Private Equity: Characteristics and Risks

What is Private Equity?

Private equity (PE) is a form of equity investment. It is a form of equity raised by the companies in a private manner rather than through any public fundraising. Not all the businesses want or are able for public funds for its business operation, in such situations they go for private equity.

The basic difference between PE and other equity based financing is that private equity raises capital on a systematic basis in sequential fundraising to support and promote the business. Other equity financing focuses on controlling stakes in the business.

PE strategies are defined as venture capital, growth capital and leveraged buyouts. Also, the terms for private equity are changing. Now private equity firms are involved in raising funds for any infrastructural investment, distressed debt and private investment in any public investment.

To define, private equity is a medium to long-term finance with return of equity stake in a potential high growth unlisted companies. PE Firms are also known as General Partners. The major sources of private equity funds are “private equity firms” and “business angels”. Businesses at early, expansion and late business cycles go for private equity funding. Businesses go for this equity for expansion in the form of bridge finance or phase finance or for buyouts in the form of leverage buyout or management buyouts.

What are the characteristics of “Private Equity” ?

Understanding the features of PE funds, we must consider it from three different perspectives:

Investment Perspective

Company Perspective
Investors Perspective

Value-Add Operation

PE involves the stake of the company therefore, smooth operation of the company is equally important for both the parties. Private equity firms are very clear with their strategies and are dedicated to value creation. Reorganization, Cost reduction, technological improvement, capacity building etc. are some activities for value creation.

Higher Risk and Higher Return

Generally PE firms invest in companies with high growth potential. Companies and PE firms operate large research and diligence operations to make business perform well. All the efforts made is to make business work. In such an uncertain environment, efforts either will lead to higher returns or will stand as a higher threat.

Alternative Source of Financing (Funding)

A company can go for different sources of funding. There are multiple alternatives for the raising funds (private or public, institutional or individuals, formal or informal). Every other source of funding has their own features which may or may not be suitable at the required stage of business. Loan from financial institutions have higher interest rate and high rigidity, public listing i.e. IPO is very regulated and costly, individual investors may vary in the ideology etc. Private equity firms provide a feasible and flexible funding route for businesses. Private equity investors are both investors and partners to the business.

Low Regulatory Oversight

Investment by PE firms in a company is a strategic decision of that firm. If a company who seeks investment must satisfy the need and demand of firms for private equity. There is no hidden agenda and required obligation. A firm considers all the return and risk before investing and accepts all the outcomes, positive or negative whatsoever.

There are no stiff standard reporting regulations, submissions or any other requirements.

High Active Involvement

PE firms actively participate in the building of the company. As pe investors hold stake in the company, they not only enjoy the ownership but they take the responsibility to make the company work and earn profit. Such equity firms support the company by providing their expertise and using their network to build the company.

Low Market Efficiency

Such equity funds are invested during the early or growth stage of a business. In such early stages, the business is very volatile and relatively illiquid. The product and services are in the development stage, the business structure is in progress, strategies are formed and dissolved, no creation of revenue stream, R&D controlling the major funds, fragmentation in operations etc. All these factors make PE investment less efficient.

Longer Strategic Horizon

The main goal of PE investment is not ownership, rather the goal is value growth and development of the company. The company and investors seek long term sustainability rather than quick gains. Due to this, private equity has a longer strategic horizon. Generally, PE firms exit the company in five to ten years after getting good return but such firms can lengthen the time horizon by reinvesting it and pursuing better results of the company.

Why do companies go for “Private Equity” ?

Raising PE funds is different from raising debt funds or loans. In private equity, investors or firms exchange their investment for stake and return on such investment is dependent highly on the growth and profitability of the business. The reasons why businesses go for PE is similar to any other sources of raising funds. Some of such reasons are :

Funds for maintaining a working capital base.
Funds for business expansion and development
To finance acquisition of other businesses

For buy-outs to restructure ownership and management
To develop new products in order to grow and remain competitive

The above points are the common reasons for any financing. Some of the particular reason why companies seek PE finding are:

Not all the businesses can afford debt financing due to interest burden. Public issues for raising funds require regulatory requirements and larger capital requirements. PE firms cater the needs of businesses and provide flexible financing options. PE firms keep the interest of business ahead to their investment.
PE firms not only inject the investment but also they bring experienced professionals, corporate discipline, confidence to the businesses.

PE firms invest in those businesses in which they see the potential to grow and really make a difference. In such investor-investment fit, private equity firms generally have a good grip in the market where the invested businesses are working. Such firms have experience in the related sector or industry.
PE financing also brings political and corporate connections which assist the business throughout the business journey.

What are the risks associated with “Private Equity” ?

With the benefits, there comes some risks associated with “private equity”. Some of such risks are as follows:.

Private equity has the risk of liquidity. PE is not flexible or liquid as publicly traded equities. Investors will face difficulty to liquidate their position. Investors are locked in for around 5 to 10 years and they also do not have a proper market to sell the stake.
Operational risk is another risk in private equity. When a PE firm invests in a business, they own a stake of that company. This means, such firms have a strong voice in the operation of the company. Generally, private equity firms work together with the company and help business grow but, there always exists a conflict situation. Lack of coordination, interest conflict, unclear process, not supportive system lead to operations risks.

There is diversification risk in private equity. Stockholders are able to diversify their investment across expansion stages of the business. Firms need to consider different aspects inside the organization for diversification.
PE is subject to market risk. Market factors like interest rate, inflation, exchange rate, government regulations, taxes and tariffs etc. affect the business and investment directly. Such factors directly favors or hurdles the investment of the investors.
Capital risk for investors and businesses. The realization value of private equity investment is dependent on various factors. To determine the value of the business and to invest in it are two risk components. There could be over evaluation or undervaluation of the capital required. In any case, either business or investment firms need to compromise.

References

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