Beginners Guide to Private Equity Investment
We explore the various types of private equity funds and understand how such deals are signed.
Private equity is increasingly becoming a lucrative option in the finance industry. High net worth individuals and institutions alike are seeking out private equity firms to pool their money into profitable investments. In this article, we discuss the world of private equity in detail. We explore the various types of private equity funds and understand how such deals are signed.
Let’s begin with the basic question – what is private equity investment?
Private Equity Investment
The investment market is categorized into private and public equity. Those stocks traded in the stock exchange make up the public equity market. While those invested in private companies, unlisted on the stock market are part of the private equity chunk. Let’s explore this a bit more.
What is private equity (PE) investment?
Private equity investments entail the purchase of equity primarily in private companies. Another approach is to invest in public companies to convert those to private. These investments are specific and not available to everyone in the open stock market. PE investments support a wide range of businesses starting with new startups to established Corporates. They play a dual role in nurturing new ideas as well as restructuring established businesses to maximize profits.
Private equity investments operate on the principle of ‘buy-sell’. The basic idea is – to buy equity in private companies in their new/less profitable stages, mentor/re-strategize business plans, ensure massive profits, and exit by selling all the shares for heavy returns. Metrics of these investments are measured in multiples of IRR. Owing to the commitment of multiplying investor’s money, the decision of these investments is carefully based on factors such as sound business models, talented management, and an attractive customer base.
Who should invest in private equity?
The private equity process is time-consuming. Right from sourcing the funds, investing, and waiting for profits takes almost 10 years. Hence high net worth individuals and institutions that can invest large sums and hold on for a long period are best suited for private equity funds. Additionally, these investors must be ready to incur the risks as well. Exit from private equity funds is a time-consuming process. Patience is key for these high return opportunities.
However, private equity investments are highly profitable when pursued with precision. Some of the stark advantages of investing in private equity are:
- Private equity is a good source of debt-free funds. Startups as well as established businesses find this beneficial as they are not burdened with periodic interest payments. On the other hand, investors have an opportunity for exponential profits as compared to traditional debt instruments.
- Since these funds support startups as well as mature companies, the extent of their reach is wide. With private equity funds, investors can risk entering new markets with high potential.
- Private equity creates accountability between investors and the company. PE firms either take a position in the company’s board of directors or take over complete ownership. Either way, this gives them the opportunity for higher involvement in the workings of the invested company. PE firms are always abreast of the latest updates and keep their investor partners informed as well. This is usually not the case with debt financing, where the relationship is strictly timeline driven transactions.
- Private equity investments happen after carefully managed due diligence. Profits may vary based on the industry but the chances of losing all money are low.
PE investments are typically large funds. They seldom operate as individuals. To source and manage such large funds, they require a structure and team to drive them. This is where private equity funds come in. In the next section, we discuss this in detail.
Private Equity Funds
With an evolving private equity market, more investors with deep pockets are flooding the scene. The inflow of such massive funds is also encouraging startup entrepreneurs to enter the market with innovative ideas and a realistic vision to see them to fruition. Thus, it has become imperative to consolidate these funds and provide startups a unified approach for funding. On the other hand, investors can contribute funds to a reliable investing process. This is the idea behind forming private equity funds.
What is a private equity fund?
PE funds are an organized effort towards private equity investments. Money from wealthy and experienced individuals and institutions are pooled under a private equity firm to operate as a single fund. These firms typically have Limited Partners (LP) who invest and General Partners (GP) who manage the funds. A dedicated team of investment professionals is entrusted with the entire process starting with sourcing these funds to the exit process.
Investors participating in private equity funds have to commit a certain sum for a fixed period (5 – 10 years). Some firms have an entry cap of $250K. This could be higher for others. The PE firm then takes the responsibility to invest these funds in prospective companies and distribute the profits made back to the investors. PE funds earn a percentage of the profits (approx. 20%) and by claiming a performance fee from investors (approx 2%) for all assets under their management. Let’s explore some basic types of equity funds.
Types of private equity funds
Based on the size of the investment and the stage of a company’s growth cycle, private equity investments are categorized as follows:
- Venture capital – This category of equity funds is targeted at startups. They are granted in phases and normally increase progressively with every round. Once a startup begins to receive venture capital, it is expected to deliver the promised milestones at every round. A venture capitalist typically holds a board seat in exchange for equity. Apart from money, they also mentor the startup management that proves beneficial to every growing business. Following are the different stages of venture capital funding:
- Seed – After a startup has bootstrapped into the market, the first round of external funding is the ‘seed’ round. As the name suggests, this money is required for the basic groundwork of a business. This includes formative activities such as developing the MVP and thorough market research. A typical seed fund ranges between $250K and $2M. Venture capital at this stage is also known as micro VCs considering the comparatively small amount.
- Series A – This round of venture capital is granted to companies that have already developed a prototype, have initial adopters, and have a well-tested business plan. Series A funds range between $2M and $10 M.
- Series B – This is the expansion stage of a startup. Usually, the Series A private equity investors choose to lead the Series B as well. Series B funding is used to expand production capacity, team strength, explore new geographies, strengthen working capital, and the likes. Investments in this category range between $7M and tens of millions.
- Series C – This is an optional funding round and not raised unless the startup has a specific requirement. These are massive investments in the range of hundreds of millions. Such massive funding is usually required for globalization efforts, acquisitions of IPs or new business, expansion of product lines, etc.
