What Does Private Equity Mean?

Equity capital that is not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.

Private equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange.

A private equity investment will generally be made by a private equity firm, a venture capital firm or an angel investor. Each of these categories of investor has its own set of goals, preferences and investment strategies; each however providing working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership.

Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. In a typical leveraged buyout transaction, a private equity firm buys majority control of an existing or mature firm. This is distinct from a venture capital or growth capital investment, in which the investors (typically venture capital firms or angel investors) invest in young or emerging companies, and rarely obtain majority control.

Simple example

A private equity fund, ABC Capital II, borrows $9bn from a bank (or other lender). To this it adds $2bn of equity – money from its own partners and from limited partners (pension funds, rich individuals, etc.). With this $11bn it buys all the shares of an underperforming company, XYZ Industrial (after due diligence, i.e. checking the books). It replaces the senior management in XYZ Industrial, and they set out to streamline it. The workforce is reduced, some assets are sold off, etc. The objective is to increase the value of the company for a fast sale. The stockmarket is experiencing a bull market, and XYZ Industrial is sold two years after the buy-out for $13bn, yielding a profit of $2bn. The original loan can now be paid off with interest of say $0.5bn. The remaining profit of $1.5bn is shared among the partners. Taxation of such gains is often minimal. Note that part of that profit results from turning the company round, and part results from the general increase in share prices in a buoyant stockmarket. The latter is often the greater component, but of course shares are not guaranteed to go up!

Notes:

The lenders (the people who put up the $11bn in the example) can insure their loans against default, at a cost, by selling credit derivatives, including credit default swaps (CDSs) and collateralised loan obligations (CLOs), to other institutions, such as hedge funds.

Often the loan/equity ($11bn above) is not paid off after sale but left on the books of the company (XYZ Industrial) for it to pay off over time. This can be advantageous since the interest is typically offsettable against the profits of the company, thus reducing, or even eliminating, tax.



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