You might have come across the term “private equity” before, but do you have any real idea of what it entails? Despite the name, private equity doesn’t have anything to do with privacy or secrecy.

In fact, it refers to the equity that isn’t listed on the public stock exchange. Having picked up a significant amount of momentum over recent years (in 2018, the total value of global private equity transactions reached a staggering 825.77 billion U.S. dollars, it’s important for businesses seeking investment to have a thorough understanding of the private equity landscape.

• What is Private Equity?
• What are the Benefits of Private Equity?
• What are the Advantages and Disadvantages of Raising Money from Private Investors?
• Is Private Equity Good or Bad?
• Is Private Equity Better than Investment Banking?
• Why do Companies use Private Equity?
• Is Private Placement Good for Shareholders?
• Is Private Equity Buy or Sell Side?
• What Happens When Private Equity Buys Your Company?
• Why do Companies Sell to Private Equity Firms?
• How Does Private Equity Raise Capital?

What is Private Equity?

Private equity is a form of risk capital (investment) that is provided outside of public markets. For anyone who wants to buy into a business, revitalise a company, buy out a division of a parent company, expand, or start up a business, private equity investment could be an excellent option.

Read Also: Foreign Investment and its Effects on Economic Growth in Developing Countries

Private equity is predominantly focused on generating capital gains. Essentially, investors will purchase a stake in a business, take an active role in the management of the business, and then draw a profit from the increased value of the business by selling or floating it.

What are the Benefits of Private Equity?

Private equity investment offers a number of advantages for companies and start-ups. First off, the combination of business acumen from private equity investors and the provision of liquid capital enables companies that receive private equity investment to develop and grow quickly.

In addition, receiving private equity as an early-stage start-up can enable a company to attempt unorthodox growth strategies without the pressure of being a publicly listed company.

What are the Advantages and Disadvantages of Raising Money from Private Investors?

By using private investors, you can raise a significant amount of finance, and often quite quickly. A private placement doesn’t need to involve brokers or underwriters and instead they can usually be arranged through banks or specialist financial institutions.

Advantages of using private investors

There are several advantages to using private placements to raise finance for your business. They:

• allow you to choose your own investors – this increases the chances of having investors with similar objectives to you and means they may be able to provide business advice and assistance, as well as funding
• allow you to remain a private company, rather than having to go public to raise finance
• provide flexibility in the amount and type of funding – eg allowing a combination of bonds and equity capital, with amounts ranging from less than £100,000 to several million pounds
• allow you to make a return on the investment over a longer time period – as private placement investors will be prepared to be more patient than other investors, such as venture capitalists
• require less investment of both money and time than public share flotations
• provide a faster turnaround on raising finance than the venture capital markets or public placements

As a result, private placements are sometimes the only source of raising substantial capital for more risky ventures or new businesses.

Disadvantages of using private placements

There are also some disadvantages of using private investors to raise business finance. For example, there will be:

• a reduced market for the bonds or shares in your business, which may have a long-term effect on the value of the business as a whole
• a limited number of potential investors, who may not want to invest substantial amounts individually
• the need to place the bonds or shares at a substantial discount to compensate investors for their greater risk and longer-term returns

Additionally, although it isn’t a mandatory requirement, having a credit rating can be an advantage. However, this is time-consuming and will be an added cost to the process.

Is Private Equity Good or Bad?

Private equity isn’t always bad, but when it fails, it often fails big

Those within the industry will tell you that private equity’s goal is not to bankrupt companies or to do harm. But sometimes, that’s just what happens: Researchers at California Polytechnic State University recently found that about 20 percent of public companies that go private through leveraged buyouts go bankrupt within 10 years, compared to a control group’s 2 percent bankruptcy rate over the same time period.

Moody’s found that after the financial crisis, from 2008 to 2013, companies owned by top private equity firms defaulted on their loans at about the same rate as other companies. However, in megadeals where more than $10 billion of debt was involved, private equity-backed companies performed much worse.

