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What Is Private Equity? How Does Private Equity Works? Research Team | Posted On Thursday, February 14,2019, 01:20 PM

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What Is Private Equity? How Does Private Equity Works?



What is private equity?

 Private equity is an investment made directly into a private company or public company that becomes private, in exchange for company’s partial ownership. Companies issuing private equities are not listed on stock exchanges like NSE and BSE. Private equities are highly illiquid as there are very few buyers in the market. Private equities are issued when the company wants to restructure its base.

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What Is Private Equity? How Does Private Equity Works?

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Private Equity Funds

A private equity investment would be made through a private equity firm, a venture capital firm or an angel investor. These categories of investors have their own set of goals, preferences and investment strategies. However, they provide working capital to a target company, to nurture its expansion, developing new products, and restructuring the company’s operations, management, or ownership.  

Types of Private Equity Firms

Below mentioned are the Private Equity Investment Strategies:

  • Venture Capital: Private equity venture capital refers to those investments made in startups and new companies, that have very minimal to nil track record of profitability. Venture capital is one of the fastest growing classes of assets. 
  • Real Estate: Private equity real estate refers to pooling of investors’ capital to invest in real estate. Below mentioned are the most common strategies in private equity real estate funds:
    • Core: Investments are made on low risk and low return strategies with predictable levels of cash flow.
    • Core Plus: Investments are made on moderate risk and moderate return strategy in core properties that require a value added element.
    • Value Added: Investments are made on medium to high risk and medium to high return strategy which involves purchasing properties to improve and sell them at a profit. Value added strategies are employed on properties that have operational or management related issues, requiring physical improvements, or suffer from capital shortage.
    • Opportunistic: Investments are made on a high risk high return strategy. Opportunistic investments in properties require a very high amount of enhancement.
  • Growth Capital: Growth capital investments are made in those companies that have a proven business model and are looking for capital investments to expand or restructure their operations to enter new markets, or finance a major acquisition. These companies generate revenue and profits that are not big enough to fund bigger expansions, acquisitions or other investments.
  • Mezzanine Financing: Mezzanine financing involves both debt and equity financing to finance a company’s growth. With mezzanine financing, companies take on debt capital, which offer lenders the right to convert to an ownership or equity interest in the company, if the loan is not repaid in full within the specified time. Companies wanting to take on mezzanine financing must have an established product with a good reputation in the industry, a history of profitability, with a viable plan for expansion.
  • Leveraged Buyouts (LBO): Leveraged buyout strategies are implemented when a company borrows considerable amount of capital to acquire another company. Private equity firms buyout investments when they feel they can extract value, by holding and managing a company for a defined period and exit the company after significant revenue has been generated.

Leveraged buyouts generally use debt to finance their buyout plan. The goal of a leveraged buyout is to generate revenues on the acquisition that outnumbers the interest paid on debt.

  • Special Situation aka Distressed private equity: Special situation funds target those companies that need restructuring, turnaround, or are in a very unusual circumstance.
  • Fund of Funds: A fund of funds FoF, is an investment strategy in which investments are made in other funds rather than directly investing in securities, stocks, or bonds.

By investing in a fund of funds, investors get benefits of diversification and the ability to hedge their risk by investing in various fund strategies. Investors must know that investing in fund of funds is costly as investors are subject to an additional layer of fees. In addition to the management fees and a performance fee that’s charged at the underlying individual fund level, investors are also levied with additional fees at the fund of funds level.

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Private Equity in India

Following are the popular private equity firms operating in India:

  • Sequoia Capital India
  • Accel Partners  
  • Warbug Pincus
  • Helion Venture Partners
  • Tiger Global Ventures
  • IDG Ventures
  • Qualcomm Ventures
  • Blackstone
  • Fidelity Growth Partners
  • Jungle Ventures
  • SAIF Partners  
  • Steadview Capital
  • Bessemer Venture Partners
  • Softbank
  • Kohlberg Kravis Roberts(KKR)
  • Temasek Holdings  

How Does Private Equity Work?

A private equity investment can be made in a private equity firm, a venture capital firm or an angel investor. These investment strategies have their own sets of goals, preferences and investment planning. However, all these strategies offer working capital to a target company, to facilitate expansion, starting new products, and redesigning the company’s operations, management and ownership. 

How Does Private Equity Firms Make Money?

There are two main ways in which a private equity firm makes money:

  • Fees: Private equity firms usually charge their limited partners around 2% of their capital as management fee on annual basis. These fees are one of the most reliable methods for private equity firms to generate revenues. Management fee is used to fund a firm’s regular operations, including employee salaries and overall costs.

Apart from charging their investors, private equity firms also generate revenues from their portfolio companies through transaction fee which is usually charged at 1% of the total deal amount and monitoring fees which is the fee charged for consulting and advisory services.

  • Carried interest: Carried interest is huge when it comes to private equity firms making big money. When they exit from a portfolio company, private equity firms are eligible for 20% of the profits, however, it’s possible only after the limited partner’s capital commitment has been regained and a preferred return, which is usually around 8% has been met. Limited partners receive the remaining returns after their exit.

Problems Hidden in Private Equity Financing

Private equity firms utilize the cash flow from their investors to buy whole or partial interest in companies. The return on those investments, called the internal rate of return IRR, attracts new investors and defines the success of the firm.

Equity firms are reported to have found a way to artificially boost their IRR as interest rates are very low, by borrowing funds to make new investments. After holding on to the investment for some time, they use investors' investment to pay off the loan and take ownership of the asset when it looks like the investment is about to generate revenues. As a result, it looks like the investors got huge returns over a short period of time. The IRR looks better, but all thanks to the use of borrowed funds.

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