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Private equity definition, how it works and pros & cons

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Last editedFeb 20203 min read

You’ve probably come across the term “private equity” before, but do you have any real idea of what it entails? Despite the name, private equity doesn’t have anything to do with privacy or secrecy. In fact, it refers to equity that isn’t listed on the public stock exchange. Having picked up a significant amount of momentum over recent years (in 2018, the total value of global private equity transactions reached a staggering 825.77 billion U.S. dollars, it’s important for businesses seeking investment to have a thorough understanding of the private equity landscape.

Private equity: definition

So, what is private equity? Private equity is a form of risk capital (investment) that is provided outside of public markets. For anyone who wants to buy into a business, revitalise a company, buy out a division of a parent company, expand, or start up a business, private equity investment could be an excellent option. Private equity is predominantly focused on generating capital gains. Essentially, investors will purchase a stake in a business, take an active role in the management of the business, and then draw a profit from the increased value of the business by selling or floating it.

What are the benefits of private equity?

Private equity investment offers a number of advantages for companies and start-ups. First off, the combination of business acumen from private equity investors and the provision of liquid capital enables companies that receive private equity investment to develop and grow quickly. In addition, receiving private equity as an early-stage start-up can enable a company to attempt unorthodox growth strategies without the pressure of being a publicly listed company.

What are the disadvantages of private equity?

Of course, there are a couple of drawbacks associated with private equity. Unlike public markets, it can be more difficult to find a buyer after the value of the company has been increased, as there’s no universal way to match buyers and sellers. In addition, it’s important to remember the price of shares for companies that receive private equity investment is determined by negotiations between the seller and buyer, rather than market forces.

What is a private equity firm?

In the UK, there are many different styles and types of private equity. The most common source of private equity investment are private equity firms (also known as private equity funds). You can think of private equity firms as a type of investment club. The principal investors (also known as Limited Partners) are institutions like investment funds, pension funds, endowment funds, insurance companies, banks, and high net-worth individuals. After enough capital has been raised, the private equity manager will begin researching companies that are undergoing a period of rapid development and growth to invest in.

What are the different types of private equity funding?

Private equity is a generic term that covers a number of different types of investment, including:

Leveraged buyouts – Most private equity investment takes the form of a leveraged buyout, i.e. buying out a company entirely with the intention of improving its value and reselling it for a profit or conducting an IPO.
Distressed funding – Sometimes referred to as “vulture financing”, distressed funding refers to investment in troubled companies that have underperforming assets or business units. After making the necessary changes, the private equity firm will sell the business for a profit.
Venture capital funding – Venture capital is a type of private equity that is predominantly focused on early-stage investments with excellent financial potential.
Growth capital – Growth capital is usually focused on stable organisations that are undergoing a period of expansion, whether that’s developing new products or expanding into a new market.

How private equity works

Private equity firms make medium- to long-term investments of around 4-7 years in companies with high-growth potential. Although the roadmap varies from firm to firm, here’s the usual process of a private equity investment:

Raising funds – Private equity investors will raise capital to form a private equity fund. Once this money has been raised, the fund will be closed to new investors.
Conducting research – Next, the private equity fund manager will identify and research a portfolio of private companies that the fund will invest in, hoping to generate a capital profit from the sale of the investment.
Improving operations – This is the most important step in the process. The private equity firm will aim to improve efficiency, boost cash flow, reduce costs, and grow the business, taking a hands-on approach by advising on strategy and development, making introductions with potential customers, and acting as a general business partner.
Selling the portfolio – The final step is for the private equity firm to realise the increased value of their stake in the business by selling it.

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