Even an industry-friendly study out of the University of Chicago found that employment shrinks by 4.4 percent two years after companies are bought by private equity, and worker wages fall by 1.7 percent.

The type of company matters as well — employment shrinks by 13 percent when a publicly-traded company is bought by private equity, but it increases by the same percentage if the company is already private. The researchers found that labor productivity increases by 8 percent over two years.

That it is sometimes harmful to the companies it buys and, by extension, the people who work there doesn’t mean it’s not lucrative. After all, there’s a reason so many investors are parking their money in these firms. “If it were such a terrible thing, it wouldn’t have grown so big,” said Steve Kaplan, a professor and private equity expert at the University of Chicago. Blackstone, for example, made $14 billion from its investment in Hilton.

But a good deal for investors does not always translate to a good deal for other stakeholders, including employees and consumers.

Is Private Equity Better than Investment Banking?

Private equity and investment banking both raise capital for investing purposes, but they do so in very different ways. Private equity firms collect high-net-worth funds and look for investments in other businesses. Investment banks find businesses and then go into the capital markets looking for ways to raise money from the investment crowd.

Investment Banking

Investment banking is a specific division of banking related to the creation of capital for other companies, governments, and other entities. Investment banks underwrite new debt and equity securities for all types of corporations; aid in the sale of securities; and help to facilitate mergers and acquisitions, reorganizations, and broker trades for both institutions and private investors.

Investment banks also provide guidance to issuers regarding the issue and placement of stock. Investment banking positions include consultants, banking analysts, capital market analysts, research associates, trading specialists, and many others. Each requires its own education and skills background.

A degree in finance, economics, accounting, or mathematics is a good start for any banking career. In fact, this may be all you need for many entry-level commercial banking positions, such as a personal banker or teller.

Those interested in investment banking should strongly consider pursuing a Master of Business Administration (MBA) or other professional qualifications.

Great people skills are a huge positive in any banking position. Even dedicated research analysts spend a lot of time working as part of a team or consulting clients. Some positions require more of a sales touch than others, but comfort in a professional social environment is key.

Other important skills include communication skills (explaining concepts to clients or other departments) and a high degree of initiative.

Private Equity

Private equity, at its most basic, is equity (i.e. shares representing ownership) in an entity that is notpublicly listed or traded. Private equity is a source of investment capital that comes from high net worth individuals and firms.

These investors buy shares of private companies—or gain control of public companies with the intention of taking them private and ultimately delisting them from public stock exchanges.

Large institutional investors dominate the private equity world, including pension funds and large private equity firms funded by a group of accredited investors.

Private equity is sometimes confused with venture capital because they both refer to firms that invest in companies and exit through selling their investments in equity financing, such as initial public offerings (IPOs). However, there are major differences in the way firms involved in the two types of funding conduct business.

Private equity and venture capital buy different types and sizes of companies, invest different amounts of money, and claim different percentages of equity in the companies in which they invest.

Investment bankers work on the sell-side, meaning they sell business interest to investors. Their primary clients are corporations or private companies. When a company wants to go public or is working through a merger-and-acquisition deal, it might solicit the help of an investment bank.

Conversely, private equity associates work on the buy-side. They purchase business interests on behalf of investors who have already put up the money. On some occasions, private equity firms buy controlling interests in other businesses and are directly involved in management decisions.

Why do Companies use Private Equity?

Private equity financing has some distinct advantages over other forms of funding and that is the reason why companies use them. Here are some of the main reasons:

Large Amounts of Funding

Of all the options available, private equity can provide by far the largest amounts of money. As we have seen above, the deals are measured in hundreds of millions of dollars.

The impact of that kind of money on a company can be massive. In 2009, The Delaware City Refinery had to close its main refinery and lay off most of its employees. In 2010, private equity firm Blackstone invested $450 million in the company, enabling it to reopen the refinery and rehire 500 employees.

