Private equity is increasingly becoming a sought after investment platform both for investors looking for high profits as well as growing companies in need of massive funding. The underlying principle of investing in private equity is the high rate of returns within a comparatively shorter investment horizon as compared to traditional methods. The promise of substantial profits and interest-free business capital is what draws stakeholders to private equity.
The equity business is all about owning shares in profitable enterprises. This is done either by investing in shares of public companies traded openly in the stock market or working with a private equity firm that deals in shares of unlisted private companies. At times, a public company may choose to receive private equity and delist from the stock market as well. In all these cases, the underlying idea is to maximize returns in comparison to traditional methods of investments. Let’s take a closer look.
What is private equity?
Private equity is a fast-growing investment market. Massive HNIs and financial institutions entrust billions of dollars in private equity firms to source and invest in private businesses not listed on the stock market yet showing promise of exponential returns. As of 2019, a whopping $3.9 trillion were held in assets across the US by private equity firms and this figure was 12.2% higher in comparison to the previous year!
Private equity funds typically have an investment horizon of 4- 7 years. These funds are either granted to early-stage growing companies or an established corporation looking to acquire new businesses or restructure their operations. All these activities take time to fruition before they begin to yield the desired scale of profits. Thus only those investors who can invest on a large scale and hold the funds for at least 10 years are suitable.However, it is important to note that not all deals yield equal returns. Investors must have the expertise and mechanism to evaluate risks before committing to these funds. The two most common tools to project return on private equity investments are MOIC (Multiple On Invested Capital) and IRR (Internal Rate of Return). We discuss these in length in the later sections.
How does private equity work?
Since private equity funds range in billions of dollars, they operate in a consolidated manner through a private equity firm. A typical PE firm comprises limited partners (who invest), general partners (industry experts who manage funds), and fund managers (who handle end-to-end operations). These firms usually charge 15-20% of profits in every deal in addition to an annual 2% as management fees to support various operations in the firm.
A private equity firm can invest across industries and geographies based on the viability of the business. They can either choose to enter at the growth phase or later for a global expansion or new IP acquisitions. The investors on board a private equity firm not only contribute funds but their expertise as well. Their immense market experience is an important value-added to every business they choose to invest in. Here are the four basic steps of private equity investments:
- Sourcing deals: Private equity is a competitive market. A strong, reliable business network is important to stay on top of new acquisition opportunities. Usually, every private equity firm appoints a dedicated team of financial analysts to identify opportunities and pitch for the deals.
- Due diligence: Once a deal is agreed on, private equity firms engage a battery of professionals such as bankers, accountants, lawyers, market researchers, and financial analysts to do the necessary background checks to assess, analyze, and verify company documents.
- Managing new company: Once the private equity firm is on board, they take over a portion of the company management. Depending on the type of funding, this could be a board seat or the entire management during their investment horizon. This happens because an equity firm not only contributes funds but aligns the company management towards maximizing profits within a given time frame. This includes mentoring and introducing best practices in financial management and strategic planning. Since the new management team’s compensation includes equity packages, their contribution to the business will directly impact profit margins.
- Exit: This is the final stage of a private equity deal. But the exit scenario and timeline is decided in the early stages when the deal is signed. A typical investment horizon is between 4 to 7 years and the private equity firm exits the business either seeing them through to an IPO or an acquisition.
Advantages and Disadvantages of private equity
Though a lucrative investment vehicle, private equity can sometimes come across as a ruthless proposition. Since large funds are at stake and timelines need to be maintained, private equity operates with razor-sharp precision leaving minimal grounds for error. This approach sometimes might get in the way of valuing the importance of private equity funding. Let’s take a look at some of the advantages and disadvantages of private equity:
Advantages of private equity
- Private equity provides access to large funds in one go. This is beneficial especially for startups as these grants are made based on the business potential and not dependent on company assets (limitations for startups) as is the case with traditional bank loans.
- Private equity investors enter with a long term vision. The aim is to maximize profits. Thus companies are not required to pay back loans with accruing interest rates. This reduces the overall financial burden allowing the business to focus on strategies and expenses that matter.
- Private equity not only brings in funds but a wealth of business experience as well. Investors are usually experts in their fields and their involvement in the business adds the extra edge of technical expertise.
- From an investor’s point of view, private equity is a reliable investment. Since the management team’s compensation directly ties with the company performance, the chances of massive losses are quite less.
