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What is private equity? How does it work

  • Marisha Bhatt
  • 22 Sep
  • 6 minutes

Every business is in need of finance and investments from time to time. This investment can boost the already existing business and open new avenues for the same in this growing economy. However, securing finances may not always be an easy task, especially for private companies in today’s world when investors are cautious of their investments and India especially has seen huge withdrawals of FDIs in the recent past. In such cases, a private equity fund can be a good source of getting the necessary investments for the organization and benefit from the same. 

Given below is a brief discussion on the meaning of private equity and why it is beneficial to an entity.

What is meant by private equity?

Private equity or a private equity fund is a pool of investors that invest directly in a company. Such companies are usually private companies that are not listed on any stock exchange or public companies that are about to be converted into a private company. Such funds invest in companies that have sound business models and cash flows and are suitable for debt financing. 

These investors can be retail investors or institutional investors with deep pockets that can invest in a business for the long term which is generally 10 years to 13 years. After the completion of the tenure of investment, the fund is dissolved and the money is returned back to the investors. The investors of the private equity may or may not be directly involved in the daily workings of the organization depending on the agreement between the fund and the entity.

How does private equity work?

Private equities usually invest in companies that are potentially distressed but have good growth potential. A private equity fund seeks such entities and can invest in them through the following means

  1. Venture Capital 

The fund may use any of these options to provide finance to the small and medium-sized enterprises that have huge growth potential but is in need of dynamic finance sources.

  1. Leverages Buyouts 

A leveraged buyout is one of the most common types of investment by PE funds. The investor usually buys a controlling stake of the intended company through equity purchase as well as through the debt component. The management of the company will get an additional push to achieve its targets in a better and more efficient manner. Some PE funds also dilute their stake in the firm after the said level of goals are achieved and may exit the firm. 

  1. Growth Capital

Growth capital is another form of investment by private equity funds. These investments are to fund the expansion of operations of established and large-scale profit-making companies. 

  1. Turnaround or distress management 

PE funds can also step in as a life saviour for companies in a distressing situation if they are not able to pay their debts. Such funds can be used to stabilize the balance sheet of the entity and help the organization come out with turnaround strategies to ease the situation.  

Who can invest in private equities?

Private equities take funds from many investors who individually may not be able to invest in companies but together can make a substantial investment. These funds are a good source of finance for startups with great growth potential. Also, small and mid-sized companies or private companies with a good growth trajectory but not enough financing options can tap into the funds through private equities. 

However, there are certain factors that need to be considered by investors who invest in private equity funds. Such investors need to understand that private equity funds usually invest in high-risk ventures. Hence, investors need to have a high-risk appetite and deep pockets to invest in private equity funds. Also, the investment horizon of the private equity funds is usually long-term ranging anywhere between 10 years to 13 years. Therefore, such investors also need to have a long investment horizon as well. 

What are the advantages of private equities?

Some of the key advantages of private equity funds are mentioned hereunder.

  1. Access to huge capital 

Private equity funds provide better access to large scale finance which is the dire need of private companies and small or medium size businesses. 

  1. Access to multiple investment options with huge growth potential 

Investors of private equity funds can get better access to investment in businesses with good profit making potential even if they are not listed on any stock exchange. Some companies backed by private equity also have the potential to be listed on stock exchanges in the future based on their growth trajectory. 

  1. Investment after careful evaluation 

An important feature of private equities is that investment decisions are made by these funds based on careful analysis of the viability and profitability of the business. This ensures the security of the capital investment of the investors and also huge potential to maximize the returns. 

  1. Accountability 

The private equity funds have professionals that are accountable to safeguard the interests of the owners and the shareholders and not take any action or decisions that are detrimental to their interest. This further instills a sense of confidence in the business to opt for financial support of the PE funds.

Conclusion 

Private equities have gained a stronghold in the Indian market especially in the startup boom. This has helped the business entities get access to deep pockets and also an opportunity for  investors to tap into potentially high risk high return business opportunities. Private equities have made substantial investment in major industries and have been their driving force for the growth and development.

FAQs

Can a a single investor be categorised as private equity?

No. Private equity is a fund of that is created by accumulating investment from many investors. Hence, a single investor cannot be categorised as private equity.

How many types of private equity funds are available?

Private equity funds are usually in the nature of limited liability partnerships.

What is the usual investment tenure under private equity?

The usual investment tenure of private equity funds is 10 years to 13 years

Can private equity funds invest in public companies?

Yes. Private equity funds can invest in  bypublic companies as well as private companies. However, most PE funds invest in private companies or companies that are about to go private.

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Marisha Bhatt