Finance Guide: A note on Private Equities
Private Equity is an equity capital that is not traded in any public exchange. Companies seeking private equity may also be growing companies not yet ready for an IPO and without the cash flow to support bank debt. Private equities is generally preferred by the issuers because it has more control over the confidential information as it requires less disclosures, has less working cost, offers negotiable terms and conditions with Investors, it insulates the company from stock market volatility.
An equity issue can be made to the new investors in two ways, Public issue through IPO or Private placement. The later is called private equity and the fund invested on the private equity placement is called the private equity fund. There are many differences exist between the public and private equities. Private equities doesnt trade in any authorized stock exchange, they do not have common regulation as in public issue.
The advantages of issuing private equities are; the operational cost is cheap, the issuer of the equity has more control over the organization. Investment return is very high; investors can reap more than 50% of the premium amount as the return.
The private equities also have disadvantages for both the issuer and the investor. For an issuer; if they do not perform well, the ownership of the company will be lost. For an investor; they lock-in period is long, if the company is not performing well there is a possibility that the money invested will be bankrupt and finally it is difficult to sell the equities in the secondary market.
Private Equity forms
Private equities are raised in multiple forms and each type has its own purpose to serve
Venture Capital is the money invested by the investor to start up a new venture or business with perceived long term growth potential. This is an important source of raising funds for the start-up firms which cannot have access to the capital market initially. Venture capital is preferred by the investors due to the high return on investment it offers which overrides the high risk involved in the venture capital fund.
Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt or bonds. The downside for issuer is that venture capitalists usually get voting rights on the company in addition to the equities and profit sharing in the form of dividend received for the ownership equities.
Venture capitalists often prefer debt with warrants because the repayment of debt is a return of principal rather than a return on capital and is therefore not taxed. The venture capitalist can then retain the warrants even though the company goes public and enjoy the upside in the now-public company. They can enjoy the tax benefits until they exit through the sale of stocks.
Growth Capital is a private equity form that seeks to maximize the capital appreciation, increase in the portfolio or asset over a long term. This form of equity is issued purely to raise the capital fund for growth perspective. While the investors look for high returns, this form of investments protects them from severe loss in the portfolio value on any uncertainty.
Buyout is an investment transaction by which the ownership equities of the company or a huge share of the stocks of the company is acquired. In private equity transactions, there are two types of buyouts happen generally
- Leveraged Buyout (LBO)
- Management Buyout (MBO)
Leveraged buyout is a strategy used to acquire a company using significant borrowed money to meet the cost of acquisition. In this type, the assets of the company being acquired are treated as the collateral for the borrowed money in addition to the assets of the acquiring company. The main purpose of leveraged buyout is to allow the companies to make large acquisition without committing lager capital fund.
Management buyout is a form of acquisition where the managers or executives of the company acquire all or large part of the equities from the existing shareholders. Management buyouts are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company, and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them. The seller is also unlikely to give any but the most basic warranties to the management, on the basis that the management knows more about the company than the sellers do and therefore the sellers should not have to warrant the state of the company.
The purpose of such a buyout from the managers' point of view is to save their jobs, either if the business has been scheduled for closure or if an outside purchaser would expect to take control of the management with his team. They may also want to maximize the financial benefits they receive from the success they bring to the company by taking the profits for themselves.
Both the LBO and MBO funds prefer a straight equity position with a board seat. The advantage is control; equity with voting rights gives the maximum amount of control over the company for a given level of investment.
Mezzanine capital is a convertible investment type, basically a debt capital which gives rights to the investor/lender to convert the debt capital to equity shares with voting rights if the money invested/lend is not returned back by the company in time. It is a hybrid of debt and equity financing that isis typically used to finance the expansion of existing companies. Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range. To attract mezzanine capital, company should shown continuous progress and have good track of records.
Private Equity Placement
Private equities fund can be either raised or invested in two modes
- Direct mode
- Private placement agencies
In this mode, private equity issuers approach the investors directly to raise the fund. And investors do research and due diligence on their own to evaluate the private equity investment.
Private placement agency
In this mode, the issue or the investor approach the third party agency/consultants to make the private equity deal. Issuers approach third party consultant to help identify the potential investors. Investors approach the consultants to help them do research and due-diligence process on the fund being invested. The consultants charge broker fees or commission for the work they do either from issue or investor depends on the seeker of the private placement agency.
Private Equity Investment Structure
The investment on the private equities can be done by two types of investors
- Qualified Institutional investors
- Qualified Individual investors
Qualified Institutional Investor
A non-bank person or organization that trades securities in large enough share quantities or dollar amounts that they qualify for preferential treatment and lower commissions. Institutional investors facefewer protective regulations because it is assumed that they are more knowledgeable and better able to protect themselves. Life Insurance Company is a typical example of institutional investor.
Qualified Individual Investor
Individual investors are those who buy and sell securities for their personal account, and not for another company or organization. They are also called as Retail investors. Wealthy individuals are typical example of individual investors.
Private Equity Issue Type
Private equities will be issued in any of the below types based on the agreement between the issuer and the investors.
- Common Stocks
- Preferred Stocks
- Debt Warrant
Common stock is a security that represents ownership of the company. Common stock holders have the right to elect the board members and have voting rights on company policies. They share the profit of the company through dividends for their ownership equities. Common stock holders can realize their money only after the preferred stock holders are paid for their equity shares.
Preferred stock is a class of ownership in a corporation that has ahigher claim on the assets of the company and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the sharesusually do nothave voting rights.
A Debt warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two financial instruments, it gives the buyer to exercise the right but not the obligation to buy the underlying stock at a specified price, quantity and time. Warrant holders have the right to convert the warrant to common stocks and they do not have any voting rights or enjoy dividends.