Disadvantages of private equity
- In exchange for private equity funds, founders must part with a majority stake in the business. This is usually 90% in the case of buyouts and significant participation in the company board of directors in the case of startups. Founders might find this situation intrusive and overpowering.
- Investors cannot access private equity investments easily as they are not available in the open market. Private equity operates only through limited partners and entertains reputed HNIs and institutional investors.
Types of private equity investment
As mentioned earlier, though all private equity investments run in millions of dollars, based on the stage of business and the industry these can be of many types. Here we discuss the two most common ones – Venture capital and Leverage buyout.
Private equity funds in the form of venture capital focus on startups still in the product development stage and in need of substantial funds to explore and expand markets. With limited assets, these companies cannot raise business loans from traditional financial institutions. Thus venture capital becomes an important source of much-needed funds. Venture capital is provided in stages. Ideally, the startup must have an angel funding round before approaching venture capital. The four stages of venture capital funding are: Seed, Series A, Series B, and Series C. Though investing in a startup is a risky proposition, if all goes well, the returns are exponential. Various tools are used to predict the return on investments. MOIC in private equity is a common method. Sometimes IRR is used in combination as well. We will discuss these in detail shortly.
Leverage buyout (LBO)
Leverage buyouts are all about taking a controlling interest in a mature business. Companies opt for such funds when they want to acquire another company. The firm initiating an LBO pays the least cash while the private equity firm covers almost 90% of it. This form of private equity is extended as a loan in the form of bonds taking company assets as collateral.
An LBO typically restructures business models to turn around underperforming business units. The introduction of a new business plan and a fresh management team is part of the process. The idea is that the returns generated from the acquisition would be large enough to cover the interest amounts required to be paid against the loan.
Irrespective of the type of investments, private equity funding relies heavily on the returns generated out of every deal. Without massive returns, it is not practical to sustain an equity firm with a team of talented professionals. Neither would investors place their faith in a firm that does not have the necessary skills to generate exponential profits from their investments. Thus ROI metrics like the MOIC private equity formula play an important role.
MOIC or Multiple on Invested Capital
The easiest way to measure gains is to visualize them in multiples. Though there are other methods to calculate the probable rate of returns, considering the industry and nature of the business, the simplest projection is in terms of multiples. MOIC does just that.
What is MOIC?
MOIC or Multiple on Invested Capital is a gross metric that determines how much value investment will eventually generate. This can be calculated both at the deal level as well as during portfolio analysis and reporting. MOIC in private equity is a reliable method to determine the valuation of an existing investment as a multiple of the original cost of investment and the extent of profits investors will receive at the exit. Let’s take a look at how MOIC is calculated.
How do I calculate MOIC?
MOIC private equity formula is one of the easiest and simplest methods of ROI predictions. This is calculated by:
This formula works for one investment. However, to get a comprehensive understanding of possible returns across various groupings of deals, a measure known as the Total value curve needs to be considered.
MOIC for private equity is never used in isolation. For a private equity firm to comprehend possible returns for their entire spectrum of investments, a combination of different ROI calculations needs to be used. MOIC values are usually combined with IRR to arrive at a reliable conclusion.
Why is MOIC important?
MOIC values are expressed in multiples such as 1.5x, 2.7x, etc. This is simple and easy to understand. MOIC values are directly tied to the invested dollar amount. It only accounts for the change in gross investment value and not the time is taken to do so.
For example, if a $10 million investment generates a return of $100 million in 10 years, the MOIC is 10x. If the same return happens over 5 years, the MOIC is still 10x. Thus MOIC focuses on the potential of the investment based on its market merit rather than any other variable factors.
MOIC vs IRR
MOIC and IRR both play an important role in the risk analysis of a private equity portfolio. However, the basic difference between MOIC and IRR is that IRR accounts for the time and speed of growth of an investment as well. As seen in the previous example, two different deals varying in time will have the same MOIC but will differ in the IRR readings simply owing to the time factor. These factors affect the MOIC to IRR conversion.
Both MOIC and IRR are important for investors to arrive at a dependable estimate for their returns. While MOIC gives a simple valuation about the estimated amount they will receive from their investment, IRR focuses on “how much” as well as “by when”. IRR plays an important role in pointing out the impact of varying holding periods on investment returns.
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