Private Equity – How It Works

Private equity is a widespread form of capital and a popular alternative form of investment. In the financial sector, it allows companies to grow rapidly and, in return, investors expect high yields from the investment. But what exactly does private equity (PE) mean?

Private equity refers to equity investments that are acquired in unlisted companies. This is why private equity is also often referred to as being off-market.

Investments are usually made by professional investment companies that specialize in private equity. Due to the present low-interest rates in the financial sector, there is an increasing search for income from equity capital. The counterpart to private equity is public equity, i.e. exchange-traded equity capital.

Private equity – How does it work?

Private equity companies use the money collected from investors to launch so-called private equity funds. The capital is used to buy shares in several target companies. Financing is usually not provided by the fund alone. External investors and banks are also involved in co-financing.

Participation often leads to a restructuring of the company in order to increase profitability. The goal is to optimize the company such that it becomes profitable. Among other things, influence is exerted on the strategy or management. Private equity companies thus also actively contribute their expertise.

Strategically, they strive for a blocking minority, i.e. a minority holding in the company of at least 25.1 percent, so that they have the opportunity to make or prevent important entrepreneurial decisions. As a rule, however, the aim is not to have complete control over the company.

After a few years, when the strategic goals have been achieved and profitability increased, an exit takes place. For example, the shares are then sold to other investors, repurchased by the former owner or the company is listed in an Initial Public Offering (IPO).

What do private equity companies want?

Private equity companies can be categorized into different areas, which are defined according to their field of activity, such as industry, company phase, region or level of financing. These are investment companies that buy shares in a company and sell them back after some time at the highest possible profit. They actively advise and support the target companies in order to increase their enterprise value. As a rule, private equity companies look for target companies that can guarantee a stable capital flow. These are predominantly small and medium-sized enterprises (SMEs).

Private equity funds are mostly closed-end funds. This means that the required capital is collected within a certain period and then the fund is closed for a certain investment period. The term of the fund can be up to ten years. The investor holds the investment for the duration of this period and thus enters into a longer-term commitment. The investor must, therefore, be certain that he can raise and hold the capital over this period. The funds have at least 10 to 25 million euros of capital at their disposal in order to acquire sufficient investments and achieve a certain risk diversification.

Typical investors are institutional investors such as insurance companies, banks or pension funds. However, it is also possible for small and private investors to invest via so-called umbrella funds. These invest simultaneously in several private equity funds. The investment is thus diversified into several companies in order to reduce the risk for the investor. The minimum investment amount for private investors is between 10,000 and 25,000 euros, depending on the umbrella fund.

Types of private equity

Investments are possible in different phases of the business, both in the founding phase and in the growth or restructuring phase. It is not uncommon for private equity firms to concentrate on certain phases of the business in which they enter a company, such as the initial phase or the growth phase. Financing in the initial phase is referred to as venture capital. This is a special form of private equity with a higher risk/return profile and is particularly relevant for startups.

Typical private equity companies tend to invest in experienced and stable companies in the late stages of corporate development. The risk of a loss of capital is already somewhat lower here, as the company has already achieved relevant sales and built up long-term customer relationships. This, in turn, simplifies company valuation and increases planning security for private equity companies.

Financial instruments in the private equity sector are primarily management buyouts (MBOs). Here the management buys shares in the company with the help of private equity investors, with the aim of later taking over the company. In a leveraged buyout (LBO), the purchase is financed by borrowed capital. In the turnaround, restructuring financing, investments are made in a company that is in a crisis and is to be restored to financial stability.

The current state of the private equity market

Private equity companies are rather rare in Germany and Europe. Prominent examples are Deutsche-Beteiligungs-AG, Deutsche Private Equity (DPE) or Auctus Capital Partners. The major private equity companies are based in the USA and dominate the rankings of the world's largest companies. These include Blackstone, KKR and the Carlyle Group.

According to current figures from BVK, the Federal Association of German Private Equity and Venture Capital Companies, there are around 300 investment companies in Germany that invest in up to 1,000 companies annually. The investments reached in the year 2017 approximately 11 million euro, more than in the previous year. Most of the increase was in buy-out activities. As a result, 2017 was a "record year" for the equity investment market in Germany. Whether or not this positive trend will continue in 2018 remains to be seen.

Private equity - Advantages and risks

Ultimately, private equity companies hope to make a profit for their investors. By selling a company, they generate, to the extent that it works, high returns after a few years. Expectations of returns are often higher than with stock investments. A return of at least 20 percent per year is customary in the industry.

Private equity is therefore primarily concerned with increasing the value of the company. Nevertheless, it must be noted that this is a high-risk investment without guarantees of success. Through the shares, the private equity investor is a co-partner and also bears the full entrepreneurial risk. A loss of capital is therefore also possible if the target company gets into an economic imbalance.

Private equity companies generally have a negative reputation among the general public. The image of the profit-absorbing "locust" is often featured in the headlines. However, private equity companies can also make an important contribution to the financing and development of companies. In theory, their support of enterprises in crisis can promote the preservation and creation of jobs.

Private equity funds are criticized by investors for their lack of transparency. Investors often do not know which companies or sectors they are investing in, and consequently in which they will be involved. Investors only learn about the success of their investments on the reporting date and with a time lag.

Have you ever invested in private equity? Let us know in the comments!