What is Private Equity?
Private equity is long-term investments in unlisted companies, ie companies outside the stock exchange. The investments are typically made by a fund and the purpose is to build a better company through value-creating activities, which in turn creates a return on investment. The companies in which private equity invests are called portfolio companies.
Private Equity in-depth defenition:
Private equity is an alternative investment class, a form of private financing that is neither listed nor active in the public market.
Instead, investments are made by private investors in the Private equity company, which in itself invests or buys parts of companies that need access to capital.
The investments made in private equity are primarily made by institutional and accredited investors, as these can set aside significant sums over longer periods.
This is necessary as there is a long wait for the holding period.
When the companies can either buy out themselves or if the investors can sell their shares in the company further, the goal of the investment is achieved and the private equity company can distribute the profit to the investors.
How does Private Equity work?
What a private equity company does is that it raises money from investors to funds and then invests in companies in need of more capital, both growth companies called “start ups”, companies that are in financial instability to restructure them to some extent, so-called “turn around companies” or completely buy up companies so-called “distressed fundings”.
The purpose of investing in turn around companies is to make the necessary changes in its operations and management and sell some of the company’s assets for a profit.
The assets in question vary from physical things such as machines and real estate to intangible property as well as patents, for example.
While distressed fundings means that companies are bought out completely with the intention of improving it and then reselling it for a profit or conducting an IPO.
Investments in start-ups are made to allow new companies with new ideas to grow by raising larger capital and then reselling all or some of their shares in the company at a profit when it has grown larger.
Disadvantages of Private Equity
Private equity as an idea has unique challenges. Firstly, it is difficult to predict how one’s investments will develop in advance, so it is important that investors have liquid funds to be able to afford the waiting time.
There is also no form of platform that brings investors / buyers together with sellers, the company that wants investment must instead actively search for suitable investors or buyers of the company.
The pricing of the shares in the company is determined through negotiations between buyers and sellers and not by market forces, as in the case of listed companies.
Likewise, the shareholders’ rights and obligations are determined through negotiation as there is no framework to follow similarly in the public market.
Private Equity over the years
It is the last three decades that private equity has been widely known as a concept. However, it has been used in practice since the beginning of the last century.
It is said that the bank magnate JP Morgan in 1901 carried out the first so-called lever instrument of a large steel company called Carnegie Steel Corporation which he merged with other steel companies, together formed United States Steel which became the world’s largest company.
However, these types of large mergers were discontinued in 1933.
Companies that used private equity had a side role in the financial ecosystem until the 1970s when venture capitalists began investing in the American technological revolution, companies from Silicon Valley including Apple and Intel received the necessary funds for its founding through private equity.
It became very popular in the 1970s and 80s and an awareness of the industry spread which resulted in greater available capital for funds and the size of investments generally increased.
Just before the financial crisis of 2008, Private Equity had its absolute peak and studies from Harvard show that companies supported by private equity performed better than their counterparts in the public market after the stock market crash.
In the years following the financial crisis, private credit funds have been responsible for the growing operations of private equity companies.
What is a venture capitalist (VC)?
A venture capitalist (VC) is a private equity investor who provides financial resources to companies that show high growth potential in exchange for a share capital.
It can be to finance start-ups or support small businesses that want to expand but do not have access to the stock market.
Venture capitalists are willing to risk investing in such companies because the return can ultimately be very favorable if the companies they have invested in succeed well.
This always entails risks that require the venture capitalists to have liquid funds and can afford to risk any failures.
How the growth companies finance themselves
Growth companies, so-called start-ups, need to raise capital in several rounds at the beginning of their growth journey. These are called rounds.
How the trips look varies from company to company and there are no exact parameters for how these rounds should look in full or how they should be defined, however, this can be explained in general terms.
1. Seed / sowing round:
The first round is often called a seed or seed round and is the money required to start the company in addition to the ones that the founders themselves put into it.
Those who invest in this round are often from contacts, acquaintances or venture capitalists who are sometimes called business angels.
The purpose of the money from this round is to get a “Minimum-viable product”, also known as “MVP” which will show how the product or service works, get sales started and give customers the chance to evaluate these.
Round two in the order is called A-round and is when the growth company begins to show results in the form of sales or services for recurring users, for example.
The goal of this round is to continue to develop the business and at the same time optimize the product or service and to show that there is a profitability in the company’s business concept.
Round three is called B-round and is about building on the company further through, for example, expansion to new markets, expanded product range and getting a complete organization in place.
The fourth round, the so-called C-round, involves scaling the company to several markets in, for example, other countries or completely globally.
For several companies, this is the last round before a stock exchange listing is made or the company continues to be financed with its own funds.
However, it is not entirely uncommon for several rounds, D- and E-rounds to be made within tech companies.
What is a buyout? A buyout is an acquisition of a controlling interest in a company. Buyouts occur when a buyer acquires more than 50% of the company, which leads to a change of control.
Companies that specialize in financing and facilitating these, act alone or cooperate with other companies and are usually financed by institutional investors, venture capitalists or loans.
In buyouts where the company’s management buys out shares, it is called a management buyout. If large loans are required to finance the purchase, it is called a leverage purchase.
Management buyouts (MBO) provide an exit strategy for large companies that want to sell departments that are not part of their core business, or for private companies whose owners, for example, are to retire.
Upon purchase, the management of the company being acquired receives a share of the profit. The financing required for an MBO is often significant and is usually a combination of loan and equity.
Leveraged buyouts (LBO) are financed by borrowed capital with the company’s assets as collateral for the loans.
The company that makes up the LBO may only provide 10% of the capital for the LBO while the rest is financed through the loans.
This is a high-risk strategy but which can result in high returns that are also required to pay the interest on the debt. The company that makes the purchase sometimes sells parts of the acquired company to pay off the debt.
Private equity vs investment company – what is best to invest in?
Whether a regular investment company or a private equity company is the best investment option for you depends on your own investment strategy, the type of company you have the highest hopes for and not least your own risk appetite.
Furthermore, the difference between private equity and investment companies is that investment companies are often much easier for small savers to invest in because significantly more of them are listed on the stock exchange.
Given that the portfolio holdings in traditional investment companies largely consist of larger, more mature and already listed companies, stability is generally better – but the growth potential can also be somewhat lower.
This is because the main and most expansive growth usually takes place in the earlier development phases.
If you are somewhat more risk-averse and want to invest in companies that could potentially become real growth rockets, PE companies can be something for you.
Compared with ordinary investment companies, however, significantly fewer private equity companies are listed on the stock exchange, which makes the supply much narrower.
The difference between private equity and investment companies
- Investing in unlisted companies – the holdings consist of smaller and younger companies at the beginning of their development curve
- Investments are made through private equity funds
- As a rule, has a definite (though not necessarily short-term) ownership horizon
- Can be divided into Venture Capital and Buyout depending on which development phase they focus on
- Investes mainly in listed companies (although separate portfolios with unlisted holdings also exist), the portfolio consists mainly of mature, more stable companies
- Investments are made to a greater extent with public capital as many investment companies are listed on the stock exchange
- Buys and owns shares in order to both take control of companies, but also to actively drive them and generate growth
- More stability, but also lower growth potential
How does Private Equity work with sustainability?
Sustainability, which investors call ESG (Environmental, social and corporate governance), is today an important part of the private equity funds’ work with portfolio companies.
There is great demand from institutional investors to invest in sustainable companies and long-term sustainable companies lead to good returns.
It is not only about investing in new business models and in technology that contributes to sustainability, but also about restructuring existing companies so that they become more sustainable and thus have better conditions to survive and become more competitive.