This article has been written by Anupriya Dixit, pursuing a Diploma in International Contract Negotiation, Drafting and Enforcement from LawSikho and edited by Shashwat Kaushik.
It has been published by Rachit Garg.
Table of Contents
Introduction
Private equity (PE) is a type of financial investment strategy in private and public companies. PE firms acquire a majority stake in the companies to influence the management of the companies; after investing, PE firms get control of the company. The structure of PE firms is usually a limited partnership. The minimum amount of investment may vary and depend on the firm and funds. PE firms believe that they can turn an underperforming company into a well-profitable, established company through their strategies and by investing as PE investors, who get partial ownership of that company.
PE firms always invest in companies for a minimum period of 4–7 years. Before investing in a company, PE firms’ investors do complete research on that company. Whereas venture capital (VC), a subcategory of PE, is a type of firm that provides financial support to startups or small businesses with high potential growth that have access to the stock market and need capital for them.
Venture capital is the seed capital for any startup. A venture fund is usually invested in new technology, new ideas, and new marketing concepts that have not proven themselves in the market. Many entrepreneurs do not have sufficient funds to execute their ideas, so they seek outside financial help to reach their goal. Here, VC firms play the role of investors. Usually, the structure of venture capital is a partnership, with the general partner serving as managers and investor advisers to the venture capital funds raised.
Objects of private equity
The main object of PE is to generate high net worth by acquiring complete control of many PE investments taking the form of LBOs, i.e., acquire a company entirely to improve its value and sell it for profit, or conduct an Initial Public Offering (IPO). A private equity fund’s main objective is to realise growth in the portfolio of private assets purchased over a period of 10 – 12 years.
Private equity firms add value by using various strategies in their portfolio, including :
- Strategic guidance: In order to accelerate development and profitability, private equity firms adopt technologies, enter new markets, and bring their own team management.
- Operational improvement: Private equity firms think they have the knowledge and skill to turn a weak business into a stronger one by increasing their operational efficiency. Which results in higher earnings and wealth creation.
- Financial optimisation: To raise more funds and benefit from tax advantages, private equity firms sometimes use debt financing. This enables them to maximise cash flow and margin development.
- Selling expertise: Private equity firms are adept at locating purchasers willing to pay a good price for their portfolio companies, whether for monetary or strategic reasons, which enables them to produce big profits.
Who invests in PE and VC
High-net-worth investors who have a high risk appetite should consider PE to earn a high return on investment; however, established companies also turn to PE investment for a fresh infusion of capital to finance their stalled projects.
Types of PE funding
Distress funding- Also known as “vulture financing,” invests in troubled companies that are underperforming assets, like if ABC is a PE firm and BCD is a non performing company, and ABC firm is investing funds in BCD company, so that is called distress funding.
Venture capital funding- Venture capital funding is a seed of startups VC works on the policy of high risk high returns. Funding firms believe that if they invest in a hundred startups, one or two will make billions of dollars in revenue, and from there, the investing firm will make a profit.
Growth capital- Usually, growth capital focuses on stable companies that are developing new products and expanding into new markets, like Byju’s.
Methods of value creation in private equity
There are three ways a private equity firm uses leverage, multiple expansions, operational improvement, and Since 1980, leverage has been the first way to add value to portfolio companies. Every firm has its own strategy. They already have a plan. Private equity firms often focus on operational improvement; they improve the performance of employees. They develop new business and service offers for customers, bring new equipment, and other methods include cost cutting and pricing reductions. Over all, private equity firms are all about supporting a company by identifying its value creation in its early stages.
List of top private equity firms
- The Blackstone Group Inc.– This was founded in 1985, and it’s headquarters are located in New York, with branch offices in Hong Kong, Dubai, Beijing, and London. They invest in the market sector, including energy retail and technology.
- KKR & Co., Inc.– Kohlberg Kravis Roberts & Co.—founded in 1976, and it’s headquarters are located in New York. They invest in consumer health care, industrial technology, and media and communications finance services.
- CVC Capital Partners– CVC Capital Partners is a British private equity firm founded in 1981. It’s headquarters are located in Luxembourg City. They invest in the core consumer and service sectors.
- The Carlyle Group, Inc. – The company was founded in 1987, and its headquarters are in Washington. They invest in the aerospace and government sectors, media and retail, health care, U.S. real estate, and global infrastructure.
- Thoma Bravo– This is an American private equity firm; it’s headquarters are located in Chicago, and it invests in software and technologies.
What is the disadvantage of private equity
The disadvantages of private equity are:
- Private equity firms invest a large amount, and investors need to wait for the long term to get returns; it takes 4 to 7 years to complete its life cycle. Private equity also involves high risk profit, as PE firms will have to convince investors to take stock of that company.
- The PE firm will have complete control over the management of the liquidated company.
