Features and Investment Characteristics of Private Equity

Private capital refers to the funding provided to companies not sourced from public markets or traditional institutional providers such as government or banks. Private capital consists of private equity and private debt.

Private Equity

Private equity is an investment in privately owned or public companies to privatize them. A private equity firm manages a private equity fund as a collection of investments. The company in which the firm invests is referred to as a portfolio company. Some of the primary strategies of private equity include:

• Leveraged buyouts.
• Venture capital.
• Growth capital.

Leveraged Buyout (LBO)

Leverage buyouts entail private equity firms creating buyout funds for the purpose of purchasing publicly traded or well-established private companies. A substantial portion of the acquisition cost is funded through borrowing, with the target company’s assets serving as security for the borrowed funds. It is anticipated that the cash flows generated by the target company will be ample to cover the debt obligations. Following the transaction, the target company transitions into private ownership or maintains its existing private status.

LBOs are two-fold: management buyouts (MBOs) and management buy-ins (MBIs). In a management buyout (MBO), the existing management team is retained and incorporated into the acquisition. On the other hand, in management buy-ins (MBIs), the current management team is replaced with the acquiring company’s management.

LBO managers aim to add value by improving company operations, boosting revenue, and ultimately increasing profits and cash flows.

Venture Capital (VC)

Venture capital (VC) involves providing financial support to or investing in private companies with high growth potential. Financed companies are usually startup companies. Nevertheless, venture capital is also applicable to companies at any growth stage, provided the company in question qualifies for funding. It is, however, imperative to note that the venture capital extended to a startup company will demand higher returns due to high-risk potential. Equally noteworthy is the fact that venture capitalists are active investors.

Venture capitalists invest in companies and earn an equity interest. In other words, they provide funding in the form of debt. Given the foregoing clarifications, we have three stages of venture capital financing:

Like all private equity managers, venture capitalists are active investors who are directly involved with their portfolio companies. They typically invest in companies and receive an equity interest but may also provide financing in debt, often convertible debt.

Convertible preferred shares are often used in startups to raise private capital from venture capital funds. These shares include an option for the holder to convert the preferred shares into a fixed number of common shares after a predetermined date and price. This provides incentive alignment between the entrepreneurs in the startup and the investor.

In the event of a liquidation, preferred convertible shareholders have seniority over common shareholders and are entitled to recover the entire value of their investment before common shareholders receive any of the proceeds.

Stages of Venture Capital

1. Pre-seed capital or angel investing: Funds are provided at the conception or idea stage. The funds are invested in turning a business idea into a workable business plan. At this stage, funds are sourced from individuals dominantly made up of family and friends. Note that venture capital (VC) funds are usually not utilized at this point.
2. Seed-stage financing (seed capital): This is the stage where VC is used. The funds are used for product development and market processes such as market research.
3. Early-stage financing (early-stage VC), or startup stage financing: This is where funds are given to companies on the verge of launching operations.
4.  Later-stage Financing (Expansion Venture Capital): Later-stage financing involves providing funds to companies after starting commercial production and sales. The funds may support initial growth, expansions, or significant marketing. Nevertheless, this happens before they venture into an initial public offering (IPO).
5. Mezzanine-stage Financing: In mezzanine-stage financing, the financed company is prepared to go public. The company is thus financed until its IPO is completed or sold. Note that the term mezzanine implies that a company is financed as it transitions from private to public.

It’s important to distinguish between mezzanine financing and mezzanine-stage financing. Mezzanine financing refers to using equity-debt hybrid instruments, such as convertible debt or convertible preferred. In contrast, mezzanine-stage financing can use mezzanine financing, but at this stage, the primary financing is typically either equity-like or short-term debt aimed at capturing potential gains from the planned IPO.

Growth Capital

Another type of private equity is growth capital, also called growth equity or minority equity investing. Growth capital involves minority equity investments. It is a case in which a firm owns a less-than-controlling interest in more mature companies seeking funds for expansion or restructuring, venturing into new markets, or funding significant acquisitions.

Usually, it is the management of the receiving company that requests growth capital. The requisitioning company aims to profit by selling a percentage of its shares before it goes public. The company aims to retain its existing management and consolidate its accomplishments.

Note that publicly quoted companies can also seek private equity capital through private Investments in public equities (PIPEs), where private offerings are made to select investors such as investment firms, mutual funds, or other institutional investors. This method of raising capital is characterized by fewer disclosures and lower transaction costs, making it a quicker and more cost-effective alternative to other, more regulated means.

In a traditional PIPE transaction, the securities offered can be newly issued common stock, shares sold by existing stockholders, or a combination of both. These investors enter into a definitive purchase agreement with the issuer, committing to purchase the securities at a fixed price. PIPE transactions are commonly used in work-out or rescue situations, where there is a significant difference between the market price and valuations.

