Private equity, meaning, definition and which funds to invest in

private equity is a form of financing that is increasingly widespread and valuable for Italian SMEs and, in general, for companies with high development potential.

The importance of this investment tool is now rooted in the world. Data from the US financial consultancy firm Bain & Company revealed that private equity funds control more than 28,000 companies globally, for a total value of 3.2 trillion dollars.

Although it is not a type of investment born recently, private equity has therefore experienced a real boom in recent decades and is today the undisputed protagonist of global finance.

Let’s see below the meaning of private equity, how it works and which funds to invest in.

What is private equity, meaning and definition

Private equity means:

a medium-long term financial operation, carried out by specialized investors and aimed at providing risk capital to a company (called target), generally not listed but with high growth potential.

The aim is then to divest and obtain capital gains from the sale of the shareholding.

The term private equity can be translated as “private investment”, with 2 fundamental characteristics:

• it must take place outside the public market and therefore contact companies not listed on the stock exchange;
• must be done through a security that does not create debt

It follows that the purchase of shares of a company listed on a stock exchange does not fall into the category of private investment, since trading on the stock exchange is by nature public. The same applies to the purchase of bonds of an unlisted company: it is not an example of private equity, since the offer of bonds on the market determines the creation of debt towards the buyer.

The subjects who invest in a company through private equity are called private equity investors, while the companies that manage the collection of funds and the purchase of company shares on behalf of investors are called private equity funds or private equity firms.

From a historical point of view, the birth of private equity is made to coincide with the foundation, in 1945, of the British company 3i Group, through which the Bank of England was able to finance small companies with high growth potential with risk capital.

However, many economists have identified examples of private equity ante litteram in some corporate acquisitions that occurred in the early decades of the 20th century, including that of the American steel giant Carnegie Steel Corporation by the banker John P. Morgan (1837-1913), founder of the US bank of the same name.

How private equity works

To understand in a simple way how private equity works, we can distinguish three phases that make this investment tool operational:

• the collection of money to invest through the creation of funds;
• the selection of unlisted companies to finance;
• divestment

First of all, therefore, private equity companies collect funds from investors who have expressed interest in certain companies. Among those who invest are:

• Listed companies;
• Banks and insurance companies;
• Prominent personalities in the business world;
• Pension funds;
• Retail investors who meet the requirements for access to the fund.

A private equity fund can also purchase shares on behalf of Exchange traded funds (ETFs) or hedge funds, i.e. speculative investment funds.

Once a company to finance has been identified, the private equity fund begins to acquire its shares for a period of time that is usually not less than 5 years. This is the actual financing phase, during which the support offered to the company translates into the provision of money, but also into support for management, the creation of a successful business plan, and general management.

When the objectives are achieved, the fund proceeds to liquidate all the company shares previously acquired.

This is the disinvestment or “way-out” and can last another 5 years. A private equity fund can liquidate its investment in different ways:

• Sell shares of the companies financed after the listing on a regulated stock exchange;
• Sell shares to a competing company or another private equity fund, without reaching the stock market listing;
• Sell shares to the company that you helped finance

How to invest in private equity: high-performance funds

Before knowing how to invest in private equity, it is important to underline that there are different forms of investment on which to focus based on your objectives.

The most well-known and widespread include:

• Seed capital: this is the financing of recently established startups, with no turnover and no real guarantees. Usually, the financing comes from the so-called "angel investors", i.e. rich benefactors who can also decide to invest without profit;
• Leveraged Buyout: consists in acquiring a company, improving its commercial and financial situation, and reselling it at a later time;
• Going public: the expression that can be translated as “going public/making public” refers to the stock listing. Consequently, the ultimate goal is to allow a company to land on a stock exchange;
• Going private: literally translated as “privatizing”, its purpose is to exit the regulated financial markets of a given company, which can be permanent or temporary;
• Mezzanine financing: they are a hybrid form between private equity and pure financing

The investor interested in this instrument must consider that it is usually a long-term investment and aimed above all at specialized investors.

Choosing the private equity companies to rely on is a fundamental step, as is identifying strategic sectors in which you want to invest.

Compared to investing in the listed market (in companies listed on the stock exchange), it is always necessary to evaluate the greater rigidity and longer timescales of a private investment.

Although the returns can also be very attractive compared to the invested capital, the commitment of the investor in private equity is longer-term and cannot be liquidated at any time as is done with the sale of shares on the stock exchange.

So, what are the high-performance private equity funds? At a global level, the following certainly stand out:

the Americans Blackstone and KKR, Carlyle Group and EQT, a Swedish fund among the largest in Europe.

Private equity: advantages and disadvantages

Like any form of investment, private equity has many advantages and just as many disadvantages.

The advantages of private equity

First of all, private equity allows companies immediate access to liquidity, without having to resort to traditional methods, such as issuing bonds or requesting a bank loan.

As illustrated above, forms of private equity can facilitate the inflow of capital in favor of companies still in the start-up phase, with the consequent strengthening of their management structure and their presence on the market.

Private equity also presents advantages for investors, who can record large capital gains after selling on the regulated financial markets the shares of the companies they have helped to finance. Obviously, the shares of a company financed through private equity can be sold and purchased even if the aforementioned company is not listed on the stock exchange, in that case however the methods of buying and selling will be different.

The disadvantages of private equity

The first disadvantage is represented by the different ways in which negotiations take place of company shares of companies financed with private equity: the sale or purchase price is the result of negotiations between buyer and seller, and is not influenced by the trend of supply and demand, as instead happens for stocks listed on regulated financial markets.

Furthermore, owning shares in a private equity company does not guarantee every shareholder the same rights, as these are also established by negotiations. For example, a company can grant a shareholder who has purchased 10,000 shares for $1 million the right to vote on future strategic choices, while another investor who has purchased 1,000 shares for $100,000, this right could be denied.

By virtue of these aspects, it is not always possible to find a perfect match between the needs of the seller and those of the buyer. Therefore, both the company that finances itself through private equity, and the investors, risk having to spend a lot of time and energy in the search for a buyer.

Private equity and venture capital: the differences

In common parlance, the term “venture capital” tends to be considered synonymous with private equity.

In reality, these are two different things, since venture capital is a specific form of private equity, thanks to which it is possible to finance innovative startups or projects with strong long-term growth potential or companies that are no longer in the start-up phase, but which on the other hand have negative cash flows.

The private investor or the companies that finance the start-up or growth of an economic reality through venture capital funds are called “venture capitalists” and have numerous analogies with angel investors, to the point that it is not always easy to distinguish these two figures.

Generally speaking, we tend to see a venture capitalist as an individual or company that invests professionally in projects that are coming out of the start-up phase, while an angel investor would prefer very small businesses that have no revenue and have not yet received funding from other parties. As already mentioned, the differences between the two figures are not always clear-cut.

Original article published on Money.it Italy. Original title: Private equity, significato, definizione e su quali fondi investire