Active Involvement

With many of the other funding options available, the investor or lender has only minimal involvement in the running of your business. Private equity firms are much more hands on, and will help you re-evaluate every aspect of your business to see how you can maximize its value.

This can lead to problems, of course, if their idea of maximizing value doesn’t match yours, as we’ll see in the next section. But having experienced professionals intimately involved in your business can also result in major improvements.

Incentives

Private equity firms have a lot of skin in the game. As we’ve seen, they often borrow a lot of money to make their investments, and they have to pay that back and generate a return for their investors on top of that. In order to achieve that, they need your business to succeed.

Individual partners in the private equity firm often have their own money invested as well, and make additional money from performance fees if they make a profit, so they have strong personal incentives to increase your company’s value.

High Returns

This combination of major funding, expertise and incentives can be very powerful. A 2012 study by The Boston Consulting Group found that more than two-thirds of private equity deals resulted in the company’s annual profits growing by at least 20%, and nearly half the deals generated profit growth of 50% a year or more.

Is Private Placement Good for Shareholders?

There are minimal regulatory requirements and standards for a private placement even though, like an IPO, it involves the sale of securities. The sale does not even have to be registered with the U.S. Securities and Exchange Commission (SEC).

The company is not required to provide a prospectus to potential investors and detailed financial information may not be disclosed.

The sale of stock on the public exchanges is regulated by the Securities Act of 1933, which was enacted after the market crash of 1929 to ensure that investors receive sufficient disclosure when they purchase securities. Regulation D of that act provides a registration exemption for private placement offerings.

The same regulation allows an issuer to sell securities to a pre-selected group of investors that meet specified requirements. Instead of a prospectus, private placements are sold using a private placement memorandum (PPM) and cannot be broadly marketed to the general public.

It specifies that only accredited investors may participate. These may include individuals or entities such as venture capital firms that qualify under the SEC’s terms.

Private placements have become a common way for startups to raise financing, particularly those in the internet and financial technology sectors. They allow these companies to grow and develop while avoiding the full glare of public scrutiny that accompanies an IPO.

As an example, Lightspeed Systems, an Austin-based company that creates content-control and monitoring software for K-12 educational institutions, raised an undisclosed amount of money in a private placement Series D financing round in March 2019. The funds were to be used for business development.

Above all, a young company can remain a private entity, avoiding the many regulations and annual disclosure requirements that follow an IPO. The light regulation of private placements allows the company to avoid the time and expense of registering with the SEC.

That means the process of underwriting is faster, and the company gets its funding sooner. If the issuer is selling a bond, it also avoids the time and expense of obtaining a credit rating from a bond agency.

A private placement allows the issuer to sell more complex security to accredited investors who understand the potential risks and rewards.

Is Private Equity Buy or Sell Side?

Buy-side is a term used in investment firms to refer to advising institutions concerned with buying investment services. Private equity funds, mutual funds, life insurance companies, unit trusts, hedge funds, and pension funds are the most common types of buy-side entities.

What Happens When Private Equity Buys Your Company?

Once a business has been acquired by a private equity company, it is in for some notable changes. It is the motive of a private equity company to find a business that is struggling financially or just having a tough time growing, buy it and do whatever is necessary to turn the company around and sell it later for a profit.

Once acquired, a target company’s management, balance sheet and business operations all become fair game in which the new private equity owners can mettle.

Private equity companies do not always acquire entire businesses. Sometimes they buy assets in a piecemeal fashion. When they do buy companies outright it’s known as a buyout.

Using a combination of their own resources and debt, the latter of which is generally piled onto the target company’s balance sheet, private equity companies acquire struggling companies and add them to their portfolio of holdings.

What they do with those businesses over the following several years determines how profitable an exit strategy will be for the business, the owners and the investors.

Layoffs

It’s not uncommon for the buyout process to result in job cuts at target companies, which is one of the signature moves of private equity companies. Layoffs are part of the cost-cutting measures that buyout companies use to make an investment more profitable for them when it comes time to exit the holding.

