Private equity (PE) is technically defined as investment in privately-held companies by entities like institutional investors, high net worth individuals (HNIs) and private equity firms.
PE is not listed on public stock exchanges. This route can also be used to buyout publicly-traded companies, leading to their delisting from stock exchanges.
PE investment is usually directed at making positive changes in a privately-held company. It could be used for:
# Expansion or diversification
# Restructuring or innovation to become more competitive
# Acquisition
A public company seeking to go private may choose to get funded by PE investors and implement strategies conducive to long-term growth.
Who Invests in PE?
PE investments are primarily made by institutional investors, HNIs and PE firms. The investors include funds such as university endowments, pension plans, pension funds; insurance companies; foundations; family offices; labor unions; and wealthy families.
Three Phases of PE Investment
# In the first phase, an investor signs a legally binding agreement to pay a specified capital to a fund over a pre-determined period. Typically, it is 3–5 years.
# In the second phase, when a PE fund manager comes across attractive investment opportunities, he or she “draws down” the capital committed by the investor. The notice period served by the manager to investors is typically of 5–15 days.
# In the third stage, the investor receives distributions as the manager of a PE fund successfully exits. These are paid in cash but could also be used to offset future drawdowns.
Ways to Invest in PE
The most popular route is investing through a ‘fund of funds’ A fund of funds, as its name suggests, has the shares of various private partners that invest in PE. For investors, it is a cost-effective vehicle because it reduces the initial investment made and allows them to have a diversified portfolio, thereby mitigating the risk.
Another PE investment route is exchange-traded funds (ETFs). ETFs track publicly traded investment products that invest in PE. These enable potential investors to make small investments with no minimum investment threshold. However, ETFs also attract a management and brokerage fee which tends to lower the overall return from investments.
A third way to invest is by purchasing the public shares of PE managers or firms. By buying their shares, investors invest in PE and diversify their portfolio (and reap associated benefits) as this entails investment in a range of funds. However, the returns from investing in public shares may not be as rewarding as direct investments in PE.
Value Addition to Business
Businesses prefer PE funding for the following reasons:
Cash infusion – PE firms have deep pockets. Availing the PE route, therefore, means access to ample financial resources to boost growth, launch a new product, expand or diversify.
Expertise – PE firms, through their network of industry experts, can add more value to the companies they invest in. They aid in meeting new business goals and maximizing value.
Connections – Some PE groups host annual events which attract CXOs and company leaders. This gives them an opportunity to connect with the top layer of corporates.
Disadvantages
As lucrative as PE investments may sound, there are certain disadvantages as well:
# Share capital – The share capital of the owner or founder decreases as it is shared with the PE firm and investors.
# Control – The owner, founder or management team may face loss of control as PE firms come in with their own set of advisers and, at times, even management.
# Date of exit – A PE firm usually has a 3 to 5-year exit strategy. However, it looks at factors such as market conditions and industry dynamics, and accordingly plans the exit. At times, the company and firm could clash on the apt time to exit.
Risks Associated with PE Investments
PE investments are illiquid and have a lock-in period of several years. Due to this, the business and investors face certain risks:
# Operational – The business being invested in must have adequate processes and systems in place or it may end up with a complete loss of control.
# Funding – Businesses invested in can face ‘investor default risk’, which means the investor is unable to provide the capital promised. Usually, PE funds do not call upon all the entire investor capital at one time; instead, only the amount needed is drawn from capital investments for specified opportunities. Hence, at times, the committed capital may not be received by the business.
# Liquidity – Once invested, the funds are locked in for a certain tenure. Hence, investors cannot access their committed capital during that period. They must wait for the defined time period to get over if they wish to redeem.
# Market – PE investments can be affected by market-related factors such as equity market dynamics, geopolitical situations, foreign exchange rates, and interest rates. Changes in any of these can affect industry trends and, therefore, the PE investments made.
# Capital – Capital risk can be summed up as the net asset value of the dormant portfolio and future undrawn capital commitments. The business may not be able to receive this amount.
PE investments are recommended as their returns are much higher and they are not affected by stock market dynamics. However, access to PE is restricted. Regular investors cannot easily invest in it either due to high minimum cap on investment or limited information regarding these funds.
PE is now recognized as a major component of the alternative investment universe. It is acknowledged as an established asset class in many institutional portfolios.
(By Mohak Marwah – Assistant Manager, Financial Services, Business Research & Advisory, Aranca)
