1.  Private equity investment can be broadly defined as any type of equity investment in unlisted companies through a negotiated process. They are comparatively less liquid than the public traded equities and are considered as a long-term investment option.

2.  They also involve investing in private companies or public companies with an intention of taking them private.

1.  Structure and Fees

1.  Private equities are generally structured as or set up as partnerships with the limited partners and general partners (the ones who manage the fund).

2.  The management fees of the private equities generally range between 1-3% of the committed capital.

2.  The committed capital is the capital that is pledged by the limited partners and drawn down as investments are made. But, once the capital provided by the limited partners is fully invested, the management fee is based on the amount that remains invested in the fund.

3.  The incentive fee on the private equities is earned only when the position of the limited partners is squared.

2.  Private Equity Target Companies

PEs generally looks for investing in the following types of companies:

1.  The companies whose stock prices are depressed or the companies that are undervalued.

2.  Companies with a management that is willing to have a PE investor.

3.  The inefficient companies.

4.  Companies with strong and sustainable cash flow.

5.  Companies with low leverage.

6.  Companies with a significant amount of physical assets.

3.  Strategies Used by Private Equities

3.1.  Leveraged Buy-Outs

1.  A leveraged buy-out is the strategy to purchase the whole company or a business unit of the whole company by an outside investor using a substantial amount of borrowed capital.

2.  The deal would be considered as a management buy-out if the current management is involved in the acquisition, and it would be considered as management buy-in if the new management acquires it.

3.  A leveraged buy-out deal could be financed through three sources, i.e. bank loans, high-yield bonds, and mezzanine financing.

4.  The bank loans are usually the senior secured loans that are usually leveraged.

5.  When the companies are unable to have a secured bank loan, they can go for high-yield bonds that have high pay-offs. These are usually unsecured debentures.

6.  Mezzanine financing is the capital provided in the form of subordinate debts with high interest rates and in some cases with an option to convert debt into equity security in the future to finance the entity.

3.2.  Venture capital

1.  Venture capital is a field of private equity industry that focuses on investing in new and young companies with high growth rates.

2.  VCs are often characterized by the stage at which the investment occurs in the portfolio companies.

3.  There are basically three stages across which the VCs can provide financing, i.e. formative stage, later stage, and mezzanine stage.

4.  The formative stage financing is provided at the time when the revenues have still not started coming in for the company. The formative stage financing can be further bifurcated into the following three stages:

    a. Angel investing, is investing when the business is still in the idea stage. This is not the stage where typically the VC investments are made.

    b.  The seed-stage, is the pre-revenue product development stage. The first round of VC investment typically starts here.

    c.  The early stage is the pre-revenue production stage. The first and second rounds of VC financing can be typically found here.

The financing at the formative stage is typically provided using the convertible preferred shares with less than 50% equity on conversion.

5.   The later stage of financing is the financing at the growth and expansion phase. This financing is done when the product of the company is out in the market and the revenues have started pouring in.

6.  The mezzanine stage financing, also known as bridge financing, is provided when the company is planning to go public.

7.  The funds for the later stage and mezzanine stage financing can be provided using convertible debt or preferred stocks, with less than 50% equity on conversion.

8.  The experience and the expertise of the management team is extremely important while selecting a VC to invest in.

3.3.  Development Capital

These firms fund the businesses in need of growth and restructuring, and in return are offered a minor share in the equity.

3.4.  Distressed Investing

This strategy involves financing the companies that are in financial distress by purchasing their debt at deep discounts. If the company turns around, the debt recovers in value. This strategy involves huge risks but offers great returns in the form of deep discounts.

4.  Exit Strategies

1.  All the investments that the PEs makes should be liquidated in order to return the capital to the limited partners. The average holding period of a private equity fund is around five to ten years.

2.  The investments of the PEs can be exited through the trade sale, where the company invested in is sold to a strategic buyer through auction or private negotiation.

3.  Some of the benefits of trade sale are:

   a.  There is an immediate cash exit,

    b. Trade sale has potential for higher valuation, as the strategic buyers value the investment higher.

    c.  Trade sale execution is less complicated than any other mode of exit like an IPO, thus its cost is also low and low disclosure requirement.

4.  Some disadvantages of trade sale are:

    a.  It may face opposition from the management and employees.

    b.  The number of buyers is limited and this may possibly result in a lower price than IPO unless the PE managers are able to find the right strategic buyer who can offer a higher valuation.

5.  Another way of liquidating the investments in a PE is through the IPO, i.e. the initial public offering to the public.

6.  Some of the advantages of IPO are:

    a.  The PE can get the potentially highest price.

    b.  Usually, the management does not oppose to the IPO.

    c.  The IPO improves the image of the PE firm, as IPO is considered as successful exit.

    d.  Through IPO, there are greater chances of retention of ownership.

7.  Some of the disadvantages of IPO are:

    a.  It has a high cost and longer lead time.

    b.  IPO is subject to the risk of market volatility.

    c.  IPO requires high levels of disclosure.

    d.  IPO has a lock-in period.

8.  The company can also go in for recapitalization, where the company is re-leveraged to be able to pay off its dividends.

9.  Yet another way of exiting the investment by a PE firm is through the secondary sale, where the sale of shares is made to another PE firm or a group of investors.

10.  Finally, when some of the investments are unable to work out they must either be written off or liquidated.

5.  Benefits of PE

The PEs also has the same benefits as hedge funds. They too have a lower correlation with the market thus providing diversification benefits. They also have higher expected returns than traditional investments.

6.  Risk of Investing in The PEs

1.  The performance of the PE is measured based on the volatility and return figures reported. These figures are reported by the fund managers themselves.

2.  There is a lack of market for the underlying investments in the PEs. This may result in an understatement of the volatility.

3.  And the return figures as reported may also be biased and subject to manipulation of accounting data, for survival.

7.  Valuation of Portfolio Companies

The PE portfolio companies do not have an active market so these may be valued based on any of the following approaches:

1.  Market or Comparable Approach. This is a relative valuation approach. Here, the valuers look for the multiples (such as a number of times the EBIT, etc.) at which the comparables are trading, and the valuation is done based on such multiples.

2.  Discounted Cash Flow Approach. This is an approach of absolute valuation. Here, the present value of all the future expected cash flow is calculated to arrive at the value of the investment.

3.  Asset-Based Approach. Here, the net asset value (NAV = TA – TL) is calculated to find the value of the investment.

8.  Due Diligence for PE

The knowledge, experience, and expertise of the general partners should be considered primarily before investing in any PE firm. The other factors that need to be considered are:

1.  The operational and financial knowledge of the partners managing the fund.

2.  The valuation methodology used them to value the portfolio, as it is one of the biggest sources of risk.

3.  The planned exit strategies also need to be considered.