Overview of Private Equity

An equity investment in a business, which is not traded on the capital market, is referred to as private equity. Individuals or private institutions invest in companies with growth potential, without managing the business on a day to day basis through portfolios of private equity projects. They take the private equity route through limited partnerships, which allows them to invest in the portfolio projects while maintaining limited liability. Private equity experts involved in such a portfolio, called general partners, are usually involved with management decisions of the companies that form part of the portfolio. The general partners usually belong to the private equity company or the private equity division of a financial institution.

The limited partnership is referred to as the fund. Sometimes several private equity funds pool their funds together. Investors, private and institutional, can also invest in such ‘fund of funds’.

The most well- known form of private equity investing is venture capital funding. This is also considered the most traditional form of private equity. Venture capital funding has founded several technological successes and failures. In this form of private equity a business is funded from incubation, through set-up, R&D, production and an exit strategy through a buy-out or an initial public offering (IPO). The time frame of such investment is for several years at a time. Venture capitalists usually have several hits and misses in their portfolio. A big success however makes it viable for the investor to invest in further businesses.

Another form of private equity and possibly the largest category in it is the Leveraged Buy Out. Unlike a venture capitalist that has a minority interest in the company of choice, a leverage buyout investor has a majority stake in the company it is buying out. Usually these companies are publicly traded, but once the buy-out happens they usually become privately held. These buyouts see the private equity firm putting 20-40% of its own funds and borrowing the rest, hence the term leveraged buyout. The private equity firm then adds value to the company by involving itself in management and re-engineering it. It then puts up the firm up for sale either privately or through an IPO.

A variant of the leveraged buyout is the management buyout. In this format the managers of the acquired company become large investors in it. Large buyouts usually exceed $10 billion. There are however usually mid-size companies taken into the portfolio. A lot hinges on value addition when the company goes private. Private equity comes from across the globe. An acquired firm usually adds value with the help of its managers, hence management buyouts, to ensure a higher rate of success.

Yet another form of private equity is called distressed investing or vulture investing. Here private equity players zoom in on companies in financial distress. They then buy them out cheaply and restructure them. Any positive accruals made initially first go to debtors.

Another form of private equity investment is private investment in public equity (PIPE). These are the securities issued by public companies to private equity investors at a discount to the prevailing market price.

Additional Resource (Video): Private Equity Model-how private equity firms help businesses.