Following such layoffs, private equity executives sometimes hire new talent of their own choosing, according to a 2008 “New Yorker” study.

Exit Strategy

It’s not the intention of a private equity company to own a business forever. After five to seven years, it must cash in and show investors profits. There are three primary ways that a buyout company can do this:

— It may decide to conduct an initial public offering, in which the holding company becomes a publicly traded stock.

— In what is known as a strategic sale, the buyout company can sell the business to a competing company in the sector.

— The buyout company might even shed the business to yet another private equity company in what’s dubbed a secondary buyout, according to a 2012 “Wall Street Journal” article.

Debt Management

Following a private equity buyout deal, target companies are likely to have taken on more debt than they had before the acquisition. Indeed, private equity companies finance buyouts using the equity of only 30 percent to 40 percent, relying on debt taken on by the target company to finance the rest, according to a 2012 “Wall Street Journal” article.

Once a buyout company exits private equity ownership, it has to manage its debt or it will be in danger of defaulting on its obligations.

How Does a Private Placement Work?

A company can be more elective about who buys its shares if it sells them in a private placement. Shares sold in an initial public offering, or IPO, are offered to the general public and tend to attract more attention.

However, private placement allows a company to raise money without going public and having to disclose financial information. A company can remain private while still gathering shareholder investments.

Private placement is also referred to as an unregistered offering. While an IPO requires a company to be registered with the Securities and Exchange Commission (SEC) before it sells securities, a private placement is exempt from that requirement.

A private placement might take place when a company needs to raise money from investors. Yet it is different from taking money from other private investors, like venture capitalists. It’s still regulated by the Securities and Exchange Commission (SEC), but under different rules, collectively known as Regulation D.

Reg D allows companies to issue securities based on the investors buying them. It distinguishes between accredited and non-accredited investors, as defined by the SEC.

Any number of accredited investors can take part in private placements. Though private placements can issue securities to non-accredited investors, only 35 such investors can be included.

If you’re looking to invest in a private placement as an accredited investor, you’ll need to meet some requirements, including:

• A net worth of over $1 million (either independently or with a spouse).
• Earned income more than $200,000 a year (or $300,000 with a spouse).

Why do Companies Sell to Private Equity Firms?

private equity investors are constantly looking for companies who have good management teams, operate in growing markets, and who have tons of upside. The only thing these companies lack is enough capital to take advantage of all the opportunities ahead of them–which is where the private equity comes into play.

In exchange for their capital, a private equity investor will take a partial ownership of the company–either a minority or majority stake.

Then, in five to seven years, they will seek a return on that investment (the time frame depends on how old the fund is as well)–either through a total sale of the company or by selling their stake to a strategic or financial buyer. That’s how they provide a substantial return to their investors.

But it’s important to note that private equity investors rarely buy 100% of a company and let the newly wealthy founder walk away to pursue their next adventure.

Rather, these investors usually want to buy a partial majority stake in the business while keeping the founder around to continue to scale the business by chasing down all those opportunities they couldn’t before, while increasing the value of the company in the process. So much for immediately retiring to a warm and tropical location.

There is another catch as well: if you sell a stake of your company to a private equity investor, you are also bringing on a business partner.

They will insist on some level of involvement or control of the business–through board seats or provisions in the operating agreement–that will allow them to keep a close eye on their investment.

That’s why it’s also essential for entrepreneurs to choose wisely when it comes to their investors. Ideally you should be looking for those who have experience in your industry and has good behavior in good times and bad.

So how do you know if selling to a private equity investor is right for you?

First off, if you’re happy running a profitable company that’s growing and you have plenty of cash to chase opportunities, then selling might not be right for you. And that’s great; congratulations!

Also, if you want to exit your business entirely, you’ll need to look at private equity and other options–which is a topic I’ll discuss in a future post.

