Private equity is among the most desirable sectors of financial services, so much so that even the chosen few who make it into the M&A divisions of investment banks are clamouring to get in.
Like the capital markets divisions of investment banks, private equity firms help raise money for companies in need of c. But while the banks will do this by selling shares or bonds in a company, a private equity company will offer funds to companies directly in return for an ownership stake. As a result, private equity companies are part or complete owners of a company in which they invest.
Most private equity firms will go through a period of fund-raising, where they raise the capital needed to make investments in particular companies. This comes from large institutional investors like pension funds, insurance companies or rich individuals. Big firms raise tens of billions of dollars and as a result most obviously do not spend this on a single firm, but instead run a ‘portfolio’ of companies. The aim is to increase the value of these companies and sell at a profit later. This isn’t always done in the friendliest manner. Private equity firms have been accused of being ‘predators’, engaging in the unpopular tactic of asset stripping – breaking a company up and selling its assets in order to make a profit.
Private equity is actually a catch-all term to describe a form of alternative investment and there are many different types of companies which have different investment styles.
The aim is to increase the value of these companies and sell at a profit later
Leveraged buy-out (LBO): This means that a private equity firm targets large, mature and (supposedly) stable companies. As the ‘leveraged’ part of their name suggests, they do this with a little of their own cash and a lot of money they’ve borrowed from other sources, which includes bank loans. During the height of the pre-crisis years, PE firms would use up to 90% debt in order to fund their investments, but nowadays this figure is close to 50%.
Once invested, LBO firms look to increase returns on their investment and create value by cutting costs, looking for new revenue sources or looking for similar companies to acquire. Huge private equity players like KKR, The Carlyle Group and Blackstone groups are examples of LBO firms.
Venture Capital (VC): Almost the polar opposite of LBOs in that they are small and nimble investors who aim to take smaller stakes in potentially high-growth companies and make sure they reach their potential. A good example of a big area for VC currently is the fintech start-up space. These firms are looking to disrupt both wholesale and retail banking industries and are flooding the market. In the first six months of 2015, VC firms invested a record $1.5bn in London-based fintech firms alone, according to figures from London & Partners.
VC firms either look to take a stake in a firm at an early stage – where they’ll typically take more control of it because of the increased risk to their capital – or at the later stage when a company’s product is more established and the VC firm feels that they can maximise its growth potential by introducing them to new customers and partners or help with the recruitment of required expertise.
Growth equity: These firms sit somewhere in the middle of LBOs and later stage VC firms. In fact, the former often have growth equity funds as part of their portfolio. The idea is that the PE firm invests in mature, expansionary companies, taking a relatively small stake. Say this company is looking to make an acquisition and needs cash, or needs capital to expand – this is when a growth equity company gets involved.
They take less of an active management approach in the portfolio company and the hope is that their stake will increase in value through the firm’s activity.
In the first six months of 2015, VC firms invested a record $1.5bn in London-based fintech firms alone
Distressed investments: It’s not the private equity firm that’s in distress, but rather the type of investment they're targeting. This type of investment falls into three distinct categories in itself. ‘Distressed debt’: Either buying up securities that are in trouble with the assumption that they are undervalued and will therefore pick up in value in the future, or with the aim of taking a controlling stake in a company on the cheap. ‘Turnaround’: Taking control of a company in financial difficulty and manage it toward profitability again. ‘Special situations’: A complex form of investment where firms look to invest in an under-valued company in order to exploit price inefficiencies ahead of an expected event.
Mezzanine Capital: Relatively speaking, easy money for a company looking to raise cash quickly. Mezzanine funds are affectively a form of debt capital for a company hoping to expand. Little due diligence is done on the investment, but strict conditions are attached – the lender has the right to convert the debt into an ownership or equity stake if the loan is not paid back on time.
On top of all these categories, you’ll have private equity firms who have a focus on a particular sector – say energy companies or technology firms – but larger institutions tend to be ‘generalists’.