Private equity

Key Takeaways

1. Private equity or PE is a form of funding by PE firms for companies that have established operations.
2. Private equity investors select settled business, then restructure the organization and refurbish the company to earn more money and sell it at a profit.
3. Private equity firms earn money by charging management fees to investors.

Private equity or PE is a form of funding by PE firms for companies that have established operations, cash flows, charting a pathway to profitability but not necessarily profit-making, and are suitable for taking on debt for financing. 

The companies up for PE funding could be privately-owned or public companies about to be taken private.

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PE firms could also look at buying out unprofitable ventures to restructure and turn a profit or even buyback the shares of a publicly-held company to work on its performance. Leveraged buyouts are a classic example of a PE firm’s modus operandi.

Other kinds of non-public equity funding for a business are venture capital and seed funding.

What is private equity, and how does it work?

Private equity firms are structured in 2 ways, Limited partnership, and closed-end funds. The limited partnership is more prevalent in the US, while closed-end funds are popular in Europe. There are two types of the partner in a limited partnership, General Partnership (GP) and Limited partnership (LP).

GP is involved in general management of the fund, target companies’ portfolio selection, post-investment advisory. GP charges management fees for partnership and have the right to receive carried interest. 2-20% compensation structure, where 2% paid as management fees even if the fund isn’t successful. And then 20% of the proceeds after breakeven are received by GP. Limited partners receive all of the fund’s profits, excluding the amount paid to GP.

A close-ended fund is different. It’s typically involved in newly created entities. Investors provide capital to that entity. And the management firm signs a contract with an entity. The compensation scheme is similar to a Limited partnership.

Private equity fund

These are the funds that are mainly focused on acquiring private companies that have not been listed on the stock exchange. Private equity funds are especially focused on equity investments. Most equity funds specialize or deal with a specific type of target based on the lifecycle stage of this target. Some PE funds are interested in young firms with high growth perspectives and a promising management team, while others focus on established companies with stable cash flows. Private Equity funds also invest in some distressed companies.

Private equity typically would try to acquire all shares of the target company, then delist it, change management, introduce measures to improve financial performance, and will sell it after two years or more or it will exit from the investment to invest somewhere else.

Active involvement, advisory, necessary management rotation, and substitution, improve its profitability and exit the investment in 5 to 10 year period. Art to bet on the right company and successfully provide guidance to optimize their chances of growth.

What is the difference between private equity and venture capital?

Venture Capital (VC) refers to an investment made into start-ups or early-stage companies. Investors making such investments are called venture capitalists and are generally large institutions. Venture capital firms provide funding to small companies or start-ups, which are starting to get a clear idea of their revenue stream and customers. Venture capitalists usually pool money in a VC fund and then go about investing in prospective companies and call them their portfolio companies. The investment is expected to give returns in multiples and has less risk attached compared to seed funding.

Private equity firms focus on more established businesses that need the restructuring of management and additional capital, so they can earn more profit after selling it. Because of this, private equity is considered less risky than venture capital. Private equity investors select settled business, then restructure the organization and refurbish the company to earn more money and sell it at a profit.