- Growth capital – Unlike venture capital, growth capital is for mature companies with established business models. Comparatively, these are small investments and used to expand into new markets, restructure the business, or finance an acquisition. Growth capital acts more like a support fund to an otherwise flourishing corporate falling short of additional funds to support expansion plans. Private equity investment in this case receives a minority stake.
- Buy out – Also known as a Leverage Buyout (LBO), this category of private equity funds is sought to finance new acquisitions of another company. It is a combination of equity and debt. The idea is that the returns would surpass the expenses incurred by the debt component. The firm undertaking the LBO provides the least fund, while the PE firm provides 90% of the investment. As a result, the PE firm takes over ownership of the company during the investment horizon.
- Others – Other forms of private equity investments include real estate, fund of funds, and mezzanine finance. Real estate private equity is categorized based on the extent of risk and possibility of returns (Core, Core Plus, Value add, and opportunistic). While fund of funds is all about investing in other PE funds, rather than directly investing in stocks and bonds. This helps diversify risk. Meanwhile, mezzanine finance is granted in the form of subordinated debts, warrants, and equity. This is mostly granted in the context of an LBO.
Process of Private Equity Investment
By now we have gathered a fair idea about the concept of private equity investments and the type of investors who create this fund. But this is only the beginning. To have a successful shot at private equity, entrepreneurs must have a clear idea about how long this process takes and how it works. In this section, we discuss the entire process of private equity investment.
The private equity investment process primarily proceeds in three phases – sourcing the capital and share purchase, restructuring the business process of the acquired company, and setting the company up for sale. However, a lot of care is taken to sign private equity deals. It is these deals that set the course for a profitable exit. Just the deal signing process could take several months to almost a year. Let’s take a look at the private equity deal process:
- Teasers – Private equity investments are either done directly by PE firms or facilitated by intermediaries such as investment banks. Irrespective of who is sourcing the deal, a lot of meticulous work goes into creating a ‘teaser’ which is a 1 -2-page document shared with the buyer. It carries a brief about the company for sale. It carries an outline of the company, its products and services, and key financial metrics. The identity of the company however is withheld until further stages.
- The non-disclosure agreement (NDA) – Once a PE firm expresses interest in a teaser, they are required to sign an NDA either with the intermediary or directly with the management of the company up for sale. After this, they are given the Confidential Information Memorandum (CIM) that carries an investment thesis, financials, projections, and the capital structure of the company on sale. Based on these statistics, the PE firm has to decide whether or not to proceed with the deal.
- Due diligence (base) – At this stage, due diligence is required to estimate the ROI based on the financial details provided earlier in the CIM. At times investment banks are involved to assess the potential of debt financing for acquisitions as well.
- Proposal submission – Every private equity firm employs a team of investment professionals to work deals. As the stakes are high, a lot of research, background checks, analysis, cold calling, and networking go into the process of shortlisting profitable deals. After the initial due diligence, this investment team submits a proposal to the PE stakeholders. The proposal might be taken into immediate consideration or sent for another revision involving consultancies if required.
- A non-binding letter of intent (LOI) – Meanwhile, the investment team issues this non-binding LOI to the target company offering a valuation range for the acquisition. The target company will then take these LOIs from prospective PEs and shortlist bids before the auction. Since ownership rights are entwined with private equity investments, the target company will evaluate the LOIs with utmost scrutiny. Some factors to be considered here are the expertise of the PE firm, their value creation strategy, the credibility of the offer, compatibility of the company management with the investors, and among several others, the range of offered purchase price.
- Due-diligence (intermediate) – Once the target company otherwise known as the seller shortlists a PE firm, they start sharing more confidential information. Virtual data rooms with restricted access to stakeholders are used in this process. It is easy to collaborate and assign tasks using this tool. Some important documents shared via virtual data rooms are IP related documents, legal and organizational entities, operational records, board meeting minutes, audit reports, employee agreements, etc.
- Internal operating model – This is a highly detailed revenue model. Based on the key drivers of the target company, PE firms create this detailed cost breakdown of every aspect, fixed and variable. This exercise provides a good exercise to estimate the expected ROI from the seller.
- Preliminary investment memorandum (PIM) – After the private equity firm has drawn its internal operating model, a PIM is created. This is a detailed 30 to a 40-page document submitted to the PE investment committee. It contains an executive summary, an overview of the target company, market and industry reports, financial and valuation reports, risk factors, exit plan, and a proposed project plan.
- Due diligence (final) – Once the private equity investment committee gives a go-ahead to the PIM, final rounds of due diligence is performed by the investment team. This team closely works with consultants on the finals checks on the financial and legal documents of the target company. Once everything seems right, investment banks are approached to explore opportunities for debt financing.
- Final investment memorandum (FIM) – After all the necessary due diligence activities conclude, the private equity investment committee signs the FIM. At this stage, the investment team specifies the value of the acquisition. The target company may accept or reject this proposal.
- Final bid – If the target company agrees with the acquisition value quoted by the PE firm, the investment team shares the final bid with the seller. This has all the important documents such as the preliminary merger documents and financials from the investment bank. Once the seller receives the final bid, the company management will take it under advisement along with many other bids they might have received. After careful evaluation, they finalize the winning bid.
- Deal signing – This step involves signing the final transactional contracts. In the final stages, the involvement of legal entities becomes crucial to close the deal. The final merger agreement is created in consultation with the private equity firm, the target company, and the company lawyers.
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