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How does private equity works?
2020-08-17 /

What is Private Equity?

Is your business in need of additional financing to bankroll its expansion and growth? Private equity is one of the best options to consider. This post breaks down what it is and how it funnels to and generates money from its investments.

Like all other financial terms that get thrown around, only a handful knows what private equity means. It’s one piece that completes a gigantic puzzle that you may know as the private markets.

You may or may not be aware of it, but most of the goods and services we consume today are from companies funded through private equity. From manufacturing, healthcare to technology industries, private equity firms infused billions of cash to thriving and undermanaged private companies.

So, what exactly is private equity, and how does it cultivate value to the private market? Read on to find out.

What is Private Equity?

Private equity (PE) is a type of financing in which the capital is invested in companies that are not publicly listed (traded at a stock market). Generally, private equity investments focus on mature companies in traditional industries.

In exchange for the capital infusion, PE firms take an equity or ownership interest from the companies they invest in. As a source of investment capital, PE springs from institutional investors (banks and other financial firms) and high net-worth individuals. Investors may choose private equity funds to chase higher returns or diversify their investment portfolios.

Since it’s a direct investment, it requires a great deal of capital outlay. This is the reason why most of their investors are wealthy individuals and huge firms with more money to burn. It requires their investors to make a minimum investment of $250,000. Some may require millions or more to join the private equity fund.

Private equity firms raise funds and pool them together to achieve a higher return on investment (ROI) for their shareholders. As a long-term investment, it may take between four to seven years for a PE investment to yield positive returns.

How does Private Equity Works?

To put it succinctly, PE firms pool money from their investors to form a fund that invests in various kinds of assets. A private equity fund can be:

Leverage Buyout

It’s one of the popular types of PE funds. It entails completely buying out a company to revitalize its business and financial operations. They then resell these companies for a profit or through an IPO (Initial Public Offering). Usually, PE firms use a mix of equity and debt to fund this type of transaction.

Real Estate Private Equity

After the catastrophic 2008 Financial Crisis that plunged real estate prices, more investors turn their heads to Real Estate Private Equity. This type of funding invests in REITs (real estate investment trusts) and commercial real estate assets.

Distressed Financing

In distressed financing, a PE firm invests in troubled companies (or on the verge of it) with failing business assets or units. They take control of the company by restructuring its business operations. Eventually, the PE firms sell these companies for a profit or make them go public.

Venture Capital

This is a type of private equity financing prominent in the startup landscape. In venture capital funding, the VC firms provide capital to small companies or startups with high-growth projection. They may invest in a company at certain or the entire stages of its life cycle.

Fund of Funds

As the name suggests, it’s a PE fund that invests in other funds such as hedge and mutual funds. This is ideal for small-time investors who can’t afford the exorbitant minimum capital requirement in other types of PE funds.

A Primer on Private Equity

Private Equity vs. Venture Capital

Many people often confuse private equity from venture capital. While they share some similarities, they are different.

Private equity is an umbrella term that refers to specific investments, stakes, or ownership in private companies. On the other hand, venture capital is a subset of private equity, specializing in early-stage startups or small businesses. As explained previously, venture capital is one of the different types of private equity.

To give you a clear picture of their differences, here’s a breakdown between private equity and VC.

Private Equity

  • Private equity firms provide capital to mature companies.
  • With funds from its limited partners, private equity investors can take a majority stake (more than 50%) in companies they invest in.
  • When the private equity firms decide to sell one of its companies to an interested buyer, they distribute the proceeds to limited partners and private equity investors. Limited partners get 80% and PE investors receive 20%.

Venture Capital

  • VC firms target their investments in young companies and startups with high-growth potential.
  • The venture capital investors take the minority stakes (less than 50%) in their investments using the committed capital.
  • This is a risky type of investment since they are investing in companies that are new or are not profitable yet.
  • VC firms gain profits when their portfolio company is acquired by another company, or when it goes public. They also earn by selling a portion of their shares to other investors.

Role of Private Equity Firms

The goal of private equity firms is to boost the value of their investments before selling these companies at a profit. PE firms raise money from investors (individuals, pension funds, trusts, etc.) and pool them together to form a private equity fund.

A PE firm manages this fund and ensures that they return the investor’s money within the investment horizon. Using the committed funds, they are mandated to invest that money within six years. This restriction can prompt PE firms to have an exit strategy for their investments within five to six years.

Grow your Business with Private Equity

If you think your business can grow significantly but lacks funds to support its growth, then private equity can step in to help. However, make sure that you understand the risk involved, especially the enormous stake of over 50% as part of their investments.

To guide you on how to take your best shot at PE financing, our founders at Full Scale can mentor you on this. Matt DeCoursey and Matt Watson are technology entrepreneurs with major stakes in Kansas City’s thriving startup scene.

We highly recommend that you listen to their Startup Hustle podcast, where they share their knowledge and experience about startups and financing. Learning from the business pros will give you the edge before diving into the murky waters of business financing.

The Matts are also the brains behind Full Scale, an offshore software development company in Kansas City. We offer a wide range of tech services such as web and mobile development, QA testing, web designing, and others. To hear about how Full Scale drive growth for your company, send us a message to get started.

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