One great reason to sell, on the other hand, would be if you see lots of opportunities for growth that you simply can’t pursue on your own. Many entrepreneurs dream big where they want to disrupt entire markets and industries–which can be difficult to do without access to a large amount of capital depending on the business model.

It can also make a lot of sense to sell if you are interested in taking some money off the table and into your pocket while also getting the chance to build up the value of your remaining equity stake with the help of the influx of capital.

That could truly be a win-win scenario for both the entrepreneur and their investors. Many times, that second bite of the apple can be as large or larger than the initial partial sale.

What’s interesting is that some people have the view that selling to private equity is somehow an admission of defeat–that the company couldn’t make it on its own. But this would be a rare circumstance. Think about it: if you were an investor looking for above-average returns, why would you invest in a failing company?

Even experts in turning around companies, which is a specialty within the private equity sector, readily acknowledge how hard and unpredictable that job is.

That’s why when most private equity groups look to invest, they are looking for great management teams who are chomping at the bit to grow and chase down every opportunity they can. Rather than an admission of failure, this is more about issuing a challenge to see how much more you can accomplish if access to capital is no longer an issue.

So when it comes to question of whether or not you should sell to a private equity investor, ask yourself what you want your legacy to be. Are you satisfied with where you company is headed or will you regret leaving some opportunities on the table and need the influx of capital to truly change your industry? Either way, you are declaring victory.

How Does Private Equity Raise Capital?

There are four basic things private equity investors do to earn money.

• Raise money from Limited Partners (LPs) like pension and retirement funds, endowments, insurance companies, and wealthy individuals
• Source, diligence, and close deals to acquire companies
• Improve operations, cut costs, and tighten management in their portfolio companies
• Sell portfolio companies (i.e., exit them) at a profit

Let’s look at each of those things in turn.

Raising Money

Private equity firms raise funds by getting capital commitments from external financial institutions (LPs). They also put up some of the their own capital to contribute into the fund (commonly 1-5% but it can be higher). The partners of the firm (the GP) might go on a roadshow themselves to raise the money or they might use a placement agent (an outside fundraising team) to help them do a lot of the legwork.

LPs are usually required to commit a significant amount of capital in order to be allowed to participate in the fund, since the last thing the partners want is to be fielding “support” calls and communications to a “long tail” of many little investors who only commit a small amount but require a lot of hand-holding to service.

The ideal fund to a PE firm would be comprised of a handful of LPs that each commit tens or hundreds of millions of dollars, or even billions of dollars, each. Huntsman Gay, the Bain Capital spinout had less than 10 LPs that each committed more than $100M.

If you’re a high net worth individual, the commitment thresholds might be a little lower than a normal LP, but they will likely still be in the millions in order to comply with federal securities laws that basically say you can only sell PE investments to rich people because they are the ones who actually probably know what they are doing.

But even though LPs make a capital commitment, they don’t give all the money to the GP all upfront. Instead, the GP begins to source and close deals, and as those deals need to be funded, they “call capital” from the LPs. LPs then have a very limited window (e.g., 2 weeks) to write a check to the GP so that the GP can fund and close the deal.

So committed funds are called “committed capital” while disbursed funds are called “contributed capital.”

Many PE funds have something called “first close” vs. “final close.” First close basically means that when a certain threshold of money has been raised, the PE firm can begin making investments and actually closing deals and new LPs can still join in by committing capital for a limited time (e.g., 1 year from first close). 

Final close means that when a second threshold has been reach, new LPs can no longer join in on that particular fund.

Sourcing, diligencing, and closing deals

When PE firms analyze companies for potential acquisition, they will consider things like what the company does (their product or service and their strategy for it), the senior management team of the company, the industry the company is in, the company’s financial performance in recent years, and the valuation and likely exit scenarios of the company.

Prospective deals come into the firm through a combination of the partners’ reputation (in which case companies themselves may reach out to the firm), investment professionals who proactively reach out to potential investment targets through their own networks or through cold calls, or through investment banks that may be representing a company and pitching it to investors through the issuance of bank books or confidential investment memorandums.

