An Introduction to Private Equity for Business

An Introduction to Private Equity for Business

August 31, 2017
Tom

Private equity is a commonly used term in the corporate finance field that a large portion of everyday people, and even many business owners, do not understand or even know about.

It’s not anyone’s fault that private equity is so often misunderstood, however, there is no reason why we can’t all learn about something that is much less complicated than it seems.

So, What Exactly is Private Equity?

Private equity; put simply, is an investment in company share which occur outside of any type of stock exchange. Going by this definition, an investor buying shares in Apple through a stock exchange app is not using private equity. However, the famous investors on Dragon’s Den who buy a percentage of entrepreneur’s startup because they believe in their product and business plan, are classed as leveraging private equity.

So, you see, private equity is simply just a fancy term for investing in a company without using a stock exchange of any kind. That’s it; simple and straightforward.

This is the just the tip of the iceberg, however, as private equity begins to get more interesting when you consider what it is often used for. For the greater good or not, private equity can be used for different types of growth and venture capital, distressed investments, and, of course, leveraged buyouts – these tend to be handled by large legal teams like Goodwin or Cravath, Swaine & Moore. We’ll take each of these private equity strategies and delve into what they are and why you should know about them.

Private Equity in Leveraged Buyouts

Even those who aren’t all that interested in the ins and outs of corporate finance tend to be interested in actions like leveraged buyouts and hostile takeovers simply because they sound dramatic in nature. While we can all get excited to some degree when something aggressive appears to be happening between companies, the reality is that these things take a lot of time and paperwork.

With all of that aside, let’s talk about what a leveraged buyout, why it’s important, and what it has to do with private equity. A leveraged buyout (often shortened to an LBO) is a company takeover which tries to use debt as far as it can to finance the takeover. This leaves only a very small amount of the company left over that has to be purchased using cold hard cash – this cash, being private equity.

Let’s illustrate an example to simplify this even further. We can say that Company B is in debt to Company A by quite a large amount – they probably needed it for either keeping out of the red or buying up assets. Either way, at some point along the line, Company A decides that they will likely make more money in the long term from simply buying and taking over Company B than waiting to collect interest on the debt. Therefore, Company A decides to take over Company B via a leveraged buyout, using the outstanding debt and a bit of private equity to fund the purchase.
You see, once again a financial jargon term like leveraged buyouts becomes actually quite basic when we break it down. With this in mind, we’ll move onto growth and venture capital with regards to private equity.

Private Equity in Growth & Venture Capital

Private equity can, and often does, play a significant part of both venture and growth capital. Trading some ownership in the company outside the stock exchange (private equity!) can be a great way to give a startup some real momentum or fuel a big change in an already established corporation. This, in essence, is the difference between venture capital and growth capital, something that will further illustrated below.

Imagine a small startup tech company in the competitive location of Silicon Valley that shows immense potential for growth, and all they need is a big investor to help make it happen. This investor decides to acquire a percentage of ownership of the company through giving them capital which will allow the startup to rocket towards business success. This is private equity being used to fund venture capital. On the other hand, growth capital is very similar in nature but slightly different in practice.

Growth capital is money given to an already established and grown company which it will use to fund some kind of significant change, like an internal restructuring of staff or expansion into more premises. Whatever the reason, an investor can decide to pump some capital into that business using private equity to get their very own piece of said business.

Without sounding like we’re repeating ourselves here, it’s becoming ever-more apparent that these financial terms for how money is used between companies are surprisingly simple when you do a little digging. The last piece of the puzzle that needs to be tackled in understanding private equity is distressed investments.

Private Equity in Distressed Investments

Distressed investments sound like they are incredibly negative, and in some ways, you could argue that this is the case. While risky by nature, using private equity in distressed investments can be a terrific way of acquiring something that could become extremely lucrative.

Let’s begin with the question likely on everyone’s mind who has made it this far: what are distressed investments? The answer is actually rather simple.

A distressed investment is when someone purchases shares of a company which is currently in debt and experiencing financial difficulties. Effectively, these people are buying devalued pieces of a failing business which they think may ultimately recover and therefore increase in value. This would explain why these types of investments are followed by the word ‘distressed’.

While many people will see the signs of a financially struggling company on a stock exchange fairly easily, a person will be using private equity to buy up these distressed shares when they do not appear on any exchange. This tends to mean that the people leveraging their private equity capital to cash in on distressed investments already know the company in some way or another, therefore they might think they know all they need to in order to take a risk like this.

Distressed investments are just a fancy corporate way of saying ‘buying the shares of a company struggling under debt’. Although, now that you know what the term means, you can use it easily for yourself.

Private Equity is Rather Simple

Busting business jargon does not have to be a difficult task – a little bit of accurate research goes a long way when it comes to these kinds of topics.

It is hoped that you have a much better understanding of what private equity is and what it can be used for in the corporate finance world after taking the time to read. Good luck investing out there.

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