Private equity is a term that often crops up in the world of finance and investment, but what does it mean, and how does it work? If you’re a business owner or entrepreneur you need to have a clear understanding of private equity, as it can be a valuable source of capital for your company's growth.
In this article, we will explain private equity and shed light on its inner workings, its relationship with venture capital, regulatory aspects, and more.
What does private equity mean?
Private equity, in its simplest form, refers to investments made by individuals or firms in private companies rather than publicly traded ones. When a business seeks private equity, it typically approaches private equity firms or high-net-worth individuals looking to invest in promising enterprises.
Private equity can take various forms, including equity investments, management buyout’s and buyin’s, and venture capital investments. Private equity is an alternative way of raising investment that is very popular for SME’s and start-up businesses particularly in the tech space.
How private equity works
Private equity companies pool capital from their investors, which can include pension funds, endowments, wealthy individuals and other institutional investors. The private equity companies then use this capital to acquire ownership stakes in private companies. The goal is to enhance the performance of these portfolio companies and eventually, realise a profit on their investments by sale or an initial public offering (IPO).
The private equity process typically involves the following steps:
1. Identifying potential investment opportunities
Firms conduct thorough due diligence to identify companies with growth potential.
2. Structuring the deal
Once a promising opportunity is identified, the firm structures the investment, often involving the injection of fresh capital
3. Taking control
In some cases, firms take majority control of the target company, giving them the authority to make strategic decisions
4. Improving operations
Firms work closely with portfolio companies to improve operations, enhance profitability, and create value
5. Exit strategy
Firms aim to exit their investments with a substantial profit, often through a sale, IPO, or merger.
Are private equity firms regulated?
Many private equity firms in the UK are subject to regulatory oversight, primarily by the Financial Conduct Authority (FCA). While they may not face the same level of regulation as banks or other financial institutions, they are required to adhere to certain rules and guidelines.You should carry out due diligence on private equity investors to see if they are a regulated fund and to check their track record on investments made to date.
What do private equity firms look for in an investment?
Private equity firms seek specific attributes in potential investments, such as strong growth potential, a robust business model and the opportunity to create value. They are particularly interested in mature companies with a proven track record and a need for capital to expand and sometimes start-ups in the tech space.
Private equity firms commonly actively participate in the management and decision-making processes of the portfolio companies they invest in.
How do private equity firms evaluate companies
Private equity firms use a meticulous evaluation process to assess potential investments. Here’s how the process works:
1. Financial analysis
Review the target company's financial statements, cash flows and balance sheets (assess revenue growth, profitability and financial stability of the target company).
2. Management team
Examine the capabilities and experience of the management team to ensure they can drive the company's growth effectively.
3. Market position and competitive landscape
Analyse market dynamics, trends and the competitive landscape to understand the company's position within its industry and its competitive advantages.
4. Growth prospects
When assessing the company's potential for expansion and market opportunities, look for indicators of a future return on investment.
5. Risks and challenges
Identifying potential risks, such as market volatility, regulatory changes or operational issues is part an important part of due diligence.
6. Operational efficiency
Scrutinise the company's operations to identify areas where improvements can be made to enhance profitability.
7. Strategic fit
Check that the investment aligns with the firm's overall strategy and investment portfolio.
8. Due diligence
Carry out rigorous due diligence, encompassing legal, financial and operational assessments to uncover any hidden issues or liabilities.
9. Exit strategy considerations
Plan for how to realise a profit from an exit includes strategies including sale, IPO, mergers and other exit routes.
10. Value creation plan
Develop a detailed plan for working with the company to enhance its value (this includes strategic initiatives and operational improvements).
How do private equity firms buy companies
Private equity firms acquire companies through various methods, such as leveraged buyouts (LBO’s) and management buyout’s (MBO’s) and management buyin’s (MBI’s).
In an LBO, a private equity firm uses a combination of its own funds and borrowed money to acquire a company.
In contrast, an MBO involves the existing management team of a company teaming up with a firm to purchase the business. The chosen acquisition method depends on the specific circumstances of the deal and the objectives of the firm.
In an MBI, a new management team will be brought in to purchase the company (sometimes in combination with the current management team (BIMBO)).
What is the difference between private equity and hedge funds?
Private equity and hedge funds are both alternative investments, but they differ significantly in their strategies and objectives. Private equity firms aim to take a hands-on approach to enhance the performance of the companies in which they invest.
In contrast, hedge funds typically focus on various investment strategies and often engage in short-term trading of publicly traded securities. The key distinction is that private equity investments involve a more extended commitment with a goal of creating long-term value.
Are private equity and venture capital the same?
Private equity and venture capital are similar in that they both involve investments in private companies. However, they cater to different stages of a company's life cycle. Venture capital firms typically invest in early-stage startup’s with high growth potential, while private equity firms focus on more mature companies looking for capital to expand or restructure. The risk profiles and investment horizons also differ, making them both distinct investment strategies.
How do interest rates affect private equity
Interest rates play an important role in private equity. When interest rates are low, the cost of borrowing for private equity deals is reduced, making it more attractive for firms to pursue acquisitions and investments.
On the other hand, rising interest rates can increase borrowing costs, potentially impacting the profitability of these investments. You should keep an eye on interest rate trends, as they can influence the availability of funding.
Get legal assistance from LawBite
Understanding how private equity works and its implications is crucial for business owners and entrepreneurs looking to secure capital investment. To navigate the intricate world of private equity, you should seek the legal support of experts who can guide you through every step of the process.
At LawBite, we're your trusted partner in navigating the legal landscape of private equity. Our corporate legal services cover everything from drafting Investment Agreements to Shareholder Resolutions and other due diligence documentation. We understand the unique needs of businesses and offer practical and tailored legal solutions.