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What is Private Equity?


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Private equity is an alternative form of financing for investing directly in private companies. Occasionally, private equity funds participate in buy-outs of public companies leading to delisting.

In simplified terms, the private equity fund earns a return on its investments by improving the sale price of each investment relative to the initial purchase price after a period of time of participation in the company.

The structure of a private equity fund consists of the limited partners, who usually hold the majority of the fund and have limited liability, and the management company (general partner), which holds a minority stake in the fund and is responsible for operating and executing the investments. The management company aligns its interests with the capitalists through this co-investment.

What is Private Equity?

Private equity, although unlisted and private capital, is regulated by the governmental bodies in charge of overseeing Financial Markets such as the SEC (US).

How does Private Equity work?

The 4 main characteristics of a PE fund are as follows:

1. Financial partner, not managing partner:

Normally a private equity does not want to be part of the day-to-day management of the company. The fund's contribution is not to control management but to professionalise it. The evaluation of the management team is usually a key element in the investment decision. Private equity usually aligns its objectives with those of the management team through different mechanisms.

2. Time horizon of the investment:

When a private equity receives capital from its "limited partners", it makes a commitment to repay that investment within a maximum period of time. As a result of this commitment, the private equity fund invests in a company over a specific time horizon, typically between four and seven years.

For this reason, private equity must agree in the shareholders' agreement on exit mechanisms to ensure that it can liquidate its shareholding at the end of the management period. 

3. Investment in the form of equity:

A PE fund provides its investment mainly in the form of capital and not so much in the form of debt as bank financing. Thus, the PE becomes a shareholder of the company and has an impact on the shareholding structure. The business project becomes a joint project of the PE fund together with the other owners of the company and the PE fund will have at least the same rights and obligations as any other shareholder.

4. Majority and/or minority participation:

Although historically, private equity was more inclined to take majority positions, it is now open to minority positions as long as they are of relative importance and reasonable exit mechanisms can be agreed upon.

What kind of risk capital and what kind of operations are there?

There are different ways for a PE fund to participate in a company, which mainly depend on the company's situation. They can be divided as follows:

  • Development Capital: In the case of a company that wants to start up an investment project (internationalisation, expanding its commercial network, new machinery, technology, etc.) for which it needs large amounts of money, which it is not able to afford with its own capital, it needs external capital. We speak of Development Capital because through a capital increase new capital is provided to the company and gives it resources.
  • Replacement Capital: When the private equity fund replaces part or all of the shareholding by buying its shares or participations, we speak of Replacement capital. It occurs mainly in the case of retirements of entrepreneurs and/or the acquisition of the company by its management team, known as Management Buy Out (MBO).
  • Mixed operations: Finally, there are mixed operations that combine development capital (cash-in) with capital to replace former shareholders (cash-out).
private equity

9 things venture capital brings to SME development

The ASCRI study on the ipact of Private Equity on SMEs summarises the following 9 differentiating values:

Alternative financing

PE is a basic pillar for SME financing, complementing banking sources.

Added value

In addition to funding, the PE also provides the expertise of its teams:

  • they offer strategic advice
  • generate credibility with third parties
  • they help professionalise management teams.
  • offer exogenous business approaches
  • they transfer best practices from other sectors.

Business consolidation

Private Equity contributes to this consolidation in two ways:

  • Growing sales, turnover or EBITDA
  • With "build up" operations: a company gains size by acquiring other company(ies), reducing fragmentation in its sector.

Employment generation

Private Equity-backed companies contribute more intensively to job creation. In the period analysed, the aggregate increase was 30%, while in the rest there was a destruction of 2.8%.

Accelerating business growth

The Private Equity intensifies the growth of investee companies. In the period analysed, each investee company increased its sales by €12.2m (3 years after the investment) more than the rest of the companies.

Improving the profitability of enterprises

The Private Equity improves the earnings capacity of its investors. An average rate of 7% p.a. in the 3rd year compared to -6.4% p.a. on average for companies under a control group.

Investment promotion

Private Equity financing multiplies the investment of its investees, which allows for an increase in production. In aggregate terms, the total assets of the investee companies are growing at an annual rate of 7% compared to 2.8% for the control group.

Support for companies in crisis

Venture Capital involves management support that helps to create value, cushion the effects of downturns through investment and seek new markets in which to grow. In the "middle market" segment, companies that received financing after the onset of the crisis in 2009 increased their turnover after 3 years by an average of 7 times more than control groups.

Impact on different sectors

Private Equity investment in themiddle market" segment is spread across almost all sectors depending on the economic cycle and growth expectations. In particular, the technology sector is becoming more prominent every year.

Examples of private equity funds

Here are some examples of private equity institutions for your reference:

Providence equity partnes

Providence equity partnes based in Boston (USA) is one of the pioneers of sector-specific private equity firms with international coverage, in its case in software and education in North America and Europe. Some of its current investees are Imaweb, Masmovil, Blackboard,...

Nazca Capital

Nazca capital based in Madrid is one of the deans of private equity in Spain with an open sectorial approach and a focus on Spanish companies. Some of its current investees are Seprotec, Filmin, IDP, ...

Ufenau

Ufenau based in Switzerland is an example of private equity with a European geographic focus and specialised in one type of growth. It invests in companies that can lead an ambitious growth process through "Buy&build" processes. Normally, they acquire 10 companies in each platform investment. Some of its current investees are Collana IT, MYTY, X1F, ...

In the process of selling a company or seeking for capital raising or strategic investor, a private equity is a good option to study.

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