Private equity is an alternative investment class and consists of capital that is not listed on a public exchange.
Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity. Institutional and retail investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet.
A private equity fund has Limited Partners (LP), who typically own 99% of shares in a fund and have limited liability, and General Partners (GP), who own 1% of shares and have full liability. The latter are also responsible for executing and operating the investment.
Understanding Private Equity
Investment comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended time periods. In most cases, considerably long holding periods are often required for private equity investments in order to ensure a turnaround for distressed companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public company.
It offers several advantages to companies and startups. It is favored by companies because it allows them access to liquidity as an alternative to conventional financial mechanisms, such as high interest bank loans or listing on public markets. Certain forms of private equity, such as venture capital, also finance ideas and early stage companies. In the case of companies that are de-listed, private equity financing can help such companies attempt unorthodox growth strategies away from the glare of public markets. Otherwise, the pressure of quarterly earnings dramatically reduces the time frame available to senior management to turn a company around or experiment with new ways to cut losses or make money.
It comes with its own unique riders. First, it can be difficult to liquidate holdings in private equity because, unlike public markets, a ready-made order book that matches buyers with sellers is not available. A firm has to undertake a search for a buyer in order to make a sale of its investment or company. Second, pricing of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces, as is generally the case for publicly-listed companies. Third, the rights of shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their counterparts in public markets.
How Does It Work?
Firms raise money from institutional investors and accredited investors for funds that invest in different types of assets. The most popular types of private equity funding are listed below.
– Distressed Funding: Also known as vulture financing, money in this type of funding is invested in troubled companies with underperforming business units or assets. The intention is to turn them around by making necessary changes to their management or operations or make a sale of their assets for a profit. Assets in the latter case can range from physical machinery and real estate to intellectual property, such as patents. Companies that have filed under Chapter 11 bankruptcy in the United States are often candidates for this type of financing. There was an increase in distressed funding after the 2008 financial crisis.
– Leveraged Buyouts: This is the most popular form of private equity funding and involves buying out a company completely with the intention of improving its business and financial health and reselling it for a profit to an interested party or conducting an IPO. Up until 2004, sale of non-core business units of publicly listed companies comprised the largest category of leveraged buyouts for private equity. The leveraged buyout process works as follows. A private equity firm identifies a potential target and creates a special purpose vehicle (SPV) for funding the takeover. Typically, firms use a combination of debt and equity to finance the transaction. Debt financing may account for as much as 90% of the overall funds and is transferred to the acquired company’s balance sheet for tax benefits. Firms employ a variety of strategies, from slashing employee count to replacing entire management teams, to turn around a company.
– Real Estate Private Equity: There was a surge in this type of funding after the 2008 financial crisis crashed real estate prices. Typical areas where funds are deployed are commercial real estate and real estate investment trusts (REIT). Real estate funds require higher minimum capital for investment as compared to other funding categories in private equity. Investor funds are also locked away for several years at a time in this type of funding. According to research firm Preqin, real estate funds in private equity are expected to clock in a 50% growth by 2023 to reach a market size of $1.2 trillion.
– Fund of Funds: As the name denotes, this type of funding primarily focuses on investing in other funds, primarily mutual funds and hedge funds. They offer a backdoor entry to an investor who cannot afford minimum capital requirements in such funds. But critics of such funds point to their higher management fees (because they are rolled up from multiple funds) and the fact that unfettered diversification may not always result in an optimal strategy to multiply returns.
– Venture Capital: Venture capital funding is a form of private equity, in which investors (also known as angels) provide capital to entrepreneurs. Depending on the stage at which it is provided, venture capital can take several forms. Seed financing refers to the capital provided by an investor to scale an idea from a prototype to a product or service. On the other hand, early stage financing can help an entrepreneur grow a company further while a Series A financing enables them to actively compete in a market or create one.
How Do Private Equity Firms Make Money?
The primary source of revenue for private equity firms is management fees. The fee structure for private equity firms typically varies but usually includes a management fee and a performance fee. Certain firms charge a 2% management fee annually on managed assets and require 20% of the profits gained from the sale of a company.
Positions in a private equity firm are highly sought after and for good reason. For example, consider a firm has $1 billion in assets under management (AUM). This firm, like the majority of private equity firms, is likely to have no more than two dozen investment professionals. The 20% of gross profits generates millions in firm fees; as a result, some of the leading players in the investment industry are attracted to positions in such firms. At a mid-market level of $50 to $500 million in deal values, associate positions are likely to bring salaries in the low six figures. A vice president at such a firm could potentially earn close to $500,000, whereas a principal could earn more than $1 million.
– It is an alternative form of private financing, away from public markets, in which funds and investors directly invest in companies or engage in buyouts of such companies.
– Firms make money by charging management and performance fees from investors in a fund.
– Among the advantages of private equity are easy access to alternate forms of capital for entrepreneurs and company founders and less stress of quarterly performance. Those advantages are offset by the fact that private equity valuations are not set by market forces.
– It can take on various forms, from complex leveraged buyouts to venture capital.
Beginning in 2015, a call was issued for more transparency in the private equity industry due largely to the amount of income, earnings, and sky-high salaries earned by employees at nearly all private equity firms. As of 2016, a limited number of states have pushed for bills and regulations allowing for a bigger window into the inner workings of private equity firms. However, lawmakers on Capitol Hill are pushing back, asking for limitations on the Securities and Exchange Commission’s (SEC) access to information.
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