PIPE transactions can be dilutive to existing shareholders. This is because the new investors typically require a discount from the market on the purchase price. This can introduce incentive conflicts between existing shareholders and new shareholders.

Private Equity Exit Strategies

Private equity firms aim to enhance the performance of businesses and then sell them at higher valuations. The decision on an exit strategy is influenced by several factors, including the dynamics of the industry in which the portfolio company operates, the overall economic cycle, interest rates, and the company’s performance.

A private equity fund typically has an investment period of about five years, followed by a harvesting period when the exit occurs and the valuation environment becomes more relevant. It’s important to note that investments in private equity funds are not made in a single payment. Instead, they are spread over time using committed capital over several years. This approach gives managers significant flexibility to optimize their entry and exit points.

There are two primary exit strategies: trade sale and public listing.

Trade Sale

A trade sale involves selling a portion or a division of a private company either through a direct sale or an auction to a strategic buyer.

This buyer is typically interested in expanding the scale and scope of their existing business. However, this type of transaction can impact the competitive environment, leading to potential regulatory scrutiny and approval. It may also face resistance from management or employees who may fear layoffs.

Advantages of Trade Sale

• There is an immediate cash exit for the private equity fund.
• There is the motivation for strategic buyers to pay more because they anticipate integration with their businesses.
• The trade sale is fast and straightforward.
• Transaction costs are lower compared to an IPO.
• There are lower levels of disclosure and, hence, higher confidentiality compared to an IPO.

Disadvantages of Trade Sale

• There is potential opposition from the management.
• It is less attractive to portfolio company employees than those for an IPO since employees can monetize the shares.
• There is a limited number of potential trade buyers.
• There is a possibly lower price for the sale compared to an IPO.

Public Listing

Public listing on an exchange can occur through three main methods:

• Initial public offering (IPO),
• direct listing, or
• special acquisition company (SPAC).

Initial Public Offering (IPO)

The most prevalent method is the IPO, which involves raising capital in public equity markets by selling its shares with the help of financial intermediaries who underwrite the offering. For instance, when Facebook went public in 2012, it was through an IPO.

Advantages of an IPO

• There is a chance of selling shares at the highest price.
• There is a high chance of management approval since it is retained.
• It enhances a private equity firm’s publicity/visibility.
• If private equity holds onto some shares, there will be future upside potential.

Disadvantages of an IPO

• High transaction fees to investment banks and lawyers,
• A potentially long completion time and the requirement for onerous disclosure.
• The public equity market also introduces stock market volatility.
• The potential lockup period (which mandates the private equity firm to retain an equity position for a specified period post-IPO) may limit a quick realization of value.
• Not all companies are suitable for an IPO. Smaller companies, those operating in out-of-favor industries, ones with unclear strategic priorities and unstable financial positions, may not be ideal candidates for an IPO.

Direct Listing

In this method, the equity of the entity is floated on the public markets directly, without underwriters. This reduces the complexity and cost of the transaction. For example, Spotify chose to go public through a direct listing in 2018, bypassing the traditional IPO process.

Special Purpose Acquisition Company (SPAC)

A Special Purpose Acquisition Company (SPAC) is a financial tool used for a public exit strategy. It can be considered a “blank check” entity established solely to acquire an unspecified private company within a predetermined timeframe. For example, a SPAC could be formed to acquire a tech startup within two years.

Should it fail to achieve this objective, it is obligated to return the invested capital to its backers. Companies suitable for an Initial Public Offering (IPO) are often suitable candidates for SPACs. However, it’s important to note that the methods used for valuing SPACs and IPOs differ. With SPACs, a single party establishes the terms, which helps reduce the risks surrounding the valuation.

Advantages of SPAC Exit

• Extended time for public disclosure on company prospects to build investor interest: Unlike traditional IPOs, SPACs allow for a longer period of time to disclose information about the company, which can help build investor interest.
• The flexibility of transaction structure to best suit the company’s context: SPACs offer more flexibility in structuring the transaction, which can be tailored to suit the specific needs of the company.
• Association with potentially high-profile and experienced sponsors and their extensive investor network: SPACs are often sponsored by high-profile individuals or firms, which can bring credibility and a broad investor network to the table.
• The valuation of the entity is fixed in advance and does not change, reducing both the volatility and the uncertainty of share pricing.
• SPACs) are permitted to offer more comprehensive forward-looking guidance regarding a company’s potential than an IPO: This allows the company to provide more detailed information about its prospects, which can help attract investors.