When investment banks run a process, they often do it through an auction where several private equity firms bid for the company, and firms drop out along the way as their bids are either rejected or accepted to each successive “round” of bidding.

The best way to get deals is through proprietary means because that means the PE firm has an edge against other firms in acquiring the company, either through personal relationships or special knowledge or simply a head start.

At Huntsman Gay, there were a few proprietary deals we looked at and closed, and those were definitely the ones we tried to move more quickly on, that didn’t tend to get dragged out in a process, and that were more pleasant to close.

To get good proprietary deal flow, the partners of the fund have to build and maintain strong relationships with key people in industry, advisers, and even bankers.

Once a potential deal has been sourced, then the investment team will conduct heavy due diligence to assess the company’s strategy, business model, management team, the industry and market, the financials, the risk factors, and the exit potential.

Diligence is typically conducted in stages that correspond to phases of the bidding process, where financial and operational information is progressively revealed to PE firms based on bidders that are still in the running at each phase.

If the deal looks promising and no dealbreaker red flags are found, then the investment professionals will present to the investment committee (comprised of partners) for funding approval.

Final terms of the deal with be negotiated with lawyers on both sides, and the deal will transact, with funds being released and equity being traded.

Improving operations, cutting costs, and tightening management

One thing to be very clear on is that the GP does NOT run the portfolio companies on a day to day basis. They are not installing themselves as CEOs and COOs. Instead, they take board seats, they may or may not reshuffle senior management of the company, and they provide advice, support, introductions, etc, relating to operations, strategy, and financial management.

How involved the GP is really depends on how big their stake in the company is. If they only own a small minority stake, then they won’t be very involved; rather, the lead investor owning the biggest stake will be most involved.

However, if they own either a sizeable percentage of the equity or a significant portion of the entire fund is invested in the company, then they will be much more highly engaged in streamlining and improving the company for a profitable exit down the line.

The GP must also produce official reports for LPs, generally each quarter, on the progress and value of their portfolio companies, along with general financial updates, and LPs may use that information to mark their own portfolios to market when they report their results to their own investors.

Exiting portfolio companies

The end goal for PE firms is to exit their portfolio companies at a substantial profit. Typically, the exit occurs between 3-7 years after the original investment, but it could be shorter or take longer depending on the strategic circumstances. 

The main sources of value capture at exit include: growing revenue (and therefore EBITDA) substantially during the holding period, cutting costs and optimizing working capital (and therefore increasing EBITDA), selling the company at a higher multiple than the original acquisition multiple, and paying down debt that was initially used to fund the transaction.

Most exits happen as the result of an IPO or acquisition by another firm, with acquisitions being the more common method. Returns are then measured by the “internal rate of return” (IRR) (which is the discount rate that makes the net present value from the entry date of all cash flows between entry and exit equal zero), or its quicker proxy the “multiple of money” (MoM) which is simply the amount of money returned divided by the amount invested for that particular investment.

Note that the IRR depends on the duration of the holding period while the MoM technically does not (although you will be judged by your investors how long it took to generate that MoM).

Read Also: The Effect of Corporation Investments in the Economic Development of the Community

So, for instance, if a $100M investment is sold for $200M just one year later, the MoM is 2x but the IRR is 100%; if it’s sold after 3 years, the MoM is still 2x but the IRR has fallen to 26%; and it’s sold 5 years later, the MoM is still 2x, but the IRR is 15%.

While partners do a lot of the coordination to sell the firm’s portfolio companies, they may also retain investment banks to handle the execution, especially when the transactions are large or complex. That’s how investment banks earn their fees — on selling the portfolio companies into PE firms and then again on selling them out to downstream acquirers.

In order for you to achieve your vision, having access to sufficient amounts of capital is a vital responsibility. You just need to figure out an effective strategy for how it can be acquired. Fortunately, there are a number of pathways available, including Private Equity.