Private equity refers to ownership or interest in a business that is not publicly listed or traded. In a private equity deal, a high-net-worth individual or a firm buys ownership shares in a business with the goal of fostering growth and gaining a strong return on their investment.
“They usually purchase a controlling share in a company, bring in a combination of debt and equity, and manage the company in a way meant to increase its worth,” explained the New York Times. “Ideally, everyone profits when the company is sold, including the former owner, who gets a slice that is worth more than the original pie.”
With this basic principle in mind, there are a few ways private equity agreements are structured. Here are the different types of private equity that may be available to your business.
Leveraged buyout
In a leveraged buyout, a company is acquired using a combination of investor equity and debt from a variety of lenders. This type of private equity deal allows the private equity firm to acquire larger companies than it would otherwise be able to afford, usually leaning on loans to cover 70-80% of the purchase price.
Why would a private equity firm use debt to acquire a business? “Simply put, the use of leverage (debt) enhances expected returns to the private equity firm. By putting in as little of their own money as possible, PE firms can achieve a large return on equity (ROE) and internal rate of return (IRR), assuming all goes according to plan,” explains the Corporate Finance Institute. “Since PE firms are compensated based on their financial returns, the use of leverage in an LBO is critical in achieving their targeted IRRs (typically 20-30% or higher).”
This type of leverage does increase risk; so, as a result, most PE firms only use this vehicle for stable, mature companies with relatively predictable returns.
Venture capital
Venture capitaldeals usually involve private equity investors and small companies or startups with high growth potential, as well as companies that have grown quickly and appear poised to continue to expand. In this funding vehicle, large ownership stakes of a company are created and sold to a small number of investors through independent limited partnerships established by venture capital firms.
Venture capital differs from other private equity funding in that most VC deals target startups and new companies that need the first round of investment to establish a foothold in the market. Many other private equity types focus on larger, more established companies.
[Read more: Choosing the Best Funding Strategy for Your Business]
Growth equity may be raised to subsidize the expansion of business operations, enter new markets or make an acquisition to boost and diversify revenues.
Growth equity
Sometimes known as growth capital or expansion equity, this type of private equity is used by mature companies to fuel the next round of growth. Growth equity may be raised to subsidize the expansion of business operations, enter new markets or make an acquisition to boost and diversify revenues. Usually, in a growth equity deal, the private equity investor only gets a minority ownership stake as part of the deal.
Fund of funds
A fund of funds (FOF), also known as a multimanager investment, is a pooled investment fund that invests in other types of funds. “Typically, FOFs attract small investors who want to get better exposure with fewer risks compared to directly investing in securities — or even in individual funds,” explained Investopedia. “Investing in a FOF also allows investors with limited capital to tap into diversified portfolios with different underlying assets.”
An FOF may not strictly be a private equity investment. Some FOFs are structured as a hedge fund or mutual fund. Usually, the fund is managed by one investor who charges a fee to the other fund participants.
Mezzanine financing
Mezzanine financing is a combination of debt and equitythat’s used by companies to raise funds for a specific project or acquisition. In a default scenario, the lender has the right to convert an equity interest in the company in the case of default after VC investors and other senior lenders are paid. As such, it’s one of the highest-risk forms of debt — they have priority over preferred and common stock but are subordinate to senior debt. Mezzanine financing deals are often unsecured but appealing in that they offer higher yields than regular debt.
These are the main types of private equity deals, but some more niche vehicles do exist. For instance, distressed private equity funds help by lending to or investing in companies in serious financial difficulty. To learn more about variations in private equity, speak to a financial advisor or legal expert.
[Read more: How to Choose Between Equity Crowdfunding and Angel Investments]
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