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What Is Private Equity and How Does It Work?

by | May 28, 2022 | General | 0 comments

If you work in startups or a growth-stage business, you’ve undoubtedly heard the term “private equity” before.

Yet most employees don’t know what the term means let alone understand the role private equity plays in the market.

In this article, we’re going to break down the phrase and provide some examples to help you understand when and why private equity could be used – as an owner, operator, or investor.

What is equity?

Before we dive into “private” equity, we need to understand what equity is in the first place.

Equity is the difference between what something is worth and what is owed

For example, if the home you own is worth $400,000 but your mortgage balance is only $320,000, you have $80,000 worth of equity.

In personal finance, the sum of all your equity (your home, stocks, retirement accounts, etc. minus your mortgage, credit cards, student loans, etc.) is known as your Net Worth.

The same simple concept applies to businesses. The value, or equity, of a business is the difference between what is owned and what is owed.

The equity of a business is calculated on its Balance Sheet.

What is equity in a company?

In financial terms, equity refers to ownership of a company—the amount of stock that investors own and, therefore, share in its profits or losses.

Equity is the opposite of debt: while debt means “borrowing money” (paying back with interest), equity means “owning part of something.”

How is equity different than debt?

Debt financing is money lent from another person or institution to another with the requirement to pay back the loan at some point in time—usually over several years. The loan amount, monthly payment, schedule, interest rate and more can range widely based on what your company is borrowing against as collateral.

Debt can be good or bad, depending on how it’s used. For example, businesses can borrow against money that is owed to them in the future (known as Accounts Receivable financing) or purchase inventory ahead of time without giving up ownership in the company.

Equity, on the other hand, is a way to invest in a company. When you buy equity, you are buying ownership in that company by providing funds for the company to use as they wish. You’re not borrowing money, but making an investment into the company with your own funds that does not require repayment.

This means that if the business goes under or fails to meet its goals, business owners don’t have legal obligations to repay equity investors like they do with debt financing.

As private equity investors purchase stakes within companies for-profit enterprises are able to expand their operations without needing access to capital markets through issuing shares or increasing their levels of indebtedness; thus reducing their risk exposure by raising new funds outside traditional banking channels such as commercial banks who often require collateral deposits before issuing loans.”

  1. Debt needs to be paid back at some pre-defined point in the future
  2. Debt doesn’t “own” equity in the company

Debt gets paid out before equity

Because debt has preference (it gets paid out before equity), it doesn’t share in the potential upside of a company. Said differently

What is private equity?

So what makes private equity “private”?

Private equity – or, PE for short – is a form of investment where individuals, families, or firms purchase ownership (via stock or stock options) in privately-held businesses that aren’t yet publicly traded.

In order to be publicly traded, companies need to have their financials audited, certified, and approved by the Securities and Exchange Commission (SEC) before offering them up as a security to the general public. Public companies are listed on stock exchanges like the New York Stock Exchange, NASDAQ, and more. These stocks are also known as “public equities” because investors can buy the equity of a public company.

Private equity investors chose to invest cash into private companies in exchange for a portion of the business because:

  1. Private stock can sometimes be bought at a discounted price and sold later at a premium, allowing for significant returns on the initial investment.
  2. Investors believe their investment will allow the company to grow in size and value, increasing the value of their equity over time.

How is equity used in a company?

Equity is the lifeblood of a company. It can be used to purchase a business, fund its operations, expand its footprint, acquire another company or project, and so on.

Equity is also one of the most valuable assets for investors because it represents ownership in a company.

In terms of private equity vs. public equity:

  • Private equity funds are only available for accredited investors—people who meet certain financial criteria set by regulators such as having an income over $200,000 per year or have a personal net worth (assets minus liabilities) of $1,000,000 or more.
  • The equity or stock of a public companies can be bought and sold by anyone with enough money to buy shares on a stock exchange.

What kinds of private equity are there?

When you hear that someone “works in private equity,” it usually means they hold a role at a company that specializes in investing in private companies. How, when, and where they invest depends on the specifics of that firm. There are many different types of private equity. All are similar in that they consist of purchasing securities of companies that have not been publicly traded or listed on an exchange yet.

What are the different kinds of private equity?

We’ll be producing a deep dive into the nuances of each private equity firm type in the future. For now, here’s a short list with a brief description of each type’s specialty:

  1. Venture Capital or Venture Firms – Invest in early-stage companies to provide capital to new product ideas
  2. Buyout Firms – Groups who raise funds from investors with plans of buying a controlling stake of a promising company. This allows them to make decisions to improve the company as they see fit.
  3. Turnaround Firm – Groups of experienced operators who buy undervalued or struggling companies with the hopes of “turning them around,” thus increasing the business’s value – and their investment.
  4. Search Firm – An individual or group of people who have raised money from outside investors in hopes of finding a company to acquire and run themselves.
  5. Fundless Sponsor – Individual searchers who find capital on a deal-to-deal basis, rather than raising a fund first and then finding companies to buy or invest in.
  6. Growth Firm – Growth firms seeks investments into solid companies that have found product-market fit and need capital to scale their growth in an effort to capture the market quickly.
  7. Family Office – Groups that manage and invest their own money in private companies rather than letting financial planners place it passively for them. Family offices may want to manage the companies they invest in, or they may work to bring in managers or executives to run the day-to-day operations.

How are private equity and venture capital different?

Private equity (PE) and venture capital are very similar in that they consist of purchasing securities of private companies.

However, PE is a broader term that includes venture capital and encompasses many other types of investment styles (see above).

The main difference between the two is that private equity tends to focus on larger, more established companies that want to stay private for a while – or indefinitely.

It’s also worth noting that unlike venture capitalists, most PE firms don’t invest until an organization has already proven itself profitable and can sustain itself after an acquisition. Even then, most will only make smaller investments in comparison with later stage venture capitalists.

Venture capitalists – or VCs – on the other hand, put money into a company earlier in its lifecycle to provide funds to get the business off the ground. They are investing in ideas and future potential rather than focusing on current profitability or existing assets like PE funds do.

Later stage private equity usually invests in the growth of a company in exchange for a portion of ownership; it doesn’t involve as much risk as early stage investing does because investors know what they’re getting into beforehand.

Final thoughts

In its most basic form, private equity is simply investing money in exchange for ownership in private companies.

Don’t be intimidated when you hear phrases like “private equity,” PE, or many other jargony phrases. Many terms in the investing space may seem complex or intimidating, but breaking them down will help you understand and use them to advance your journey in the pursuit of a prosperous future.

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