How private equity firms exit a deal
The exit of a deal plays a major role in private equity investment. Private equity firms use several strategies, i.e.
- Trade sale- PE firms generally acquire a company for specific periods (usually four to seven years) with the goal of exiting a PE deal through a sale above the initial investment price.
- Initial Public Offering (IPO)- this is the most common way to exit the PE. A private company gets listed publicly for the first time to exchange their stock. An initial public offering provides the highest valuation in comparison to other exits.
- Secondary sale- In a secondary buyout,also known as sponsor-to-sponsor, a company is sold to another company active in the same industry. This is quite a different way to exit the deal.
- Management Buyouts (MBOs) – MBO is a type of strategy where existing management purchases assets and operations from the present owner. This is the most risky way to exit.
- Liquidation- Liquidation is a process where a company sells its assets and closes the business. Liquidation is not a highly valued exit; mostly failing companies use this way to exit.
Types of venture capital funding
- Seed capital- This is a type of capital that is to be provided to startups that have no product or organised company. Mostly, this fund is provided to startups for market research to create a sample product and cover administration costs.
- Startup capital- Startup capital is provided to new businesses for launching their first product; startup companies only rely on venture capital funding.
- Early stage capital- Early stage capital is provided to those companies that have samples of their product and want to grow their business more.
- Expansion capital- Expansion capital is provided to established companies that want to expand their business in a new market.
- Late stage capital- Late stage capital is provided to well – established companies that have already proven themselves. This funding is used for their growth in acquisitions or preparation for an initial public offering (IPO).
- Bridge financing stage- Bridge financing is a type of venture capital finance that helps companies bridge a gap between funding rounds or prepare for an IPO. This is a short term funding while waiting for a larger one to be secured.
List of top venture capital firms
- Sequoia Capital – This is one of the oldest and most successful venture capital firms in the world, investing in startups across various industries like healthcare, consumer goods, and technology.
- Andreessen Horowitz – This is an American venture capital firm founded in 2009. It is located in Silicon Valley, California, and they provide funding to startups across various industries like Healthcare, Software and Fintech
- Kleiner Perkin – This is an American venture capital firm located in California. mainly provide funding to early stage and growth companies and startups; they also invest in the industries of hardtech, healthcare, and fintech.
- Kholsa Ventures – This is an American venture capital firm founded by an Indian, Mr. Vinod Kholsa, in 2004. They invest in early to late stage startups and are mainly active investors in the space sector.
How venture capital firms exit deals
Although there are various ways to end the deal depending on company’s situation, some common methods are listed below –
- Strategic acquisition- Strategic acquisition, or trade sale, is a popular exit route for private equity funds. This is because the buyer can have a strategic advantage in acquiring the business. Which may complement their existing portfolio of businesses. As a result, the buyer is often willing to pay a premium to acquire such a business.
- Initial Public Offering (IPO)- The second way to exit the deal is to go public for the first time, sell their stake, and generate returns.
- Secondary sale- A secondary sale is known as a secondary buyout (SBO). A secondary sale allows investors to exit the deal by selling their shares to other investors. The benefit of secondary sales is that investors may exit the investment without going through the process of taking the entity public.
- Management buyouts (MBOs)- MBOs come into play when the corporate manager or team purchases the company from its owner; this acquisition includes everything related to the company, like its liabilities and assets. In some situations, startups may buy out the VC firms to exit the deal.
- Liquidity or bankruptcy- If a company is unable to pay bank debt and is going through a highly depressed situation, VC firms may exit by selling its assets. This is an undesirable situation for a company.
- Control over exit- By controlling the board of directors and inserting negotiating exit rights in the investment agreement, VC firms may exit the deal.
Conclusion
Nowadays, PE investment is the most preferable investment, as PE funds provide funding to financially depressed companies, which helps the depressed company grow again, and it is like giving a second life to a company by increasing its value. However, investors invest in established companies too, which is beneficial for both investors to get high returns and control over the management and operations of that company, and the company gets financial support in order to restart or accelerate their companies. Every investor uses different strategies to reconstruct the company according to its current situation. PE could be a great investment; this may leave a positive impression on the economy and create job opportunities.
Whereas venture capital works with startups that face financial crises, this is risky as compared to private equity, as the return chances are low in VC, but this is seed capital and gives wings to startups to start their operations to achieve their goal.
There are many pros and cons to VC firms because, often, a company needs additional funding, and in that case, an entrepreneur starts losing his stake and power to make decisions for the company.
References
- https://www.investopedia.com/articles/financial-careers/09/private-equity.asp
- https://financetrain.com/exit-strategies-for-private-equity-investors
- https://hbr.org/2007/09/the-strategic-secret-of-private-equity
- https://smallbusiness.chron.com/top-risk-factors-venture-capital-investments-75055.html
- https://www.geraldedelman.com/insights/key-risks-in-private-equity-investment
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