When it comes to products we all know and love, you may be hard-pushed to find many that aren’t backed by private equity firms.
But private equity isn’t limited to big brands. It’s also available to small businesses to launch products, recruit staff, grow their operations, and more.
While publicly-listed companies can raise money by selling ownership – or shares – to anyone on a stock exchange, private companies don’t have this privilege.
This is where private equity comes in. It’s one of the common sources of capital for small businesses.
But what is private equity?
What Is Private Equity?
Private equity typically refers to a type of financing where a private equity firm invests money into a company that is not publicly listed – that is, the company’s shares are not traded on a stock exchange.
This investment can be made to help increase a company’s value before selling it at a profit.
Imagine a fledgling printing company struggling to grow due to limited funds.
A private equity firm comes along and invests in the company by way of capital injection and strategic guidance, which can enable the printing company to develop a new product line, hire employees, and expand its customer base.
The private equity firm then can sell the printing company at a profit, making it a win-win for both parties.
But a private equity firm brings more to the table than money and mentorship. They also offer operational expertise, which can help small businesses streamline their processes, boost profit margins, and scale more effectively.
How Does Private Equity Work?
Investors who work at a private equity firm are known as private equity investors.
They are critical in identifying companies with good investment potential and raising a pool of capital to invest in them.
This pool is called a private equity fund, which is led by a group of limited liability partners including institutional investors, high net worth individuals, and pension funds.
When the fund reaches its fundraising target, the private equity investors close the fund and invest the capital by acquiring equity stakes in promising companies.
Private equity firms then work with investee companies to help increase their value. This could take the form of incorporating a new strategy or restructuring the company altogether.
When a private equity firm sells a company, it normally makes a profit and allocates returns to limited partners that invested in the fund.
What Are the Three Main Strategies for Private Equity Investments?
A private equity investment isn’t a one-size-fits-all solution.
There are many forms of private equity available depending on the stage of an investee company’s lifecycle and investment goals.
But here are the main strategies for private equity investments:
- Venture Capital: Venture capital involves a minority, or non-controlling, investment in early-stage companies or startups with an unproven business model.
- Growth Equity: Growth equity describes a minority investment in more mature companies, which are experiencing rapid growth via a proven business model.
- Buyout: A buyout refers to the acquisition of a majority, or controlling, interest in mature companies.
Understanding Private Equity Companies
What is a private equity company?
It’s an investment management firm with an ownership stake in its investee companies.
It often has stakes in multiple companies, which is called its portfolio, and the companies that make up this group are called portfolio companies.
Private equity is just one form of alternative investment. Others can include hedge funds and mutual funds.
- Hedge funds make short- and long-term investments in publicly-listed companies whereas private equity firms typically make long-term investments in privately held companies.
- Mutual funds normally invest in publicly-traded companies where liquidity is offered to investors through daily trading while private equity firms invest in private companies, which are illiquid assets. Furthermore, mutual funds raise capital from everyday investors whereas private equity funds are raised by accredited investors.
Key Functions of Private Equity Companies
Private equity companies can play a critical part in the financial ecosystem.
In addition to fundraising, here’s an overview of their other functions.
1. Deal Sourcing
Private equity firms are always on the lookout for investment opportunities.
These are typically found through industry contacts, proprietary networks, investment banks, and other intermediaries.
2. Due Diligence
Extensive due diligence is a necessary precondition for making an investment, the purpose of which is to discover any underlying issues in the investment opportunity.
During the sourcing process, private equity firms scrutinize target companies’ financials, business operations, market position, growth potential, risks and so forth.
3. Portfolio Management
Once an investment has been made, private equity firms manage portfolio companies to improve their performance and increase their value.
This can be achieved by measures ranging from strategic direction to exit planning.
4. Risk Management
Private equity firms manage investment-related risks, such as regulatory shifts and market fluctuations.
They are responsible for devising risk management strategies that safeguard investors’ capital and help ensure long-term success.
5. Exit Strategies
One of the priorities of private equity firms is to exit their investments profitably.
Exit routes include everything from a management buyout to taking the portfolio company public via an Initial Public Offering (IPO).
Private equity firms can be more enthusiastic in their support of small business. They also may invest more money than other types of investors. This can provide a valuable lifeline for businesses that may not otherwise realize their full potential.
Private Equity Funds
Private equity funds make their money by collecting fees for investment management and performance.
To help calculate their fees, they apply the ‘2+20’ rule below.
1. Management Fee
Irrespective of a fund’s performance, a 2% fee is paid to a private equity company to cover operational costs incurred while managing the investment portfolio, such as travel.
2. Performance Fee
A performance fee is conditional upon an investment being sold at a profit.
The fee is 20% of any investment profit, which is paid to the private equity firm's employees to incentivize greater returns.
Both management and performance fees are calculated as a percentage of assets under management (AUM).
Advantages of Private Equity for Small Businesses
Small businesses can benefit from private equity in several ways.
1. Capital
Even the most promising small businesses can face challenges securing capital through traditional financing, such as bank loans.
Private equity firms can be more enthusiastic in their support of small business.
They also may invest more money than other types of investors. This can provide a valuable lifeline for businesses that may not otherwise realize their full potential.
2. Control
With private equity, investors own a part of the company, but the owner(s) retain overall control.
3. Flexibility
Flexibility is important for small businesses, particularly how deals are structured and repayments are made.
Private equity firms may offer more advantageous terms than other investors and traditional lenders.
There are also factors small-business owners should consider before partnering with private equity firms:
- Higher Fees: Private equity firms can charge higher fees, which may dip into profits.
- Higher Interest Rates: Private equity firms may also set higher interest rates than other investors.
- Loss of Control: Although small-business owners maintain control of their company, they must still relinquish some control to private equity investors who have a say in how the business is run.
Practical Tips for Small Businesses Considering Private Equity
Here are some tips for small-business owners considering entering into private equity partnerships.
1. Goal Alignment
Being at odds with a private equity firm can be a small-business owner’s worst nightmare.
From the outset, it’s important to consider ensuring that there’s alignment between the business goals and the private equity firm’s objectives.
2. Exit Strategy
To play the private equity game to win, it’s important to realize that it may not necessarily be a one-time deal.
Consider planning for multiple exit opportunities. Multiple exits can equal multiple payouts.
Exploring Cash-Flow Sources for Business Success
Private equity can be a game-changer for a small business.
While its financial muscle and strategic expertise can take your business to the next level, you should carefully consider whether private equity aligns with the specific needs and goals of your business.
After all, private equity isn’t for everyone and there are certainly other cash-flow sources you can consider, but it’s well worth bearing in mind that private equity isn’t just for big businesses. It’s for small ones, too.
Photo: Getty Images
