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Private Equity Funds – Its types and Advantages

Akansha Gupta

| Updated: Aug 10, 2021 | Category: AIF Registration

Private Equity Funds – Its types and Advantages

Private equity investments are classified in a wide category of (AIFs) Alternative Investment Funds. Private equity funds and investors either invest directly in private firms or participate in buyouts of public companies, culminating in the delisting of public stock. A Private Equity Fund, also referred to as Private Equities, is a type of equity capital made up of investors who make direct investments in private firms. Such stocks are capital that is not listed on public markets and is governed by industry-specific standards. Private equity investments typically have longer holding periods. As a result, the investors drawn to private equities are often retail or institutional investors who can afford to invest substantial quantities of capital over a longer period of time. The firm then utilizes this large money to support growth, purchase new technology, and improve the balance sheet, and so on. In most situations, private equity investments need very extended holding periods in order to assure a turnaround for failing corporations or to allow liquidity events like an initial public offering (IPO) or a sale to a public company. Such funds’ term (investment horizon) might range from 5 to 10 years, with the option of an annual extension.

What is Private Equity (PE)?

Introduction to PE (Private Equity) in India

Almost $100 billion of capital has been invested in the private equity sector during the previous 13 years in India. Many businesses have profited from this critical source of finance. Private equity funding has aided the growth of numerous small and medium-sized enterprises. This has resulted in job opportunities and affected the development of strategic competencies.

One distinguishing aspect of private equity funds would be that the money pooled in for the purpose of fund investing is not traded on the stock exchange and is not available for subscription to anybody. Because private equity funds aren’t available to anyone and everyone, the funds are often obtained from institutional investors (HNIs and Investment Banks) that can afford to invest significant quantities of money over an extended duration. Private equity funds are a great way to earn a high rate of return. Private equity capital inflows hit about $26.5 billion in FY 2017-18, and the trend is anticipated to continue in the future years.

How PE (Private Equity) creates its values?

Private equity serves two key tasks in the creation of value:

  • Transaction execution/deal origination
  • Portfolio management

The primary role of deal origination is to build, maintain, and create connections with mergers and acquisitions (M&A) intermediaries, investment banks, and other transaction specialists in order to ensure high-quantity and high-quality deal flow. Transaction execution includes evaluating management, the industry, past financials and predictions, as well as determining value.

To create transaction leads, some businesses hire internal employees to find and contact company owners actively. When internal staff is employed, the excessive expenditures associated with investment banking middlemen’s fees are reduced.

When both parties agree to proceed with the transaction, the deal professionals, in collaboration with different transaction advisers such as investment bankers, advocates, accountants and consultants, carry out the due diligence process.

What are Private Equity Funds (PE Funds)?

A private equity fund is a type of collective investment plan that invests in various stocks and debt securities. They are typically run by a corporation or a limited liability partnership (LLP). Private Equity Funds make investments in unlisted private firms in exchange for shares in the business. When unlisted firms are not able to fund themselves through the issue of equities or debt instruments, they typically turn to PE funds or venture capitalists.

Limited Partners (LP), who generally own 99% of a fund’s shares and have limited liability, and General Partners (GP), who own 1% of the shares and have full liability, are the two types of investors in a private equity fund. The latter is also in charge of carrying out and managing the investment.

These firms provide investors with a diverse portfolio, lowering the risk factor. A PE Fund’s investment period spans from 4 to 7 years. The business anticipates that after 7 years, the investors will be able to exit the investment and make a good return.

How do Private Equity Funds work?

Private equity companies make medium-to-long-term investments in businesses with great development potential, often lasting 4-7 years. Although the road map differs from company to company, the following is the typical procedure of a private equity investment: –

  1. Fundraising – Private equity investors would raise capital to establish a PE fund. After this amount is raised, the fund would be closed to new investors.
  2. Investigate – The private equity fund managers will then choose and research a portfolio of private firms in which the fund would invest, with the goal of generating a capital profit through the sale of the investment.
  3. Improving operational efficiency – This is the most essential phase in the process. The private equity company will work hands-on to enhance efficiency, raise cash flow, cut expenses, grow the business, advise on strategy and growth, create introductions with new clients, and serve as a general business partner.
  4. Selling the portfolio – The last stage is for the private equity company to sell the portfolio in order to realize the increased value of their interest in the business.

Types of Private Equity (PE) Firms

There are several forms and types of private equity in the United Kingdom. Private equity firms are the most prevalent source of private equity investment (also called as private equity funds). Investors in private equity companies have a diverse set of investment preferences. Many investors are passive investors who rely on the company’s management to produce revenue returns. Some investors, on the other hand, are known as active investors. This sort of investor provides operational assistance to management in order for it to flourish.

For the company’s growth, the active private equity firm maintains ties with C-level executives such as CEOs and CFOs. They are well-versed and aware of the operations of the company and the synergies. Sellers typically look favorably on investors who are active at the operational level to boost the growth of the company.

Investment Strategies

Private Equity Funds Investment Strategies

1- Venture Capital (VCs)

Investors (sometimes known as angels) contribute capital to entrepreneurs through venture capital investment, which is a type of private equity. VC can take many forms based on the stage at which it is delivered. Seed capital is capital supplied by an investor to help a company grow from a prototype to a finished product or service. Early stage finance, on the contrary, can help an entrepreneur expand a business faster than a Series. When capital is put into firms that aren’t fully established and don’t have access to regular funding or financial markets, it’s called a pool.

