Types of Private Equity

In my previous article "Private Equity" we saw what Private Equity is and what its purpose is. There are many different types of Private Equity that are available. In this article, we shall take a detailed look at all of them one by one

Venture capital:

Venture Capital involves the financing of start-up companies. These companies generally don’t have the ability to source capital from traditional sources like banks or public markets as they are in the early stages of their life cycle and often generate negative cash-flows. So, rich individuals who can afford to take huge risks usually invest or rather fund such new business ventures.

Financial is provided during the following 3 stages:
1. Seed Stage – For research, assessment and development of an initial concept
2. Start-up Stage – To finance product development and initial marketing of the product
3. Expansion Stage – For the increase of production capacity, development of markets or products or enhancement of working capital.

Growth Capital:

It refers to equity investments, most often minority investments in relative mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition with a change in control of business. Companies often seek growth capital to finance a transformational event in their life cycle. These companies are usually more mature than venture capital funded companies. They are able to generate revenue and operating profits, but don’t have sufficient funds for major expansions or acquisitions.

Leveraged Buyout:

The objective of a buyout is to purchase a significant portion or obtain majority control of a company. Buyouts attract a bigger portion of private equity capital, both in number and size of deals, then venture capital transactions. Buyouts lend to concentrate on the later stage financing in a company’s lifecycle, thereby taking on more established and mature companies that have a steady, stable and predictable cash flows from the business. Cash flows generated by these companies can be used to pay down the debt, assuming borrowings were used as part of the acquisition process. Larger deals are usually financed by debt as well as equity. These deals are called Leveraged Buyouts or LBOs.


Distressed Debt:

These debt funds seek to acquire controlling stakes in companies that are in financial difficulties or even insolvent through the purchase of debt. They convert this debt into equity through the reorganization of the company.

Infrastructure:

Infrastructure is broadly defined as the permanent assets a society requires to facilitate the orderly operation of its economy. It is the backbone of the economy and is considered an absolute precondition to sustainable economic and industrial development. Due to the large size, cost and often monopoly characteristics of these asses, infrastructure has historically been financed, built owned and operated by the government. Infrastructure assets include:

1. Transport: Toll roads, airport, railways etc
2. Energy: Gas and Electricity transmission, power generation and distribution
3. Water: Irrigation, portable water, waste treatment
4. Communications: Broadcast/Mobile towers, satellites, transmission networks
5. Social: Educational facilities, healthcare facilities, correctional facilities

Mezzanine:

It is a hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies. Mezzanine financing is advantageous because it is treated like equity on a company’s balance sheet and may make it easier to obtain standard bank financing.

Secondary Funds:

The secondary market for private equity is a market for the buying and selling of capital commitments to private equity funds by limited partners, i.e., secondary funds purchase existing limited partnership interests from investors in private equity funds after those funds have been partially/fully invested in underlying portfolio companies.

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"