Wednesday, June 29, 2022

Private Equity

Private equity is an alternative form of private financing, away from public markets (not listed on stock exchange), in which funds and investors directly invest in companies or engage in buyouts of such companies , in simple words, it is money that people, companies and other entities have invested in private companies; ones that are not listed on a stock exchange

Private equity firms make money by charging management and performance fees from investors in a fund.

Private equity investment comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended time periods( generally between 0-5 years). In most cases, considerably long holding periods are often required for private equity investments in order to ensure a turnaround for distressed companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public company.

Private Equity Structure

  • Advantage & Disadvantage of Private Equity
  • 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 glare of 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.
  • Private equity has unique challenges
  • It can be difficult to liquidate holdings in private equity because, unlike public markets, a ready-made order book that matches buyers with sellers is not available. A firm must undertake a search for a buyer in order to make a sale of its investment or company.
  • Pricing of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces, as is generally the case for publicly listed companies
  • The rights of private equity shareholders are generally decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their counterparts in public markets
  • How Does Private Equity Work?   

Private equity firms raise money from institutional investors and accredited investors for funds that invest in different types of assets. The most popular types of private equity funding are listed below. 

  • Distressed funding: Also known as vulture financing, money in this type of funding is invested in troubled/ distressed companies with underperforming business units or assets. The intention is to turn them around by making necessary changes to their management or operations or make a sale of their assets for a profit. Assets in the latter case can range from physical machinery and real estate to intellectual property, such as patents.
  • Leveraged Buyouts: This is the most popular form of private equity funding and involves buying out a company completely with the intention of improving its business and financial health and reselling it for a profit to an interested party or conducting an IPO. Up until 2004, sale of non-core business units of publicly listed companies comprised the largest category of leveraged buyouts for private equity. The leveraged buyout process works as follows. A private equity firm identifies a potential target and creates a special purpose vehicle (SPV) for funding the takeover. Typically, firms use a combination of debt and equity to finance the transaction. Debt financing may account for as much as 90 percent of the overall funds and is transferred to the acquired company’s balance sheet for tax benefits. Private equity firms employ a variety of strategies, from slashing employee count to replacing entire management teams, to turn around a company.
  • Real Estate Private Equity: There was a surge in this type of funding after the 2008 financial crisis crashed real estate prices. Typical areas where funds are deployed are commercial real estate and real estate investment trusts (REIT). Real estate funds require higher minimum capital for investment as compared to other funding categories in private equity. Investor funds are also locked away for several years at a time in this type of funding.  
  • Fund of funds: As the name denotes, this type of funding primarily focuses on investing in other funds, primarily mutual funds and hedge funds. They offer a backdoor entry to an investor who cannot afford minimum capital requirements in such funds. But critics of such funds point to their higher management fees (because they are rolled up from multiple funds) and the fact that unrestricted diversification may not always result in an optimal strategy to multiply return.
  • Venture Capital: Venture capital funding is a form of private equity, in which investors (also known as angels) provide capital to entrepreneurs. Depending on the stage at which it is provided, venture capital can take several forms. Seed financing refers to the capital provided by an investor to scale an idea from a prototype to a product or service. On the other hand, early stage financing can help an entrepreneur grow a company further while a Series A financing enables them to actively compete in a market or create one.
  • How do Private Equity firm makes money.
  • The primary source of revenue for private equity firms is management fees ( includes management fees & performance fees)
  • Certain firms charge a 2-percent management fee annually on managed assets and require 20 percent of the profits gained from the sale of a company.
  • Difference between Hedge fund and Private Equity.:  Both the funds appeal primarily to individuals with a high net worth but still are different from each other.
Hedge FundPrivate Equity
Hedge funds are alternative investments that use pooled funds and employ a variety of strategies to earn returns for their investors. The aim of a hedge fund is to provide the highest investment returns possible as quickly as possible  Private equity funds more closely resemble venture capital firms in that they invest directly in companies, primarily by purchasing private companies, although they sometimes seek to acquire controlling interest in publicly traded companies through stock purchases.Private equity funds are focused on the long-term potential of the portfolio of companies they hold an interest in or acquire.
Hedge fund investments are primarily in highly liquid assets, enabling the fund to take profits quickly on one investment and then shift funds into another investment that is more immediately promising.Long-term focus of private equity funds usually dictates a requirement that investors commit their funds for a minimum period, usually at least three to five years, and often from seven to 10 years.
Hedge funds may then lock those funds up for a period of months to a year, preventing investors from withdrawing their money until that time has elapsed. This lock-up period allows the fund to properly allocate those monies to investments in their strategy, which could take some time.Hedge funds may then lock those funds up for a period of months to a year, preventing investors from withdrawing their money until that time has elapsed. This lock-up period allows the fund to properly allocate those monies to investments in their strategy, which could take some time.
Most hedge funds are open-ended, meaning that investors can continually add or redeem their shares in the fund at any time.Private equity funds, on the other hand, are closed-ended, meaning that new money cannot be invested after an initial period has expired.
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CA Divya Thakkar
Chartered accountant | IIM Bangalore 7+years of experience in Consultancy, Investment Banking, Ecommerce & IT Industry. Expert in IFRS, USGAAP, INDAS & US Regulatory requirement. Currently working with Deloitte Touche & Company in Risk ,Finance & Control advisory. Worked in Companies like Barclays Bank, HCL Technologies Ltd & BazaarCart.

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