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As a business owner navigating the world of potential investors, there are a lot of different players to understand. Two heavy hitters worth getting to know are private equity firms and investment bankers. Both are involved in helping businesses raise capital. However, the roles they play are very different. Here’s a closer look.
What Is Private Equity?
Private equity firms use capital pooled from wealthy individuals, endowments, insurance companies, pension funds, and other sources to invest in private businesses. Unlike venture capital, private equity funds typically invest in mature companies rather than startups. They also help manage their portfolio companies in order to increase their worth or extract value before exiting the investment.
How Does Private Equity Work?
There are different types of private equity, but private equity funds generally take the capital they gather and invest it by buying companies (or shares in companies) they hope to make more profitable. The investment the private equity firm makes can provide companies with funding to help them grow through research and development, mergers and acquisitions (M&As), and purchasing equipment and real estate. Private equity funds typically negotiate for all or some control of the companies they invest in. The funds expect a return on their investment when the company they’ve invested in is eventually sold or when shares are offered to the public in an initial public offering (IPO). As a result, private equity firms will often use their capital, influence, and expertise to guide the company toward increased growth and value. Ideally, this is a win-win situation for the company and the private equity fund. If the company is already run well, however, a private equity firm may do very little to change how the company runs day to day. In some cases, private equity firms may buy companies that are already publicly traded and turn them back into private companies. They may also buy companies with the purpose of breaking them up to sell for a profit.
Pros and Cons of Private Equity
There are both benefits and drawbacks to receiving funding from a private equity firm. Here’s a look at how they stack up.
Pros of Private Equity
Provides an injection of capital that can be used to support and grow your business
Avoids having to get a business loan (which, if your business is struggling, may come with a high interest rate)
Can help your business move towards a sale or IPO
Cons of Private Equity
Can be a lengthy process, since it can take months to convince a private equity fund to invest in your business
May require handing over some or full control over your business
Because their focus is on generating profits, private equity firms with a controlling interest will often lay people off and/or replace talent
What is Investment Banking?
Unlike private equity, investment bankers are not in the business of investing directly in companies. Rather, they act as a bridge between companies and investors.The primary role of an investment bank is to advise businesses on how to meet their financial challenges and help them procure financing, whether it be from stock offerings, bond issues, or derivative products. In short, they help companies make and execute big financial decisions.
How Does Investment Banking Work?
Generally speaking, investment banks will assist a business with complicated financial transactions, such as M&As, managing capital, and/or underwriting debt. They also help companies go public and make changes to the management or structure of the company. When it comes to M&As, for example, investment banks act as advisors to both buyers and sellers. They can help value a business, negotiate prices, and facilitate the transaction. When a company wants to go public through an IPO, the investment bank will help the company set the initial price of the offering and navigate the steps required by the Securities and Exchange Commission (SEC). They will also create a prospectus that outlines the details of the IPO and help market the company’s shares.
Pros and Cons of Investment Banking
Investment banking comes with its own set of advantages and disadvantages for businesses. Here are some you may want to consider before choosing to work with an investment bank.
Pros of Investment Banking
Can help your company raise money for expansion and improvement
Typically have deep networks of investors they can tap when raising capital
Can be a powerful ally if your business wants to sell, buy another business, or offer shares to the public
Cons of Investments Banking
Typically don’t serve small businesses
They are not a source of capital but, rather, help businesses raise capital
Fees charged to facilitate fundraising, M&As, or an IPO can be high
Private Equity vs Investment Banking
Ultimately, private equity firms and investment banks perform different roles and serve different business needs. However, there is some overlap. Here’s a look at the similarities and differences between private equity and investment banking.
Similarities Between Private Equity and Investment Banking
Both private equity and investment banking:
Are involved in raising capital for a business
Seek to maximize profits for investors
Are involved with placing the shares of companies into the hands of investors and facilitating M&A deals
Differences Between Private Equity and Investment Banking
A private equity firm helps businesses raise capital through direct investment; an investment bank helps businesses raise capital through indirect methods (such as by facilitating an IPO).
An investment bank advises clients on transactions like M&As and restructuring; private equity investors are investors, not advisors.
Private equity raises money among wealthy individuals and uses the money to buy businesses; investment banks find money for businesses by raising it in capital markets.
Getting Funding From Private Equity or Investment Banking Firms
Whether you should seek out funding from private equity vs. investment banking will depend on your company's current situation and future goals. Private equity firms will often buy either all or, at least, a controlling interest in the companies they invest in. Investment bankers, on the other hand, will work alongside your business to facilitate fundraising or help you negotiate a deal. When a company wants to go public or is working through an M&A deal, it might solicit the help of an investment bank. Companies looking for a more hands-on type of investor will usually go with private equity.
The Takeaway
Over the lifecycle of a business, private equity firms and investment banks can be important partners in growth. Private equity can provide direct infusions of capital, usually in exchange for shares and some control of the company. They’ll do what they can to increase the value of a business so they can turn a profit when they cash out during a sale or an IPO. When a company has become large and successful, it may choose to work with an investment bank to help it raise additional capital, facilitate a sale, or help it go public. That said, not all businesses will need to work with either of these groups. In fact, a small business may instead want to apply for a business loan or small business grant to help expedite growth. There are many types of business loans available to meet a variety of business needs.
3 Small Business Loan Tips
Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.
Frequently Asked Questions
How Is private equity superior to investment banking?
Why is private equity considered prestigious?
Does investment banking invest directly in businesses?
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About the Author
Austin Kilham
Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
