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Companies that are looking to raise capital have a number of options, including taking out business loans, issuing stock, or selling bonds. Yet another option is to bring in a private equity investor. Private equity companies seek to invest in or buy promising private companies with the hopes of making a high rate of return when they eventually exit, often via resale or issuing an initial public offering (IPO).Before dipping your toe in these waters, it’s important to get a sense of what private equity is and how different types of private equity work.
What Is Private Equity?
Generally, private equity funds invest in private companies and other assets with the aim of later selling their stakes at a profit, typically after seven to 10 years.Private equity funds are considered an alternative type of investment, which means it doesn’t fall into the one of the conventional investment categories, such as stocks, bonds, and cash. Other types of alternative investments include hedge funds, managed futures, commodities, and tangible assets. Investment banks will often compete with private equity firms to buy good companies and to finance promising startups.
How Does Private Equity Work?
Private equity firms typically get their funding from institutional funds and accredited investors (typically high net-worth individuals with expertise in investing).The fund will then invest in, or buy a company outright, aiming to grow that company and increase its profitability in a set period. Its investors (who are often experienced former executives), may also lend mentorship, management experience, and industry expertise to that company. Ultimately, they plan to sell the business or take it public on an exchange through an IPO, then divest and distribute the profits to the investors.There are many different types of private equity funds. Some focus on working with young companies that are looking to grow, while others target failing companies that need restructuring in order to turn a profit. Still others focus on buying up assets like power plants and hospitals.
Types of Private Equity
The term “private equity” actually refers to a wide variety of fund strategies with various goals. Here's a guide to 10 different types of private equity.
1. Venture Capital
Venture capital typically invests in startup companies in exchange for a minority stake in the company (less than 50%). For a young business, venture capital can be an essential source of capital, since they may not have access to different types of small business loans. For a private equity fund, it’s a risky form of investment, since the company isn’t very mature and hasn’t necessarily proved an ability to grow or turn a profit. However, there is also the potential for exceptional returns.
2. Growth Equity
Growth equity funds invest in more mature businesses that are looking to scale operations and enter new markets. Though the company is more established, it may still need to raise capital to fund additional growth. Once again, the private equity fund provides money in exchange for equity, typically a minority share. An investment at this stage tends to be less risky than the venture capital stage, since there is more information to go on, including company records, a proven product, and consumer feedback.
3. Management Buyouts
If a mature, public company wants to go private and then make structural changes, a management buyout may be a good option. In this type of buyout, a company’s management typically buys the company’s assets, often raising funds through a private equity firm. All the company’s stakeholders cash in their shares before management takes control. The private equity firm in this scenario may take a minority share in the company in exchange for its funding.
4. Leveraged Buyouts
Leveraged buyout funds typically invest in more mature businesses, usually taking a controlling interest. These funds use extensive amounts of leverage (using their own assets and assets of the acquired company as collateral) in order to buy a larger company that it could purchase using only the private equity fund capital. By leveraging the investment, private equity firms aim to maximize their potential return.
5. Real Estate Private Equity
Real estate private equity funds raise money then use it to acquire and develop real estate. The fund operates the property, improves it, and eventually sells it to turn a profit. Some funds are conservative, investing in lower-risk rental properties with predictable cash flows, while others invest in land or more speculative development deals, which carries greater risk but also greater potential for returns.
6. Infrastructure
Infrastructure private equity raises money to buy major assets, such as utilities, transportation hubs (like toll roads, airports, and bridges), and hospitals. which they improve and eventually sell. A growing area of focus for these funds is renewable energy, such as solar power plants and offshore wind farms.
7. Fund of Funds
With this type of private equity, the fund doesn’t invest directly in companies or assets. Rather, it buys into a portfolio that contains other private equity funds. This allows investors to achieve the benefits of greater diversification and access funds they might not otherwise have been able to invest in.
8. Mezzanine Capital
Mezzanine financing can be a good option for companies looking for a combination of secured debt and equity financing. Companies typically use this hybrid form of financing to raise funds for specific projects. For investors, it can offer a higher rate of return than debt and carry a lower risk than equity financing.
9. Distressed Private Equity
As the name suggests, distressed private equity funds seek to invest in companies that are in crisis. The goal is to take control of the company during the bankruptcy or restructuring process, when they can purchase it at a low price. They will then restructure the company and work to turn its fortunes around, eventually selling (ideally at a profit) or taking the company public.
10. Secondaries
If a private equity investor wants out of a fund, they may be able to sell their investment commitment to a “secondaries” fund. These are special funds that exist to buy those commitments and turn a profit on them. In some cases, they may also purchase companies or assets from the portfolio of another private equity fund.
The Takeaway
As private equity has evolved, so have strategies they use to invest in companies. Whether you’re looking for startup funding or a combination of capital and operational expertise to take your business to the next level, there may be a private equity fund that meets your needs.However, as with any type of equity financing, private equity generally requires you to give up some ownership, as well as some control, of your business. If you prefer to retain full ownership of your firm, you may want to instead consider getting a small business loan.
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Frequently Asked Questions
What are 3 common kinds of private equity?
What types of investment are pursued by private equity?
What are some examples of private equity funds?
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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.
