Private Equity and Private Companies: A Temporary Marriage
- Private equity companies provide meaningful investment capital to growth-oriented businesses.
- Companies enjoy direct and indirect benefits from a private equity company backing them.
- Private equity has a specific investment horizon, after which it implements an exit strategy.
No company can thrive nor survive without capital. A source of capital that finds its way to businesses that show significant growth opportunities and are in need of a cash injection is the vehicle, which is private equity (PE). By definition, it is an investment made in a private company that is not publicly listed. PE offers this capital to companies that necessitate it for an identified reason and purpose. Be that as it may, the role of a PE does not stop there. PE is not a philanthropic instrument - it is a deliberate strategy to invest in companies and participate in or lead management-level decision-making to create a lucrative exit opportunity.
Public vs Private Companies
There are three key differences between investing in public and private companies. One, with public firms, the share prices are driven by the market. Yet, PE requires an extensive and intense negotiation process to determine a fair value of the equity. Second, the liquidity of public shares is high since these can be sold nearly instantaneously, whereas private stock has no stock exchange, which makes it challenging and time-consuming to find a buyer. Third, shareholders experience a high level of protection due to the fact that company performance can be monitored constantly. PE investors do not enjoy this luxury and are obligated to protect themselves.
Benefits of PE
In the scenario that a PE firm does opt to invest in a company, this provides four direct or indirect benefits to the target company. Backing up a specific company is not a decision made overnight, and other parties are aware of this fact. Consequently, a PE-backed company indicates great health and growth potential. Moreover, the company gains access to the PE’s network, such as suppliers, banks, and customers. As mentioned before, PE takes up an active role in management. This comes together with both soft knowledge in terms of company management, but also hard knowledge that encompasses a more specialized outlook. Lastly, an obvious benefit is the injection of cash that the entire investment is built on.
Strategy of PE
Both private equity and venture capital target very specific moments in the life cycle of a company. The stages include seed-, startup-, early stage-, expansion-, replacement-, and vulture financing. This is where the distinction between PE and VC comes to play. VC is applied specifically to the seed-, start up- and early growth phases.
A highly used method throughout all these stages in the world of private equity is leveraged buyouts – also referred to as LBOs. This method starts with a PE investor creating a so-called special purpose vehicle (SPV) in which it holds a 100% stake. Then, the PE raises debt capital to the point that the debt-to-capital ratio is 90%. Once that requirement is fulfilled, the investor uses the cash to fully acquire the target company. The past decades have shown exponential growth in private markets. Dealmaking is at record levels, with the global value of LBOs reaching $1.2trn in 2021, whilst the previous record was set in 2006 with $800bn.
However, as highlighted in the title, the relationship between a PE firm and a private company ends at a certain point, most often after 5-7 years. Once the specified goal of upgrading technology, expanding the business, acquiring another business, or even reviving a failing business has been reached, the PE firm looks toward an exit opportunity. One of these strategies to offload the investment is to offer company shares to the public market through an initial public offering (IPO). Another, and perhaps most used, strategy is for the invested company to be strategically acquired by another company that can use the firm’s resources and capabilities. The synergy between the acquiring company and PE-backed company and the value that it offers drive a premium on top of the firm value. In addition, it is fairly common for PE firms to sell their stake in the company to another PE firm. The least favourable exit strategy is to liquidate the company after a failed strategy.
A temporary marriage - one that can leave both partners much better off. As the global reach of private equity extends, it will help the industry provide benefits to companies, investors, and economies all around the world.