class. For example, venture capitalist interest exceeded more than $130 million in 2018.
Private equity (PE) firms, or private equity funds, are alternative investment management companies. PE firms are essentially a pool of funds utilized to invest in or buy businesses.
This type of investment is also quite attractive in the eyes of hedge funds. Sometimes, these can be confused with venture capitalists since they are both investing in and exiting from companies. However, the PE firms differ with aspects like size and the type of companies that they prefer. PE firms tend to go for mature companies that are well established in the market.
Friends and Family
Friends and family make up a relatively small investor sector. Most of the investment from friends and family comes in the early stages of the business. Often, this may not be sufficient to get the company up and running successfully. Generally, the average investment through this method is only around $30,000. While it may not be the most substantial, they may be more forgiving to your business’ ups and downs.
Although this is a more casual method, always be sure to thoroughly document everything. This way, the investor understands what they are getting into and it may safeguard from potential legal trouble in the future. The risks involved need to be explained clearly. If you don’t play your cards right, there is a risk of losing a good relationship when it comes to private equity for small investors, regardless of friendship or blood ties.
Private Equity’s Advantages
There are numerous advantages that start-ups and companies can enjoy from being private equity versus listed in public markets. One of the biggest benefits to the company is the availability of liquidity. This helps with carving out a business plan for the future. Additionally, companies that are traded in public markets are obligated to publicly disclose all financial reports and earnings every quarter. On the other hand, private companies keep their finances private and are granted discretion to decide who they may want to share it with.
Publicly held companies often feel ample pressure to have glimmering quarterly earnings to appease shareholders and attract new investors. Private companies do not face the same rigid standards, allowing them to breathe freely and focus on long term objectives, goals, and success. Overall, private companies enjoy much more flexibility and freedom.
Private Equity Disadvantages
As with everything, owning private equity has a set of downsides. The liquidation process may be rather difficult for the funds' manager to find buyers – unlike the case with public markets where buyers and sellers are able to meet in great numbers. The pricing for private equity is only decided while negotiating between buyers and sellers. As a result, there is a tendency for undervaluation at the time of sale.
Creating Value through Private Equity
Many search for answers to the question, “Can I invest in private companies?” There are a couple of ways through which a company is capable of raising funds to utilize for their business, administrative, and overhead costs. Irrespective of the numerous choices, it is possible to generate investments with two important functions:
- Transaction execution/deal origination
- Portfolio oversight
The deal origination is all about creating, preserving, and improving the relationship with M&A (mergers and acquisitions), investment banks, intermediaries, and other professionals in order to get high-quality deals flying at a higher quantity. The deal flow is all about the acquisition of prospective candidates to invest in. The companies may hire staff in order to identify and get in touch with potential leads on a proactive basis. It is important to keep acquiring new leads in this incredibly competitive landscape. This helps in the easy acquisition of equity investments, which can be put into the growth of the business.
The business also needs to work on lowering the transaction costs by reducing the fees given to middlemen in the world of investment banking. The financial professionals will be able to provide a full auction of the process so as to reduce the chances of a buyer successfully getting hold of a company. The deal origin professionals are meant to establish a good relationship with the transaction professionals so as to get an early lead.
Private equity funds are often raised on their own by investment banks and businesses. They often do not offer a lot of space for a competitive bidder. The competition ramped up by the investment banks for acquiring good companies make it tough for private equity firms.
The completion of a transaction involves going through a lot of aspects like management assessment, industry assessment, valuation analysis, and overseeing the financial history and forecast. The investment community agrees to a particular acquisition candidate and this leads to the deal professionals providing an offer to the seller. If the two parties are happy with the offer, the deal professionals start to work on the transaction aspect with investment bankers and lawyers in order to complete the due diligence phase. This phase is extremely critical in order to uncover potential aspects that can kill the deal.
Conclusion: Strategies in Private Equity Investment Are Limitless
The process of investing in private equity firms is not always easy since there are multiple strategies that may need to be applied. Two popular strategies are venture capital investments and leveraged buyouts.
The process of venture capitalism varies. This is because it largely applies to take an equity position in a very small and young firm. A lot of factors are taken into account like debt financing, cash flow, and revenue flow. This is very similar to mutual funds because a purchase is being made on the basis of potential.
A leveraged buyout is a process that is followed by angel investors who are trying to make an investment in a private company. They make the purchase through debt that is collateralized on the assets and operations of the firm. The PE firm tends to pick up the target using the funds obtained through the target’s use as collateral.
The heavy upside when it comes to investing in private companies has given rise to a greater amount of interest in this field over the last few decades.