This article will explain Private Equity (PE) and how it works, its characteristics, and its risks and advantages. This article will provide you with valuable advice and information about the various ways to invest in private capital.
What is private equity?
Private equity: Investing in the unlisted
Private equity is the investment in unlisted companies. It involves purchasing shares in small and medium-sized businesses that are in the development stage, but not on the stock exchange.
Private equity is therefore a source of financing for unlisted SMEs/SMIs. It is an alternative to bank loans and does not require companies to go through an IPO (Initial public Offering). This can be costly and time-consuming for companies.
Private equity financing is accompanied by a long-term vision. Private equity financing is often more flexible than bank financing, bond, or IPO.
In reality, creditors and shareholders can sometimes place some pressure on profitability and target achievement deadlines. A financing support through a private equity company is more flexible and focuses on the “long-term.”
If a SME has to invest heavily in a given year N to grow its business, it will likely be easier to finance it through Private Equity than if it had shareholders seeking dividend yields. This principle holds true for bondholders who also want to receive returns on their bonds (financial-debt securities).
Finance’s private equity industry
As a Private Equity manager, you would analyze, meet, or accompany SME or SMIs in their search for financing.
You never know, maybe the 200-employee business in your city’s industrial parks is growing quickly because of its innovative business model? It might be a good idea for you to invest in it and help its future growth.
This is not an easy task at first glance. You will also need to be able to analyze the “files”, such as growth, sector dynamism, and company policy.
You must have sufficient capital to finance these companies and be aware that diversification is better.
These elements create a lot of obstacles for individual investors. It is still very difficult for individuals to invest directly in listed companies. Private equity investments are possible through listed private equity firms and private equity funds like FIP, FCPI, and FCPR.
Private equity firms tend to choose sector specializations like healthcare, technology or consumer.
Their role is to support the long-term growth of SMEs, building trust and partnership, and aligning common interests. It is possible to improve the performance of SMEs.
The common goal of the funded company is long-term value creation and attractive returns for private equity firms.
The majority of a private equity firm’s portfolio is made up of small and medium-sized business and mid-sized enterprises. If they believe there is potential, these firms may arbitrate a portion of their investments in publicly traded businesses.
Portfolio management is also the responsibility of the management teams at private equity firms.
Private equity firms’ management teams have a high level of expertise. Their primary function is to seek financing for private (unlisted), high-potential companies. They also calculate rates of return.
These teams then conduct “field investigations”, meeting with managers, visiting premises and providing legal support.
Private equity companies’ “entry tickets” can be both low and high. They can be as low as a few million euros for small SME’s, or as high at over 500 million euros for larger companies.
“There are two main types of private equity capital. The first is development capital. This is used to support the growth of private companies. The second is venture capital. It is used to finance a company’s initial stages.”
Private Equity: The different capitals that can be used to invest in the unlisted
Development capital
Development capital is the term that describes the operation to acquire equity stakes of unlisted companies that have reached break-even and are generating profits to fund their growth. You can either make development capital in equity (i.e. a dilutive capital investment that represents a share of capital) or in quasiequity (i.e. amortizable or bullet-bond financing that is convertible into capital or not).
Turnaround capital
Turnaround capital refers to the transaction to acquire an equity stake of a distressed unlisted business. It is expected that the influx funds and support of the manager will allow for a return of profits in the medium-term. This is a riskier segment of private equity and is only practiced by a few companies.
Transmission of capital
Capital transmission refers to the purchase of shares in mature companies that, despite being financially sound (they often generate steady cash flows), don’t have the successors or ability to continue their management. With the support of an investment bank and/or fund, shareholders can transfer the company to another company or to a third-party if they wish to exit.
Innovation capital
Innovation capital is the term that describes the operation of buying a stake in a company during its creation or launch phase. It is the financing of innovative and/or start up companies that are not yet listed. It is, therefore, a way to ensure the production and marketing products and/or services offered in the start-up.
What are the benefits of private equity investing?
