What is private equity and how does it work?



What is private equity and how does it work?

 There are companies which are listed on the stock exchange and can be traded publicly. But there are also companies which are not listed on the exchange and therefore over the counter exchange (NSE/BSE) is not possible. 

 Private equity is altogether a different asset class wherein institutional investors and accredited investors invest large sums of money (from private equity funds) into unlisted companies or in buyouts of the public companies. The buyout results in the delisting of public equity. The investment horizon in private equity investments is usually mid to long term (average being 6-7 years). One can't sell private equity on a day to day basis.

 There are 2 types of partners in a private equity fund:

  1. Limited Partners: They usually own 99 percent of the shares in a fund. They don't get involved in the day to day operations of the fund and have limited liability.
  2. General Partners: They usually own 1 percent of the shares in a fund. They are fully responsible for the operations of the fund and carry full liability.
Private equity has a characteristic of both good and bad. Companies prefer private equity instead of high-interest bank loans because private equity gives the company better access to liquidity and a chance for senior management to experiment with new products. Otherwise, the company is burdened with performing good every quarter and giving handsome returns to the investor. One more benefit is that even startups can raise private equity with the help of their proof of concept. 

However, an investor needs to be invested for a long time and even the company has to do a lot of hard work to find the investor. Valuing the company is another big problem as it is not listed on an exchange. Furthermore, the investors do not enjoy the same rights as the investors in a publicly listed company.

How does it work?


 The money that is raised from institutional investors by the private equity firms is invested in different asset types. The following are the types of private equity fundings:
  1. Venture Capital: It is the investments made in startups which have little or no track of profitability but have a promising future. The aim of the investment is a low rate buy and high-value exit. 
  2. Real Estate: Under this, the investors capital is used to buy different real estate properties which have a prospect to grow in value in the future.
  3. Growth Capital: This investment is done in already established companies which are running well, have all their operations in place and are profitable. The money would most probably be required for major expansion or acquisitions.
  4. Mezzanine Financing: This type of investment is lustrous as it is shown as equity in the balance sheet. However, the amount is actually borrowed as debt. The debt can be converted to equity in case the company fails to repay the debt.
  5. Leveraged Buyouts: When a company wants to acquire another company, LBO is exercised. Under LBO, the company borrows debt (usually 90%) to acquire another company and puts in some percentage of its own money (usually 10%), assuming that the returns from acquiring will be more than the interest cost of the loan. In future it hopes to exit at a profit.
  6. Funds of Funds: This involves investing a private equity firms money in other private equity funds instead of directly investing in some company's stock or securities.
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 Thanks for reading!
Please comment on any financial query you had like me to address. I will try to post something worthwhile. 


Coming up Next: What are the different investment schemes that are provided by the government?

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