Private equity is essentially a way to invest in some assets that aren’t publicly traded or to invest in a publicly-traded asset with the intention of taking it private. Unlike stocks, mutual funds, and bonds, private equity funds usually invest in more illiquid assets, i.e. companies. By purchasing companies, the firms gain access to those assets and revenue sources of the company, which can lead to very high returns on investments. Another feature of private equity transactions is their extensive use of debt in the form of high-yield bonds. By using debt to finance acquisitions, private equity firms can substantially increase their financial returns.
Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet. Generally, private equity fundraises money from investors like Angel investors, Institutions with diversified investment portfolios like –pension funds, insurance companies, banks, funds of funds, etc.
Types of Private Equity
Private equity investments can be divided into the following categories:
Leveraged Buyout (LBO): This refers to a strategy of making equity investments as part of a transaction in which a company, business unit, or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically more mature and generate operating cash flows.
Venture Capital: It is a broad sub-category of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business.
Growth Capital: This refers to equity investments, most often minority investments, in companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.
Structure of Private Equity
Huss (2005) describes that investing in private equity can be done in two ways: a direct investment or an investment through a fund. A direct investor participates in privately placed offerings and is responsible for the investment process. Such an investment is not only very time consuming and costly, but it requires a certain know-how and experience in the private equity market. When investing through a fund, one can be faced with problems due to asymmetric information between investors and entrepreneurs. These entrepreneurs have a better knowledge of the real conditions of the firm, the market, and potential risk factors.