Private Equity Investing

Private Equity Investing

29 Jan 2019

A primary advantage of having a reasonable amount of money at your disposal is that you have access to opportunities to grow that money at a rate that may not be possible for the layman who does not have much surplus funds. Private equity funds are among such instruments. They pool money from wealthy individuals and entities (big global funds typically won’t take less than $50 million) and invest in aggressive and relatively unconventional ways. Some of their bets may fail but the others make spectacular returns. When things go well, investors end up with a rate of return that gives them handsome returns, which in turn takes them the next or higher level in their investing journey.

Private equity is basically 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 which engage in the 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 newer technologies, make acquisitions, expand working capital, and bolster and solidify balance sheets.

Private equity 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 full glare of the 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.

Advantages of Private Equity

Private equity financing has some distinct advantages over other forms of funding. Here are some of the main benefits:

  • Large Amounts of Funding - Of all the options we’ve looked at so far, private equity can provide by far the biggest amount of money. As we saw, the deals are measured in hundreds of millions of dollars. The impact of that kind of money on a company can be massive. Let us take one global example - in 2009, The Delaware City Refinery (US) 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. On the domestic side, restaurant search and delivery platform Zomato, which was once incurring losses and was on the verge of a shutdown received several rounds of funding from various venture capital firms and is today successfully competing with other players from the industry
  • Active Involvement -With many of the other funding options we’ve looked at, 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.
  • 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 a profit growth of 50% a year or more.

Disadvantages of Private Equity

Such large amounts of money, of course, come with a few strings attached. Here are some of the downsides of private equity funding:

  • Dilution/Loss of Your Ownership Stake -This is the big one. With the other funding options that we’ve looked at, the investment came at a cost, but you still stayed in control of your company. With private equity, you get much more money, but usually have to give up a much larger share of the business. Private equity firms often demand a majority stake, and sometimes you’ll be left with little or nothing of your ownership. It’s a much bigger trade, and it’s one that many business owners will baulk at.
  • Loss of Management Control - Beyond the money, you can also lose control of the direction of your business. The private equity firm will want to be actively involved, and as we mentioned in the previous section, that can be a good thing. But it can also mean losing control of basic elements of your business like setting up a strategy, hiring and firing employees, and choosing the management team. Some of the other options involved relinquishing control, but because the private equity firm’s stake is usually higher, the loss of control is much greater. This is especially true when it comes to the PE firm’s “exit strategy.” That may involve selling the business outright or other options that don’t necessarily form a part of your plans.
  • Different Definitions of Value - A private equity firm exists to invest in companies, make them more valuable, and sell their stakes for large profits. Mostly, this is good for the companies involved—any business owner would like to create more value. But a private equity firm's definition of value is very specific and limited. It’s focused on the financial value of the business on a particular date about five years after the initial investment, when the firm sells its stake and books a profit. Business owners often have a much broader definition of value, with a longer-term outlook and more concern for things like relationships with employees and customers, and reputation, which can lead to clashes.
  • Eligibility - Private equity firms are looking for particular types of companies to invest in. They have to be large enough to support those major investments, and also they have to offer the potential for greater profits within a relatively shorter time frame. Generally,this implies that either your company has a very strong growth potential or that it is in financial difficulties or is currently undervalued. A business that can’t offer investors a lucrative exit within about five years will struggle to attract any interest from private equity firms.

Investors need to get very choosy before committing their hard-earned money in private equity funds. Individuals should consider foraying into private equity if they are looking to diversify their portfolios beyond the listed space. Many get lured by the promise of extremely high returns. Only investors who are well aware of the risks should dabble in this space. Over the past 15 to 20 years, investing in private equity has had an uninspiring performance history. The large pools of capital were raised because of the greed for higher returns coupled with stronger push from the distribution community.

It took several years to break-even for the investments made upto the year 2008. Most PE funds ended up having marginal stakes in investee companies with inadequate investment rights. They therefore had limited influence with promoters on key decisions. First time managers who did not have enough experience raised the most PE funds . There was an adequate focus on entry valuations and risk management because they were saddled with excess capital. Liquidity is not easy and thus most private equity funds are now struggling with exits. PE funds impose a performance fee above a certain threshold with provisions of profit share on return above the threshold and profit share on the entire return. The incentive to sell is large as the money is locked in for many years. Private equity funds are ideally meant for sophisticated investors. Some underperforming PE funds seem to have found innovative methods of giving the fund value as a multiple of the amount invested in the investee companies and not including the fees charged. Listing or selling of investment always discovers the evaluation.

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