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Tuesday, February 1, 2011

Private Equity

Private Equity is a catch all term that is used to describe various investment strategies. Let me begin with a caution “Private Equity is not for the normal investor who invests his hard earned money in small quantities”. Private Equity products are usually available for investment only for High-Net-Worth Individuals or HNIs as they are more commonly called. This is because, these instruments carry extremely high levels of risk when compared to the normal investment options like shares, mutual funds, bonds etc. This article is just an introduction into Private Equity.

What is Private Equity?

Private Equity refers to the equity capital invested in a private company. You may be asking me how is equity held privately?

Lets say I am planning on starting a new business which requires a capital of 10 lacs but I have only 5 lacs at my disposal. I contact two of my friends who are interested in the new business I plan on starting but are not aware of the business nuances. I convince them to invest in the project promising them private equity as returns. i.e., I will create 10000 units each worth 100 rupees and give 2500 each to my two friends and retain 5000 myself (10 lacs is the total investment and I put in 5 lacs myself so I keep 5000 units or 5 lacs worth of equity myself and give 2500 each to my two friends who invested the 2.5 lacs in my project)

Now there are 10000 private shares of my company that are jointly held by me and my friends.

Aim of Private Equity:

The Aim of Private Equity is to monetize later through trade sale or buyout or an IPO.

Ex:

Buy Out: If I sell my business 5 years later when my business is worth 50 lacs, every rupee invested in my project is worth 5 rupees now. So anyone who is buying my business will be paying 50 lacs as a whole and I will share the proceeds with my friends based on what they invested. i.e., I will give 12.5 lacs each to my two friends for the 2.5 lacs they invested in me.

Trade Sale: If my business is doing very well, potential private equity buyers will be willing to buy into my company. So if my company is worth 50 lacs at the end of 5 years and a potential buyer contacts my friend and strikes a deal, he can sell his 2500 shares of private equity he owns in my company to the buyer who will pay him 12.5 lacs which is the worth of those 2500 shares he owns.

IPO: You might already know what an IPO is. So if I plan on releasing an IPO for my company, I have to take care of my private equity holders too. So lets say I give out 10 lakh shares to the public, a ratio will be decided for private equity holders. So for ex: 2500 private equity shares might be worth 25000 normal equity shares and my friend will be allotted 25000 shares when my company gets listed. He will make a profit by selling these 25000 shares in the stock market.

Risks involved in Private Equity:

The main risk involved in private equity is the fact that, my business might go bust or not make profits as suggested in the preceding paragraphs. There is no guarantee that my business will be a success. So, if I screw up on my business strategies and my company goes bankrupt, the 2.5 lacs my friends invested is gone. I din’t guarantee them returns when they invested. I only projected that if the business goes well, they will make solid profits.

But, as in all investments, rewards from private equities usually outweigh the risks involved.

There are many different types of Private Equity investments available. They are covered in the next chapter "Types of Private Equity"

1 comment:

  1. nice lucid article :)keep continuing posting such good articles :)

    ReplyDelete

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