Private equity is an alternate investment class. It is organized as a limited partnership which invests in companies that are not listed. Private equity consists of investors, individual and institutional, that directly invest in private companies, or who buyout public companies and delist their public equity. These are different from venture capital funds, that invest in start-ups and younger businesses who need initial capital for establishment and growth. Private equity funds are more engaged with established businesses which need a cash infusion or if the previous investors wish to exit the business. Private equity investors are usually those who have surplus funds to invest for the long haul.
Types of PE Funds
Private equity firms bring individual and institutional investors to gather funds that invest in different types of businesses. Some of the main areas where PE funds can invest are given below.
- Venture capital: Venture capital investors, or angel investors provide seed capital or early financing to the entrepreneur in the initial stages of business. This is a crucial stage of investment where the entrepreneur’s idea or prototype is scaled up to create or compete in the market and grow his business.
- Growth capital: In India, most PEs invest in the growth story of a company by providing growth capital. A small private company cannot scale its business to a large extent without external, non-debt funding, and PE funds provide the very same. Thus, with the help of PE, small companies can go beyond conventional means of funding based on just its existing assets and realize their expansion plans.
- Leveraged buyout: This is a common form of PE, where the PE fund infuses money to completely takes over the business through a special purpose vehicle (SPV). After takeover, the PE takes measures to strategically improve the financial health of the company by downsizing,replacing the management, etc. to turn around a company and then looks for an opportunity to resell the business for a profit. They can also raise an Initial Public Offering (IPO) to divest their holding.
- Distressed funding: This became a popular investment avenue for PE firms after 2008 crisis. Here the fund invests money in distressed companies with under-performing assets. They can take either of the following courses of action – a) improve operations, b) change the management, c) sell individual assets for a profit. Under performing assets could be plant and machinery, state, or even intangible assets like intellectual property rights.
Global advent of PE
Private Equity funds became a part of mainstream funding in America in the 1970’s during the technological revolution. Technology mammoths like Apple and Intel can accredit the scaling of their businesses by leaps and bounds to the early PE funding received. 70’s and 80’s saw the rise of PE players who were a perfect fit for companies struggling to obtain funds away from the market without resorting to high cost debt. The PE industry boomed all the way till the 2008 financial crisis. A Harvard study found that companies that were funded by PE performed better than publicly funded companies.
PE in India
The early 2000’s saw a great deal of enthusiasm around PE, due to factors like younger entrepreneurs entering the market, over 7% of GDP growth, reduction of bank NPAs, etc. However, apart from the period between 2005-2008, the prospects of PE investments appeared rather bleak. This was because it was observed that Indian companies preferred going the public route than private equity route.
However, companies which went the PE route displayed incredible progress. According to McKinsey’s research, companies in India that obtained PE funding have increased revenues and profits much faster than public companies. PE in India has proven to be a significant source of capital for Indian companies. PE in India contributed 36% of equity raised by companies in the last decade. During slowdown in the economy, PE backed firms performed better than other firms. Private equity provided 47% equity funds to companies in 2008 and around 46% on an average during 2011 to 2013. 2017 saw a record PE investment in India of $26 bn which was a 60% increase from the previous year.
However, the need for PE investments in India is very different from other developed countries. Ashish Dhawan, co-founder of ChrysCapital PE observes “Our belief has been that over the last decade, the sweet spot for private equity is really not what it is in the Western world, which is leveraged buyouts, financial re-engineering, taking family-owned businesses and professionalizing them,” he says. “Instead it’s working with entrepreneurs who have a mid-sized business, putting in capital and helping the business to become three or four times its size over a five-year period of time.”
The downside of PE investment
The ultimate objective of a PE firm is to increase shareholder value for the investors of PE. PE funds look at businesses as a short-to-medium-term value creation opportunity, which they achieve by gaining outright control of the company. Time horizon for PE investment is generally less than ten years, and to achieve this goal in a certain period of time, many-a-times, an aggressive approach is taken by the PE funds. Many businesses are wary of PE investments because the goals and objectives of the company may not match with the interest of the PE. Long term company goals may be compromised for the short-term profit objectives of the PE fund. In case of leveraged buyouts, and distressed funding, PE firms often resort to extreme measures like letting go of employees, selling off valuable assets like IP, reducing the influence and role of the founding fathers of the business, etc. which affects the goodwill of the business and can be detrimental in the long run.
- What kind of returns are generated by PE funds for its investors?
Since PE funds prefer to enter businesses during the high growth phase, they aim for a minimum internal rate of return (IRR) of about 25-30% per year with a time horizon of 3-5 years in any particular business. This means that PE investors are looking to double, triple or quadruple their returns in this time period. This is called as Multiple On Capital Invested (MOIC).
- What is the structure of a PE Fund?
A PE is generally organized and managed by a partnership firm This is called as a General Partner (GP). High Networth individuals and Institutional investors like pension funds, sovereign wealth funds, insurance companies, foundations, etc., participate in the firm as Limited Partners (LPs), and contribute money for investment. These Limited Partners contribute almost 85-95% of the capital for investment, while the rest is shelled out by the PE firm. The PE will create separate funds and invest in different companies/sectors through this route. Individual Funds make investments in investment seeking companies. The structure of PE Fund is illustrated below:
- How is Private Equity different from a hedge fund?
A hedge fund, just like a PE, is also a limited partnership. But the primary difference between the two is that hedge funds indulge in speculation and earn profits thereon; while PE aims at investing in businesses over a longer horizon to increase shareholders value. Some of the differences are mentioned below:
Hedge funds invest in short term and liquid assets, and are aimed at booking profits as soon as possible, to move on to the next promising investment. PE Funds, on the other hand, look for making substantial profits over a longer horizon by improving the company’s value.
PE firms have to commit a certain amount of capital to be infused in the business over a certain period of time, failing which severe penalties may be levied on the fund. On the other hand, hedge funds can invest their money in lumpsum and can liquidate it at any point.
Hedge funds are open-ended investments with no restrictions on transferring, while PE investments are close-ended and cannot be transferred for a certain time period.
PE charges the investors a fixed management fee (e.g. 2%), along with a variable incentive fee (e.g. 20%), after crossing a certain pre-decided hurdle rate. In case of hedge funds, since investors invest on different NAVs, the hedge funds would earn an incentive if the fund crosses the high water mark, i.e. the highest value that the NAV has reached.
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