Private equity is investment in unlisted companies that are privately – not publicly – owned.

Most private equity investment is conducted by private equity firms which raise funds from institutions, such as pension funds, for investing in high growth businesses or for acquiring businesses in which greater efficiencies could be achieved.

The term “private equity” embraces management buy-outs and buy-ins, development capital and venture capital, which is investment in start-up and early stage companies.

How does it work?

The private equity process typically involves a private equity fund management firm raising a Limited Partnership fund, usually of 10 year duration, which is invested in the first 3-4 years of its life in buying majority or sometimes minority stakes in companies that meet the fund’s investment criteria. The private equity manager actively helps the companies in which it invests to develop, restructure and grow profitably. This usually involves taking a seat on the board and providing a range of assistance, including strategy advice particularly on capital markets and financing, market analysis, networking and sourcing additional management. Successful fund raising by a private equity firm is largely dependent on returns made by previous funds, so building a successful track record is crucial.

Are all private equity firms doing the same thing?

No – a wide range of investment activities are covered by the term “private equity”. Private equity firms have many differing investment strategies and criteria, covering sizes of investment, regions or countries in which they invest, specific industry sectors, or specific types of transaction such as start-up, expansion, buy-out or turnaround.

How are company holdings realised?

When the company has been developed sufficiently to be attractive to other investors, it may be sold to a larger company, floated on a stock market or sold to another private equity firm, whose focus on specific industry sectors, geographies or stage of company development might bring something particular to the company’s further growth.

How long do private equity managers hold investments in companies?

Investments by private equity firms are typically held for several years, depending on the stage of the businesses, their success, growth prospects and market conditions for selling or floating the business. Early stage investments can be held for many years, during which they may be refinanced, while they develop into mature businesses. If a company is underperforming, the private equity investor will usually move quickly to restructure, refinance or change management strategy, but it may decide to cut off further funding quite early on. The aim is always to achieve the best return on each investment, however and whenever that can be achieved.

What about debt?

Apart from early stage companies, most private equity investments are also financed by debt. The use of debt in addition to equity is known as “gearing” or “leverage” and is normal in the financing of most companies – privately held companies are no different in this respect. Private equity firms are very aware of the advantages and risks of using debt and its use forms an integral part of their competitive advantage as buyers and owners of a business. Debt is often repaid from the cash flows of the portfolio company, thereby enhancing the value of the equity. But as a company progresses, it may equally be able to support a higher degree of borrowing, allowing repayments to the equity investors. Levels and types of debt tend to reflect the prevailing interest rate climate and the opportunities for acquisitions and internal investment facing the company. Debt can be increased or decreased through the life of the investment, in order to achieve the most cost-effective deployment of capital.

Private equity investment is a long term activity. Funds are structured for 10 years – and can sometimes be extended if conditions require this – precisely because they need to allow for sustained company growth and for various cycles. These include the fund raising cycle, where private equity firms tend to fund raise every 3-5 years; specific industry cycles, e.g. in energy or chemicals; stock market cycles where high prices present the best time for many exits and low prices offer the best time for acquiring stakes in companies, and domestic economic conditions.