Private equity: Very high potential returns
Private equity’s main advantage is undoubtedly its potential returns. Private equity is about financing promising companies that have yet to mature. Capital gains can be very significant by investing in capital early. The potential for a large gain is therefore quite high.
Private equity investments can bring tax benefits
Additionally, tax benefits can be obtained by investing in unlisted via funds. If the units have been in your possession for at least five years, you can benefit from a capital gains exemption by investing in private equity via a FCPR. Additional tax benefits can be obtained by subscribing to certain FCPRs, such as FIPs or FCPIs.
Private equity investing via specialized funds or companies has many benefits
Diversification through multiple investments is one of the many benefits of private equity companies and private equity funds. Private equity funds or companies can have more than 50 equity investments in their portfolios. Diversification is a way to reduce risk.
Let’s not forget the intangible value of the experience of management teams at private equity firms and private equity funds. They are often involved in growth and have sector expertise.
What are the risks associated with investing in private equity?
Private equity: A higher risk of capital loss
Private equity investments are, as we have seen in the past, immature companies at an early stage of their development. While the goal is to select companies that can gain market share and establish themselves within their sector, some companies will not achieve the expected success. Two very real options that can lead to significant capital losses are bankruptcy and stagnation.
Private equity: A difficult-to-access and opaque sector
Private equity is small and medium-sized businesses, as well as very small companies. There are many of them, which can be difficult to identify. This sector is difficult to access and direct investment is still rare. This segment will be dominated by listed and private equity firms.
Private equity: an illiquid segment
Liquidity risk is another aspect of private equity investing. Investors are more likely to find a counterpart to buy their holdings in unlisted companies.
Private equity companies are subject to risks
Private equity investors may be at risk from misjudgments made by private equity managers when selecting companies to invest in.
These misjudgments can be caused by investments in young companies, or in companies in transition, which do not achieve their goals. There are many reasons for this, including the emergence of competition, poor management, or other macroeconomic risks.
Also, SMEs are more risky than large companies when they are targeted in private equity activities. SME are, in fact, more risky because of their small size.
These are our top tips for investing in private equity.
You should ensure that the private equity investment is a good match for your investor profile
Before investing in private equity, one must ensure that their investor profile, including their risk profile and investment horizon are compatible with private equity. Private equity is a risky investment and should be considered long-term.
Private equity’s objective is to support private companies over the long-term.
Arbitrage and short-term trading strategies are not allowed in the business model. Investment diversification must be considered as one of the risk management criteria.
Understanding your private equity investment and its specificities
An investor has many options within a global universe that includes several hundred companies that specialize in private equity as well as FCPI / FIP/ FCPR type funds. Before he subscribes, he should thoroughly review their strategies.
The fund’s liquidity issues should be of primary concern to the investor. This should include the lock-up period which should correspond with his investment horizon. However, the lock-up may be extended. Investors will need to consider the level of risk (described in the DICI), as well as any tax benefits and fees that may affect the investment’s performance.
As with all stock market investments, investors must evaluate the fundamentals of the stock. They should pay attention to the tangible net assets per share, average earnings per share and operating profitability per share. The debt ratio, as always, must be considered.
Private equity firms are open about their business models and strategies. Investors have the option to choose the best ones. These firms specialize in particular sectors or have large private equity firms that offer different types of funds. There are many variations in this universe.
Altamir, a French listed company, decided to specialize in specific sectors, such as TMT (Technology, Media and Telecom), services, consumer, and healthcare.
Tikehau Capital on the other hand favors entry tickets between EUR10 million to EUR70 million as a maximum investment ceiling per private company. There are no sector limits.
Diversification is a must!
Private equity is a risky asset class. It is best to limit your wealth in this area due to the potential risks. Private equity should not be a large part of your financial capital.
Diversifying is not just possible by this method.
But that’s not all. You should diversify your portfolio by investing in private equity funds and/or companies within the private sector.
Private equity is more profitable if you invest more.
Do not hesitate to ask for help
It can be difficult to select the right assets to invest private equity, especially when tax issues are involved. A wealth management advisor can help you choose the best private equity funds and companies for your investor profile.
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