Private equity is an asset class that consists of equity securities and debt in operating companies not traded publicly on a stock exchange. A private equity investment is typically made by a private equity firm, a venture capital firm, or an angel investor. While each of these types of investors has its own goals and missions, they all follow the same premise:
They provide working capital in order to nurture growth, development, or a restructuring of the company.
There are several types of private equity strategies that every investor should know about, as outlined below.
Leveraged buyouts (or LBO) refer to a strategy when a company uses capital acquired from loans or bonds to acquire another company. The companies involved in LBO transactions are typically mature and generate operating cash flows.
A PE firm would pursue a buyout investment if they are confident that they can increase the value of a company over time, in order to see a return – when selling the company – that outweighs the interest paid on the debt.
Leveraged buyouts involve a financial sponsor, who agrees to an acquisition without committing to all the capital required. This is done by the financial sponsor raising the acquisition debt, which looks to the cash flows of the acquisition target to make interest and principal payments.
Historically, the debt portion of a LBO ranges from 60%–90% of the purchase price.
Growth Capital typically involves minority investments in mature companies looking for capital to expand or restructure operations, finance a major acquisition or enter new markets.
Companies involved in Growth Capital typically can generate revenue and operating profits, but can’t generate enough cash to fund major expansions, acquisitions, or other investments. This lack of scale can make it difficult for these companies to secure capital for growth, making access to growth equity critical.
By selling part of the company to private equity, the primary owner doesn’t have to take on the financial risk alone, but can take out some value and share the risk of growth with partners.
Mezzanine Capital, or Mezzanine Financing, is used by private equity investors in order to reduce the amount of equity capital required to finance a leveraged buyout or major expansion. It refers to subordinated debt (or preferred equity) securities representing a junior portion of a company’s capital structure that’s senior to the firm’s common equity.
Mezzanine Capital is often used by smaller companies unable to access a high yield market. This strategy provides these companies the opportunity to access additional capital – beyond what traditional lenders are willing to provide.
Of course, because of the increased risk, debt holders require a higher return on investment, when compared to other more senior lenders.
There are some considerable benefits toward Mezzanine Capital, including being able to receive the capital needed without giving up a considerable amount of equity ownership.
Venture Capital typically involves less mature companies, start-up companies, or companies in early-stage development. You’ll often see venture investments applied toward new technology, new marketing concepts, or new products that don’t have a proven track record or steady revenue streams yet.
The products and ideas developed by entrepreneurs require substantial capital that these businessmen and businesswomen simply don’t have access to. They’ll often turn to venture capitalists. The VC’s need for high returns (in order to compensate for the increased risk of these types of investments) makes this a potentially expensive capital source for any company.
Venture Capital is most suited for businesses that face large up-front capital requirements that cannot be financed by alternative sources, such as debt.
This is a broad category that refers to investments in equity or debt securities of financially stressed companies.
The term “distressed” involves two sub-strategies:
1. Distressed-to-Control, or Loan-to-own – Where the investor acquires new debt securities, anticipating he or she will gain control of the company’s equity following a restructuring.
2. Special Situations (or Turnaround) – Where an investor provides debt and equity investments to companies undergoing significant challenges. Special situations may include mergers and acquisitions, bankruptcy and more.
It’s worth noting that in addition to private equity funds, hedge funds also employ this investment strategy.
Real Estate: Typically refers to the pooling together of investor capital to invest in various real estate properties. This is often considered the riskier end of the investment spectrum and includes “value added” and opportunity funds.
Funds of Funds: This type of strategy involves investing in a fund whose primary purpose is to invest in other private equity funds. This strategy is employed by investors looking for diversification, access to top-performing funds, experience in a specific type of fund prior to investing, or exposure to hard-to-reach or emerging markets.