What Is Private Equity and How Does It Work?
Private equity can be a powerful way for a young company to raise the funds it needs to grow. One type of private equity, venture capital, exists pretty much solely for this purpose—to invest in startups and small businesses that have the potential to grow into much larger and more valuable companies over time.
Sounds simple enough. But private equity exists for reasons other than fueling promising startups, and private market fundraising is a vast industry—$7 trillion in assets under management, according to 2021 data from consultancy firm McKinsey. That scale would seem to call for a bigger-picture explainer, so let’s take a few minutes to unpack what founders need to know about private equity and how it works.
- What is private equity?
- How does private equity work?
- Venture capital vs. private equity: What’s the difference?
- Advantages and disadvantages of private equity funding
- Final thoughts on private equity for startup founders
What is private equity?
There are several ways that companies, young and mature alike, raise the money they need in order to do things that are good for their future prospects. These are things like growing their revenue, managing their debt, increasing their operational efficiency, et cetera.
One very common way for a company to raise money is by selling stakes of ownership in the company to investors. A public company can sell these stakes of ownership—or shares—on a public stock market, and pretty much anyone can buy them and become a stakeholder in that company.
A private company cannot do this, and so perhaps its founder is left with a conundrum: I want to raise funds and I am willing to sell stakes of ownership in my company to do so, but I do not know how or to whom I may sell them. This is where private equity investment can play a very helpful role.
Private equity (sometimes called PE by in-the-knowers) is a type of financing in which private money is invested into a private company, with the hope that the investment will eventually turn a profit for the investors. Put simply, private equity refers to all the shares and debts of companies that are not public and thus cannot be traded on a stock exchange.
These private companies may be large or small. They may be mature businesses or they may just be starting out. Private equity contains multitudes, and private equity investors may follow a number of different strategies and approaches to ensure they profit off their investments.
All of which begs a question: Who are these private investors, exactly?
What is a private equity firm?
A private equity firm is a firm that exists to invest in private companies. This is a pretty broad definition, but again, the private equity industry is big and holds a lot of different players. Different private equity firms like Blackstone or Bain Capital have different approaches when it comes to selecting which companies to invest in and how to invest in those companies.
In general, private equity firms will try to increase the value of the companies they invest in by giving them the resources they need to grow, restructure, or stay competitive in a changing market. This increased value translates to increased profit for the firm in either the short-term or long-term, so private equity is ideally a win-win for both the company and the investment firm.
But where does a private equity firm get the capital to invest in promising companies? This large amount of capital can’t appear out of thin air, and it generally comes from a pool of capital that’s known as a private equity fund.
What is a private equity fund?
A private equity fund is a pool of money that a private equity investor raises to invest in companies he or she deems promising. This money usually comes from a group of limited partners, i.e. investors with limited liability.
Since private equity is an alternative asset class that can be complex and require long holding periods, these “limited partners” aren’t your average, everyday retail investors. They typically include accredited investors (high-net-worth individuals who know what they’re doing) as well as institutional investors and larger pension funds.
In a typical private equity setup, the private equity firm acts as the general partner and the investors act as the limited partners. The limited partners own the vast majority of shares and have limited liability, while the private equity firm owns a much smaller stake. The firm also takes on full liability and manages the details of the investment opportunities—from selecting the companies to include in the fund’s portfolio to helping those companies increase their value.
This requires a lot of hands-on work, but it’s a good deal for the private equity firm.
How do private equity firms make money?
Generally speaking, the money a private equity firm brings in comes from two primary sources. A private equity firm makes money by:
- Collecting management fees from limited partners. For the trouble of arranging and managing the investments in its fund’s portfolio, a private equity firm collects management fees from investors. This fee may vary between firms, but it’s often in the ballpark of 2% of assets under management (AUM). Since this fee is collected regardless of how investments perform, a private equity firm stands to profit on every investment no matter how it pans out.
- Collecting performance fees based on how its investments perform. Private equity firms also need an incentive to, you know, give their investors a good return. This incentive typically comes in the form of a performance fee, or a percentage of the investment fund’s profit that the firm takes for itself. Again, this specific percentage may vary depending on the firm and the fund, but it’s typically around 20% of the profit.
How does private equity work?
So, now you know the basics of how PE funds are set up and how PE firms make their money. But as we mentioned earlier, private equity funding is not a one-size-fits-all proposition. Firms employ different strategies depending on the companies they target with their investments.
Just as no two companies are alike, no two private equity strategies are exactly the same. With that said, there are some general investment strategies common among private equity firms. Let’s take a look at how each works:
Buyouts of mature companies
Here’s one type of private equity that probably isn’t as relevant to the founder of a young company, but certainly is responsible for private equity’s checkered reputation in mainstream culture.
In a typical buyout, a private equity firm “buys out” a mature, public company. purchasing a majority (50%-plus) share in the company and taking it private. The reasons for taking a public company private vary. It may be that the company needs dramatic restructuring or internal changes that would be more difficult to execute if it were beholden to public investors.
