There are many major forces in today’s investment world. Few are bigger than private equity. In this guide, our investment experts at Red Grass Ventures plunge into the weeds of private equity to explain what it is, how it works, its different forms, and why it may be beneficial for prospecting investors. Explore private equity below, and invest with our team today.
Private Equity: A Definition
To define private equity, it’s easiest to take the two words within the term and examine how they work together. We’re starting at the end with the term “equity.” Equity is defined as valued shares representing a portion of ownership in a company. In today’s market, equity of companies can be traded publicly or privately. Public equity can be purchased by anyone in the form of equity shares. (Companies often go public with an initial public offering (IPO) in an attempt to raise capital and expand.) Private equity, by contrast, is not publicly listed or traded. Private equity represents shares in a company purchased by private entities.
Who’s Doing It?
At this point, you may be wondering who, exactly, is involved in private equity. If the public cannot buy shares of certain companies, who can? And why would they do so? Before getting to the why, we’ll spend some time explaining the who. Investment for private equity typically comes from large firms and high-net-worth individuals capable of purchasing large shares of private companies. Today’s private equity industry is comprised of large firms funded by investor groups or large institutional investors (pension funds, for example).
Often times, those looking to invest in private equity cannot deal directly with private companies: instead, they must invest their money with private equity firms. Private equity firms have the connections and expertise to invest capital, with the ultimate goal of significant return on investment (ROI).
Put simply, private equity firms pool investor money to acquire significant stakes (in other words: a lot of shares, often even an owning percentage) in certain companies. Determining which companies are selected for investment rests in the hands of high-ranking private equity firm employees, as well as those investors who have contributed large sums of capital. (Many private equity firms require several hundred thousand or million dollars to invest. Control over investment decisions requires even more.)
Types of Investment
Not all private equity firms invest in the same way. There is a spectrum of investment — which is really a spectrum of involvement — with passive investment on one end and active investment on the other. Pure passive investment is strictly financial: private equity firms supply companies with capital, and companies use it to grow and increase profits. With active investments Red Grass Ventures becomes more than just a financier. In these situations, we provide operational support to companies (typically in the form of management) to help them grow and realize goals that align with both parties.
Private equity firms offering active investment typically have extensive networks comprised of “C-level” relationships. In layman’s terms, this means private equity firms looking to take an active role in investment have a list of CEOs and CFOs they can call on to hire or consult for their prospective companies. This is often a huge benefit for companies in search of private equity investment, as these connections bring in talent that can help companies realize their goals.
Benefitting Both Parties
You may still be wondering why a company would want investment from a private equity firm in the first place. The first and simplest answer is capital. Private equity firms can offer companies money, which can catapult those companies to new levels of success. The next answer is expertise and connections. Private equity firms can supply companies with new personnel and connections, which can help them grow in ways that money can’t necessarily buy.
But what about private equity firms? What’s in it for them? We mentioned above that the ultimate goal of a private equity investment is to garner significant ROI. Infusing capital into growing companies can help them grow much larger and earn on their own. When this happens, private equity firms earn back their investment capital and then some.
It’s easy to understand, on a general level, that a successful company could garner significant ROI for a private equity investor. What’s harder to understand is how private equities get to the point where their investments are yielding significant returns. This starts with successfully deal origination and transaction execution. Many private equity firms have staff that research and reach out to companies in order to secure deals. Similarly, private equity firms have connections to source investment from wealthy individuals or other entities. Private equity firms must use their expertise to execute transactions that they predict will yield the highest ROI. This involves assessing an individual company’s management, understanding the current state of a given industry at large, scrutinizing historical financials and forecasts, and ultimately conducting valuation analyses. If a private equity firm decides to move forward after this phase, the deal moves into the due diligence phase, which includes validating a company’s operational and financial figures.
Concerning the deal itself, private equity firms create value through a number of different investment strategies. Two of the most widely-implemented are venture capital investments and leveraged buyouts. The latter of these strategies, leveraged buyouts, are the least intuitive for many just starting to learn about private equity. In a leveraged buyout, a private equity firm is able to buy a company for only a fraction of the purchase price. The purchase is financed (leveraged) with debt, and the company’s existing and future assets are used as collateral. In these cases, a private equity’s promise of growth or a high-return company sale is what seals the deal.
The second strategy, venture capital investment, is more straightforward. With a venture capital investment, a private equity firm simply gives a company capital so that the company (which is typically relatively young) can grow and ultimately provide an ROI for the private equity firm.
In many cases, a private equity firm’s final goal is to sell a company to a larger corporation for a profit. However, this is not always the go-to investment strategy. Many private equity firms will hang on to stake in companies for much longer as those companies become profitable and provide steady ROI through earnings.
Private Equity With Red Grass Ventures
Learn more about how we’re using our experience to change the private equity landscape and providing expertise to business owners.