Private equity, as opposed to getting funding from the public market (think stock market), relies on investment funds that come from private investors. Private equity funds are formed by collecting money from a few or sometimes thousands of investors, and then using that money to invest in private companies. Private equity encompasses not just private equity funds, but also venture capital funds and leverage buyouts (LBOs). Private equity is not the same as investment banking. Investment banks sometimes have private equity funds, but in general, investment banks help facilitate some private equity investments by providing valuation and other services to the private equity fund.
Let’s take a more in depth look at the different types of private equity funds and how they operate.
Private equity funds are created by a private equity company. Basically, investment money from a few or a lot of investors is pooled into a fund. It’s similar to a mutual fund except that investors do not buy the private equity fund through the stock market. Instead, the investors invest directly with the private equity company. Since private equity is not regulated the same way as the public funds, investors in private equity must be “accredited”, which means that they have to have a high value of net worth or meet very high income levels for the past several years.
Once a private equity fund is formed, the money in the fund is used to invest in companies. Most private equity funds invest in private companies. Typically, private equity funds look for struggling companies to invest in, that they can use their expertise to make changes to and bring back to profitability. In fact, a large percentage of these funds look for companies that they can turn around and then sell for a profit. Private equity firms not only purchase large shares in these companies, but they take an interactive role in managing the companies, refinancing them, and reorganizing the companies to be more profitable. Sometimes they buy multiple companies and merge them together to form a larger, more profitable company.
Once a turnaround is complete, or the private equity firm has increased the value of the company, they look to sell their investment. These stakes can be sold to other private equity funds or the company itself can borrow the money to buy back the stock itself. Sometimes the private equity firm brings the company public. By bringing a company public, the private equity firm is able to sell a portion of their stock in the IPO, as well as have access to the liquid stock market in order to sell future shares. Regardless of how they do it, private equity firms and funds do not want to invest in a company for very long. They are typically looking to make 2 to 10 year investments that they can sell to earn money for their fund shareholders.
Private equity is the generic term for these types of companies. There are other private equtiy companies that specialize in funding start ups or that look to buy companies using primarily debt. We’ll discuss those next.
Venture Capital Funds
Venture capital funds are private equity funds that invest primarily in start up companies. Because most start up companies fail, venture capital investing is one of the most risky investments available. It also offers some of the best returns available if the fund is successful. Venture capital funds collect money in the same was as traditional private equity funds. They get accredited investors or other large trust or endowment funds to invest in their fund. Once the money is raised, they use it to buy ownership in start up companies. If a startup company is very desireable (think Facebook or Google back in the day), the venture capital firm will have to compete for its investment. In order to compete, a venture capital firm must have a lot of great industry contacts as well as a strong history of helping to bring successful companies public. For example, a venture capitalist will meet with a start up company and offer use of their business and partner contacts in order to help the startup gain customers, technology or talent.
A venture capital company’s goal is to invest in a startup for the lowest valuation possible, and then help sell the company for the highest price possible. Most successful venture capital investments result in the sale of the company through an IPO or the acquisition of the company at a favorable price. For those startups that fail, the venture capital company typically loses all of their investment. For the startups that are successful, a $10,000 investment can sometimes be worth as much as a million dollars.
Leveraged Buyout Funds
There is another type of private equity fund that uses private money to invest in companies. These are called leveraged buyout (LBO) funds. A leveraged buy0ut is a transaction that uses a great deal of debt (also called leverage) to buy an existing company. For example, a leveraged buyout fund could potentially buy a $100 million company by contributing $10 million in cash and taking out a loan against the business of $90 million. As you can guess, leveraged buyouts are very risky because if the company falters for any reason, it becomes very difficult to continue to make the large debt payments. On the plus side though, using leverage to buy a company also amplifies the returns. In the example above, if the fund was able to improve the company’s performance and sell the company for double the price it paid, it would end up making about $100 million on a $10 million investment. While that is a dream scenario, it is possible for LBO funds to make heady returns.
There is a specialized version of an LBO called an MBO, or managed buyout. A managed buyout happens when the managers of a company pool their own capital and take on debt so that they can buy their company. This type of transaction happens a lot in service companies like investment companies, law companies, and other consulting or service companies. In a managed buyout, the employees typically become owners of the company and then try to improve the company’s cash flow so that they can pay off the debt they took on to buy the company. In many cases, MBOs are independent for a short while and often find new financial backers to relieve some of their debt. In other cases, the companies remain private. In yet other cases, a public company can be taken private by an LBO or MBO.
So in conclusion, private equity can mean a lot of different things. There are specialized versions of it that have specific functions. In the end though, it is clear that the purpose of private equity funds is to create value by helping a company improve, and at the same time offer attractive returns to its investors.