A leveraged buyout (LBO) is one common type of buyout you may have heard of. In a leveraged buyout, a firm may acquire a company in not-so-great business health by using a combination of debt and equity. In this case the firm may not have to spend a lot of committed capital upfront to finance the buyout, and any debt used to help finance the transaction is transferred to the company’s balance sheet (the company is, of course, now responsible for paying off this debt). The firm is then tasked with helping to shift the company’s trajectory back towards profitability—hopefully so much so that paying off the transferred debt isn’t such a burden.
Of course, sometimes these types of buyouts involve layoffs and other unpopular management decisions, and sometimes they just don’t work out. These cases tend to tarnish private equity’s mainstream reputation, but they hardly account for all private equity investments.
Investments in growing companies
Sometimes a growing company needs an extra infusion of capital to keep up the momentum, and private equity plays an important role here. A private equity fund that invests in a growing company will usually get a minority share of that company in return for funds to help that company grow to the next stage. (The company’s founder and other existing stakeholders also stand to benefit from new liquidity.)
This type of investment can be risky, but it’s generally less speculative than venture capital, because the company involved already has somewhat of a proven track record and may even be profitable.
Seed funding for early-stage startups
Also known as venture capital (VC), this is probably the type of equity that a founder of a young company will encounter first. Venture capital is a significant part of the private-market landscape and holds a special place in the imaginations of startup founders, who often require seed funding to get their early-stage companies off the ground.
VC is distinctive enough from the other types of private equity—and relevant enough to this conversation—that it’s worth spending a little more time unpacking it.
Venture capital vs. private equity: What’s the difference?
Venture capitalists and venture capital funds focus on investing in small (sometimes tiny) companies with high growth potential in the coming years. Such companies are oftentimes found in the tech startup space.
Though it’s often considered its own thing, venture capital is indeed a type of private equity. Three traits tend to distinguish VC from private equity strategies that involve more mature companies:
1. The size of the companies involved
Many startups and companies funded by VCs are still in the earliest stages of their lifecycle. They may not yet have proven that they can be profitable, and they may have little more than a tantalizing idea and some notion of how to execute it.
For many firms, VC is simply a numbers game. It’s highly likely that most of a firm’s investments will fail, but if one investment pans out, it may pan out in a big way that more than makes up for all the failures.
2. The percentage of equity or company ownership the firm gets
In the case of buyouts especially, a private equity firm may purchase a controlling stake in a company that allows it to take a more hands-on approach to correct what it perceives to be holding that company back.
Venture capital is oftentimes perceived as more of an investment in a young founder or team. For this reason, a VC firm is content to take a minority stake of ownership in the business. This allows the founder or founding team to retain a significant chunk of equity and continue to work toward growing the company, believing that they’ll have even more to gain from a future investment round or exit.
3. The type of company and the industry it operates in
If venture capital has a home base, that base is Silicon Valley. Technology of all stripes tends to be what occupies the imaginations of VC investors most. This makes sense, as many of the most successful and lucrative tech companies started out with VC backing.
Other private equity firms may tend to invest in more traditional industries, or to work with older companies that are being pressured by new market forces. This isn’t always the case, of course, but it illustrates the primary differences in objectives and outlook between VC and other private equity firms.
Advantages and disadvantages of private equity funding
Advantages of private equity
Believe it or not, the vast majority of companies that exist in the world are private. The private markets play an important role in providing fundraising opportunities to these companies. It’s also fair to say that private equity fuels a good deal of innovation amongst entrepreneurs—especially venture capital, which finances early-stage startups that still need time to prove out their profitability.
And, though there are certainly cases in which buyouts and the like do not work out, these types of private equity can provide a necessary lifeline to businesses that would otherwise languish. The opportunity for a company to de-list from the public market and take the time it needs to restructure or reorganize can ultimately mean the difference between failure and success.
Disadvantages of private equity
Though private equity firms tend to make significant profits, private equity is not a universally successful industry when it comes to investor and company outcomes. Some mature companies that are bought out end up being mismanaged by private equity firms and forced into bankruptcy.
On the other side of the spectrum, venture fundraising can put a number of pressures on a founder. The path to closing a fundraising can be unsteady and is oftentimes riddled with rejections and unforeseen difficulties. Questions such as “How much do I need to raise?” and “How should I raise it?” and “How much is my company really worth?” can be hard to answer.
The latter of these questions is especially tough to pin down for a private company, as there are no market forces to dictate exactly what your company’s valuation should be. That’s a negotiation that needs to take place between your company and any investors you engage with.
Final thoughts on private equity for startup founders
Private equity may sound a bit intimidating, but as a founder you should also consider its benefits. Some private equity firms can offer helpful business and management tips gleaned from its other portfolio companies, and the funding they provide can help you grow your team and business to the next level.
If you’re the founder of a young startup and need some extra guidance when it comes to equity, Pulley can help. Schedule a call with our team today and see how you can take control of your equity.