Private equity has turned into a major portion of alternative investment classes. It is now widely accepted as a mature asset class among institution portfolios. Investors that had little or no investments in private equity are gradually raising their stakes in the game and expanding their private equity investments. This is a major reason private equity investment firms are increasing across the globe.
Private equity is considered a part of alternative investment. It comprises a variety of investment techniques, strategies, and other asset classes that complement stock and bond portfolio, and other traditional ways of investments.
What is private equity?
In simple words of Judah Karkowsky, private equity investments can be defined as investment in securities through negotiation. Major portion of private equity investments is in unquoted companies. Private equity investments are made as part of a transformational, value-added, and active investment strategy. Investing in private equity requires a specialized skill set, which requires investors to pay the most attention when hiring a manager for their investments. Private equity covers a wide range of investments—buyout, venture investment, replacement capital—which follow different processes at different stages of a company, all of which require different applications of these skills.
Private equity investing is divided into following major categories–
1. Seed investment
2. Start-up investment
3. Growth/expansion capital
4. Replacement capital
5. Buyout
The above categories of investments are made at different life stages as a company matures. Each investment has its own dynamics. While this is a simple overview of private equity investments, it provides an easy way for portfolio construction.
Various private equity investments
As described above, private equity investments fall at different life stages of a company. How is the capital provided as part of the investment used differentiates one investment from another?
- Seed stage investments – This is the foremost stage in private equity. The capital provided is used for research, assessment, develop a prototype, or validate a proof of concept.
- Start-up stage: start-ups capital is used for product development and initial marketing. At this stage, companies are typically in the business for a short period and may have sold a few products to validate customer demand. However, they are not generating profit.
- Expansion stage: At this stage, investors provided capital for companies to grow. The capital is used for hiring people, expanding product features/benefits, or increasing business partnerships. Companies are typically at a break-even point and use the capital to scale up production, increase operational efficiency, and decrease turnaround time.
- Replacement Capital: Investors purchase shares from existing investors in the company. Sometimes an investor can pay a debt and reduce the burden on the company.
- Buyouts: This is perhaps the most well-known investment in private equity. A buyout typically means buying a controlling stake in a company, which is often followed by a change in management leadership. Buyout funds are targeted toward mature companies that have sturdy business plans to bear expansion costs, mergers & acquisitions, or spinouts of divisions and subsidiaries.Many times investors can acquire multiple companies to work together. This is called ‘buy and build’ strategy. Buyout investment style can vary from investor to investor, which usually ranges from growth-focused investment to value-added investment, and from early to late-stage investment.
while some PE funds can be actively involved in the operations of the company, some adopt a passive management style. - Special Situation: Sometimes companies may need capital to operate at unprecedented times like global pandemics. While the operation is shut, there’s no way for companies to generate revenue. In these times, private equity firms that invest in distressed companies come into the picture. There are investors who particularly invest during such times. Investing in these times can be broadly categorized into distressed debt, equity-linked debt, and project finance. The opportunity for investment arises due to changing industry dynamics, government regulations, or unforeseen events like the financial crisis. Mezzanine debt financing, where debt-holders seek appreciation in equity appreciation, is a major investment in such a situation.
Takeaways for investors
The number of private equity funds has increased steadily over the last few years, which include investors that have significant long-term commitments to private equity. A large number of commitments to funds come from institutions in their respective region. As investors seek a higher level of geographical diversification in their investment portfolios.
Furthermore, investing in private equity improves the risk-reward characteristic of an investment portfolio. For investors, private equity investment offers the opportunity to generate higher absolute returns while improving portfolio diversification.
