Understanding the Basics of Private Equity

Private equity investment is a vast and wide-reaching form of investment that can potentially generate high returns for investors whilst also being capable of more resilience than many other types of investment in periods of market stress. In this article, we'll explain the basics of private equity investing and give you all the information you could need to get started.

What Is Private Equity?

For investors new to private markets, there can be confusion as to what private equity investment actually is, with potential investors asking about the difference between private equity vs venture capital or how hedge funds differ from private equity funds.

Private equity investing refers to the investment of capital into companies and organisations that are not publicly traded (on the stock market) and are open to being bought out entirely or receiving significant private investment in exchange for equity.

Private equity investments can be made directly into single companies (for example, to support a management buyout or in the form of growth equity) or through funds operated by professional managers. Private equity funds will typically raise capital and then deploy that capital into a range of different companies over a period of time; for example, two years. This aims to create a diverse portfolio by spreading sources of risk and return across different underlying companies and also adds temporal diversification.

Types of Private Equity

Depending on the stage of a company’s growth or the specific use for the capital being raised, you may encounter different terms used to describe an investment opportunity or a transaction in a private company.

Venture capital

Perhaps the most commonly known branch of private company investment, venture capital is a term that's commonly used to describe an equity investment into a smaller, emerging company which has the potential for sizeable growth. This is often in industries that are still relatively young and ripe for development or where the company’s products or services have the potential for global application. Examples of this include deeptech, fintech or ‘Internet of things’ (IOT) companies. The company may not yet be profitable or may be re-investing all profits for growth. 

Private equity funds that specialise in venture capital investment seek to identify companies that have the potential to generate sizeable returns, but which require capital to achieve that growth. Private equity funds will take a significant stake in the company and aim to help it reach its potential.

When venture capital funding is received by a company, it will invest all of the capital into the company and use it to expand its operations in a short timeframe. The intention of this funding is to transform the company into an industry-leading powerhouse, whilst adding value by upskilling the internal team to help ensure long-term success and stability.

Growth equity

While venture capital identifies companies that are yet to scale up, growth equity targets more established and mature companies that need capital. These companies also need the support that professional investment brings in order to grow to the next level.

Growth equity investments are often sought by companies that require additional capital in order to facilitate this period of growth. In these cases, if the business can make the necessary changes and expand, there's a strong possibility that revenue and profitability will increase substantially. Consequently, the value of the company can increase, which is a key factor in a private equity investor’s ability to generate returns on an investment on exit.

Although still risky, investments in more mature companies are seen as lower risk than venture stage companies, as they already often have a good level of established revenue and profit.

Buyouts and leveraged buyouts

A buyout is where a controlling stake in a company is purchased from previous shareholders. This acquisition may be organised by a management team already in place at a company, who may be wishing to take a company on from the original founders. It may also be a new management team organised by a private equity firm which has purchased an interest in the company.

Some buyouts are leveraged, which means the private equity firm will use debt to complete the purchase and use the company's assets as collateral.

When a company is going through a period of decline or stagnation, the opportunity for it to be bought out may be appealing for some private equity funds, especially if the company is fundamentally strong but experiencing temporary problems. The reasons for this stagnation may not be down to anything being inherently wrong with the company. It may be a symptom of there not being enough capital available to help take it to the next level.

In a leveraged buyout, the private equity investment capital is used to pay a small fraction of the agreed purchase price, with the rest being collateralised using the target company's assets and internal value. This means that firms can buy out companies that would otherwise be unattainable using a smaller amount of upfront capital. This can open the doors to additional, industry-specific investment later down the line.

At Connection Capital, we provide financing for management buyouts to UK SMEs, creating access to direct private equity transactions for our clients. We also offer a range of private equity funds operating buyout, growth and venture strategies.

How Does Private Equity Create Value?

Private equity firms undertake a vast amount of due diligence before completing any deal and will look at a number of factors before deciding whether to invest in a company. The underlying figures and investment case must demonstrate to investors that the company has the potential to realise the target return.

When we look at how private equity investors create value, we should look at why companies look for this type of investment. Companies who seek this form of investment often require capital in order to facilitate a period of growth to maximise profitability and open them up to new markets and audiences.

This is how private equity creates value — it enables companies to make the necessary changes that will increase revenue and profits. That is rarely just through the provision of capital alone. Professional investors are able to draw on past experiences of working with private companies, as well as networks of specialists who can help improve various aspects of a business, from strengthening management to entering new markets, planning acquisitions, through to, eventually, preparing for an exit.

Benefits of Private Equity Investment

Private equity firms are able to support companies to achieve their growth plans through the supply of capital. The private individuals or organisations investing in private equity may enjoy various benefits to their investment portfolio.

Portfolio diversification

Diversification aims to reduce the volatility of your investment returns by spreading risk and return sources across different asset classes. Traditionally, many investors relied on a 60:40 mix of public market equities and bonds to achieve this. In recent years, the true level of diversification in this model has been called into question, as both asset classes have struggled to perform. Investors have sought exposure to alternative asset classes like private equity to add further diversification and to target the enhanced return potential of these investments.

Illiquidity premium

This is the incentive for investors to invest in private equity. Lengthier investment and hold periods are appropriate for private market focused investment strategies — such as venture and private equity. A value creation plan takes time to be developed and executed and for results to become apparent. If this is successfully done, the returns to investors can be higher than public market equivalent investments.

We hope this article has helped you understand the basics of private equity. If you’re interested in exploring further, and want to learn how to invest, get in touch with a member of the Connection Capital team, and we’d be happy to explore your options.

Please note:
Past performance is not a reliable indicator of future performance. Investments in private equity are high risk and speculative which means there is no guarantee of returns and investors should not invest unless they are prepared to lose all of their money. This type of investment is illiquid so can’t be easily accessed until the exit point. The investor is unlikely to be protected if something goes wrong.