The private equity market is an essential source of capital for start-ups, private midmarket companies, struggling companies, and publicly traded companies seeking buyout funding.
This market has been the fastest-growing corporate finance market in the last 15 years, outperforming other markets such as the public equity and fixed income markets and private placement debt needs by order of magnitude.
Currently, the private equity market is about a quarter the size of commercial bank loan demand and the commercial paper market. Private equity capital stocks and partnerships raised in recent years have matched, and in some cases exceeded, total IPO and high-yield bond issuances.
But what exactly is private equity? This article is a basic concept for those who want to learn about private markets or work in industries related to private markets.
What Is Private Equity?
Private equity refers to investments in privately held companies not listed on a stock exchange. Private equity firms raise funds from various sources such as institutional investors, high-net-worth individuals, and pension funds to form mutual funds.
These funds are used to own private companies or provide capital for corporate expansions, restructuring, and other strategic initiatives.
Private equity firms typically try to make a profit for their investors by buying undervalued or underperforming companies, improving their operations, and ultimately selling them at a profit. We may also invest in promising start-ups and high-growth companies to help them grow and eventually exit the investment.
Private equity investments are characterized by a long-term view, often several years, in which the private equity firm actively manages the investee companies. This involvement may include implementing operational improvements, strategic planning, and possibly management changes.
Do private equity investors earn superior returns?
PE funds can create value for investors by creating value within their investments, by diverting value from providers by buying below value, or a combination of both by building better businesses or doing a better deal.
Three factors are relevant to the comparison of the returns. First, findings might suffer from sample selection bias because buyouts do not occur randomly in the population of firms.
Second, findings might suffer from survivor bias because only surviving companies remain within a sample over time.
Finally, non-exited investments are carried out at a valuation calculated by the fund managers rather than market valuation, which may lead to distortions in the raw data (Driessen, Lin, and Phalippou 2007).
However, it is important to note that private equity investments also come with risks and challenges. These typically require large capital commitments, have limited liquidity, and have high fees compared to traditional investments.
Additionally, not all private equity investments produce superior returns, and performance varies significantly depending on the fund, strategy, market conditions, and the skills and expertise of the investment team.
What are the main strategies for PE investments?
- Leveraged Buyouts (LBOs): This is one of the most well-known private equity strategies. It involves acquiring a company using a significant amount of debt financing, with the acquired company’s assets serving as collateral for the debt. The private equity firm aims to improve the company’s operations, profitability, and cash flow throughout 3 to 7 years before exiting the investment, typically through a sale or an initial public offering (IPO).
- Growth Equity: Growth equity focuses on investing in companies that have demonstrated a solid track record and have the potential for significant growth. These investments often involve minority stakes in established companies looking to expand, develop new products, enter new markets, or make acquisitions. Growth equity investors provide capital and expertise to fuel the company’s growth.
- Distressed Debt: Distressed debt investing involves purchasing the debt of companies that are experiencing financial difficulties, such as bankruptcy or restructuring. Private equity firms specializing in distressed debt seek to acquire the debt at a discount and then work with the company to restructure its operations and finances to generate a return on investment.
- Mezzanine Capital: Mezzanine capital is a hybrid form of financing that combines elements of debt and equity. Private equity firms provide mezzanine financing to companies in the form of subordinated debt or preferred equity. Mezzanine capital sits between senior debt and equity in the capital structure and often has a higher risk but offers a higher potential return.
- Special Situations: Special situations investing involves capitalizing on unique or complex investment opportunities. This can include investments in companies undergoing significant changes, such as restructurings, turnarounds, or mergers and acquisitions. Private equity firms specializing in special situations employ a range of strategies to unlock value and generate returns.
Bottom line
Private equity firms play an important role in the economy by providing capital, expertise, and strategic advice to companies. However, they also employ financial engineering techniques and often use leverage to maximize profits, which may result in downsizing and other cost-cutting measures, or other cost-saving measures.