Private equity is finance provided in return for an equity stake in potentially high growth companies.
However, instead of going to the stock market and selling shares to raise capital, private equity firms raise funds from institutional investors such as pension funds, insurance companies, endowments, and high net worth individuals.
Private equity firms use these funds, along with borrowed money and their own commercial acumen, to help build and invest in companies that have the potential for high growth.
Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions.
However, it does not always take a monetary form; it can also be provided in the form of technical or managerial expertise.
Venture capital is typically allocated to small companies with exceptional growth potential, or to companies that have grown quickly and appear poised to continue to expand.
Venture capital refers to funds used to invest in companies in the seed (concept), start-up (within three years of the company’s establishment) and early stages of development. In turn, private equity denotes management buyouts and buy-ins.
In general venture capital funds invest in companies at an early stage in their development when they often have little track record of profitability and are cash-hungry.
In contrast, private equity funds invest in more mature companies with the aim of reducing inefficiencies and driving business growth through often increased margins and/or new sources of revenue growth.
As soon as a private equity house completes an investment, often before, it will sit down with the company’s management team and work out the best strategy to take the business forward and drive growth.
This method of working side by side - of private equity backer sitting down with management - is fundamental to why private equity is such a successful way of building a business.
This ‘active ownership’ stands in contrast to public companies, where there are often hundreds or thousands of different shareholders. In private equity, the investors will generally own a controlling stake and are directly involved in the running of the business.
A plan may include seeking out and entering new markets for growth, product development and innovation, training of management teams, improving procurement and the efficiency of supply chains, making acquisitions, strengthening financial controls and operating systems and preparing a company for exit.
By having a much shorter reporting line between investor and company management team, it ensures the interests of the two are very much aligned. Both the private equity house and the management team are motivated by the same goal – to increase the value of the business. By keeping the reporting lines short, private equity has a strong incentive to be actively engaged in the running of a company.
The ultimate aim of venture capital investors is to create value. As such, they look for high quality management teams with a credible plan to grow their business.
Venture capital investors are long-term investors and work with the company’s management to improve the company’s performance and strategic direction by aligning incentives, improving business plans, making operational improvements and strengthening corporate governance.
With this mentality to buy and help build, coupled with a disciplined approach to organisational governance, venture capital investors display a nimbleness and adaptability that raises the value of their investment and ensures that value can be realised in the future.
The attraction of private equity investment to a company and to the management is the opportunity for managers to own a significant portion of their business.
Aligned interests between the managers and the investors fosters the sense of ownership that is central to the concept of private equity investment.
Besides the infusion of capital, companies also benefit from the experience and insight that fund managers bring to the board room.
Private equity/venture capital adds value to a company in a variety of ways. Thorough due diligence sheds light on a company’s strengths and weaknesses alike, and with it comes a sound initial investment rationale.
By targeting growth sectors and new markets, pe/vc investors can focus on creating better revenue generation and implementing programmes that yield operational efficiencies. In addition to cost reduction, organic growth is now increasing in importance as growth by acquisition is becoming relatively harder to undertake.
It is also critical to establish a structure in which both investors and business managers share a common ownership vision, and are motivated to maximise value. Active ownership, effective organisational change and powerful incentive schemes are all part and parcel to the hands-on governance model that includes constant and keen oversight, defined goals and timing, disciplined decision-making and deep resources to match.
Ultimately, this approach leads companies owned by pe/vc to outperform similar publicly-owned companies with relative benchmarks.
The main reason for investing in private equity is to improve the risk and reward characteristics of an investment portfolio.
Investing in private equity offers the investor the opportunity to achieve higher absolute returns while at the same time improving portfolio diversification.