Disadvantages of SPAC Exit

• SPAC transactions raise the cost of capital due to the dilutive effects of various capital instruments, such as warrants. This means that the value of existing shares can be diluted, increasing the cost of capital. For example, if a SPAC issues new shares to raise capital, the value of existing shares might decrease.
• There exists a valuation gap between the value of SPAC equity and the equity acquired by SPAC. This can be further complicated by possible dilution effects:
• Particular deal-related risks could also be linked to the successful execution of the definitive purchase and merger agreement. This refers to the risk that the deal might not go through as planned. For example, regulatory hurdles or disagreements between the parties could derail the deal.
• Regulatory authorities, including the US SEC, are reevaluating the categorization of SPACs under well-established regulations that may introduce stricter operating standards. This could make it more difficult for SPACs to operate and impact their attractiveness to investors.
• There can be substantial trading activity in SPAC equity in the months following the announcement of a purchase transaction, resulting in a stockholder overhang. This influx of large blocks of shares sold on the open market can exert downward pressure on the share price, causing volatility and potentially diminishing the value of the shares.

Other Exit Strategies

In private equity, a firm has several other exit strategies at its disposal. These strategies include recapitalization, secondary sale, and write-off/liquidation.

Recapitalization

Recapitalization is a strategy involving the firm increasing or introducing leverage to its portfolio company and paying itself a dividend from the new capital structure. For example, a private equity firm might introduce debt into a previously debt-free company and then use the borrowed money to pay a dividend to itself.

This is not a true exit strategy, as the private equity firm typically maintains control. It allows the private equity investor to extract money from the company to pay its investors and improve its internal rate of return (IRR).

Secondary Sale

A secondary sale is another exit strategy that involves the sale of the company to another private equity firm or group of financial buyers. For instance, a private equity firm might sell a successful startup to another private equity firm.

Write-off/Liquidation

A write-off or liquidation takes place when a transaction has not performed well, and the investment will probably depreciate. The private equity firm then revises the value of its investment downward or liquidates the portfolio company before moving on to other projects.

Private Equity Investment Categories

Private equity investments can be categorized into direct and indirect investments. Direct investments are those made in a single, specific asset. For instance, an investor might directly invest in a startup company like Uber or Airbnb.

On the other hand, indirect investments are made through a fund-of-funds vehicle that holds stakes in various other private funds. This is akin to investing in a mutual fund that holds a portfolio of different stocks.

Another form of private equity investment is co-investments, where the investor participates alongside a main sponsor who sources, structures and executes the transaction. This is similar to a scenario where an investor partners with a venture capital firm to invest in a promising startup.

Risk–Return from Private Equity Investments

Higher-Return Opportunities

Private equity funds may offer higher return opportunities compared to traditional investments. This is due to their ability to invest in private companies, influence portfolio companies’ management and operations, and use of leverage. Using leverage or borrowed money, can also amplify returns if the investment is successful.

Risks

Investing in private equity, including venture capital, is riskier than investing in common stocks. It requires a higher return for accepting its higher risk, including illiquidity and leverage risks. Illiquidity risk refers to the difficulty of selling an investment, while leverage risk refers to the potential for losses if the investment does not generate enough return to cover the cost of borrowed money.

Comparing Private Equity and Public Equity

Both private equity and public equity entail direct ownership and control of a company. In both cases, owners are shareholders with voting rights at the annual general meeting of shareholders, and they have a direct and proportionate claim to residual cash flow rights through dividends.

However, private equity ownership offers greater direct control over decision-making than public equity, primarily because of substantial shareholdings. Consequently, effectively managing direct private investment exposure necessitates specialized knowledge specific to the industry and sector in which the firm operates.

Question 

Which of the following best describes private capital?

1. Funding is sourced from public markets or traditional institutional providers such as government or banks.
2. Funding is provided to companies that are sourced from private sources in the form of equity investment only, known as private equity.
3. Funding is provided to companies that are sourced from private sources in the form of equity investment and capital extended to companies through a loan or other form of debt, referred to as private debt.

The correct answer is C.

Private capital refers to the funding provided to companies not sourced from public markets or traditional institutional providers such as government or banks. Private capital is a broad term that encompasses both private equity and private debt.

Private equity refers to investments made in private companies or public companies that are being taken private by investors who typically take a long-term view and seek to add value through active management. On the other hand, private debt refers to loans or other forms of debt extended to companies by private lenders rather than through the public markets. Private capital is often sought by companies that cannot access public markets or prefer the flexibility and discretion that private capital can offer. It is a crucial funding source for startups and companies seeking to grow or restructure.

A is incorrect. Private capital does not refer to the funding sourced from public markets or traditional institutional providers such as government or banks. These are considered public sources of capital, not private.

B is incorrect. Private capital does not refer only to the funding provided to companies sourced from private sources in the form of equity investment, known as private equity. It also includes private debt, capital extended to companies through a loan or other form of debt by private lenders.