Venture capital is a kind of fund that invests in young, emerging companies and startups with minimal or no access to outside financing markets. These new businesses are generally in the early stages of development, but they have a lot of room for expansion in the near future. Emerging companies with ambitious value propositions and innovations might benefit significantly from venture capital funding. Venture funds have no debt and may create tremendous profits if they invest in the right fledgling business. VCs have been instrumental in helping India’s companies grow.

2- Growth Capital 

Private equity growth capital funds invest in existing businesses that have a proven business plan in order to help them develop, increase or restructure their operations, entering new markets, or financing a huge acquisition. In other words, growth capital is utilized to fund previously established private companies that lack the necessary assets. Leading to a shortage of required assets, such businesses are unable to access the traditional sources of capital needed to expand.

Because the firm that requires expansion capital is usually a significant profit-generating organization, it is usually a minor investment. These companies utilize growth capital to support large expansions, acquisitions, or other expenditures since they are unable to leverage their existing assets to get traditional growth financing.

3- Leveraged Buyouts or Management Buyouts (LBO)

A leveraged buyout is a type of VC fund that invests money in a larger firm along with additional leverage (typically in the form of stakeholdings) on the organization in order to create favorable and significant returns. In comparison to VCs, the amount of money invested is also higher.

A leveraged buyout happens when a company borrows a large quantity of money in the form of loans and bonds in order to purchase another company. To put it another way, when capital is utilized as a tool to drive the company’s current management toward the goal. The goal of keeping a large interest in a firm for an extended period of time is to manage the company’s funds in order to produce significant value. PE firms dilute their share and depart the company after a considerable value has been produced.

This is the most typical kind of private equity investment. It entails buying a company outright to strengthen its commercial and financial health before disposing it for the benefit of an interested party or launching an initial public offering (IPO). Until 2004, the main category of leveraged buyouts for private equity was the selling of non-core business divisions of publicly listed corporations.

The procedure for a leveraged buyout is as follows. A private equity company selects a possible acquisition target and establishes a special purpose vehicle (SPV) to finance the transaction. A leveraged buyout typically uses debt to fund the transaction. The LBO business must provide a small portion of the financing (typically, around 90 percent of the cost is financed through debt).

The goal of a leveraged buyout is to create acquisition returns that are greater than the interest paid on the debt. This is an excellent alternative for the LBO business to earn significant profits while only putting a slight amount of money at risk.

4- Real Estate

Following the 2008 financial crisis, which caused real estate prices to plummet, there was a rise in this sort of finance. Commercial real estate and real estate investment trusts (REIT)[1] are two common sectors where funds are spent. Compared to other types of private equity fundraising, real estate funds demand a larger minimum investment amount. In this form of fundraising, investor money is likewise locked up for several years at a time. Real estate funds in private equity are anticipated to increase by 50% by 2023, reaching a market size of $1.2 trillion, according to research company Preqin.

Private equity real estate funds participate in the investment of a variety of real estate assets. These funds’ strategies are based on:-

  • Core: Funds are invested in low-risk, low-return methods with consistent cash flows.
  • Core Plus: Investments in core assets with a moderate risk/return profile that require some sort of value addition.
  • Value Added: A medium-to-high-risk / medium-to-high-return approach that entails acquiring property with the intention of improving it and reselling it for a profit. Value-added techniques are generally used for properties with operational or managerial difficulties, physical upgrades, or capital restrictions.
  • Opportunistic: A high-risk/high-return approach, opportunistic property investments necessitate substantial improvements. Investments in development, the acquisition of raw land, and mortgage notes are all examples.

5- Funds of Funds (FoF)

A ‘fund of funds (FoF) is an investing strategy in which capital is invested in other funds rather than directly assets, stocks, or bonds. Investors benefit from a fund of funds because their money is spread over many fund strategies, reducing risk.

As the name implies, this form of funding focuses on investing in other funds, typically mutual funds and hedge funds. They provide a backdoor into such funds for investors who cannot pay the minimum capital requirements. However, opponents of such funds point to increased management fees (due to the fact that they are made up of several funds) and the fact that unrestricted diversification may not necessarily lead to the best approach for multiplying returns.

6- Turnaround/Distress Situations

When a company’s current debt cannot be recovered, it turns to equity capital investment. The money will be utilized to help stabilize the balance sheet of the company as well as assist management’s recovery initiatives.

In the US, companies that have filed for bankruptcy under Chapter 11 are frequently candidates for this sort of funding. Following the financial crisis of 2008, private equity companies increased their distressed funding.

Advantages of Investing in PE Funds

Some of the advantages of investing in private equity funds are as follows:-

  • Large amounts of funding: Since PE Funds are debt-free, they are a fantastic source of financing. Private Equity can provide a substantial sum of startup financing to a new business.
  • Active Participation: As a shareholder, you could hold the expert management PE team entirely responsible for preserving your shareholding interests.
  • Untapped potentials: The realm of potentially private equity company investments is substantially unexplored and undeveloped ground. There are numerous options on the horizon, ranging from unlisted privately held firms that have just begun expanding to unpopular sections of larger organizations or even corporations that aren’t performing well on the public market that can be taken private.

Private equity company investments offer a lot of untapped potentials. Investors can earn good returns by investing in unlisted privately-held companies with high development potential. Investors might also find possibilities to invest in businesses that are underperforming on the public market and will eventually go private.

  • Stringent company selection process: Private equity investment companies are highly selective, devoting significant resources to evaluating potential companies in which to invest. This also entails recognizing the dangers involved and how to mitigate them. Managers can be very selective among a large number of possible firms and choose one that contains all of the essential features.
  • Clear accountability: Private equity-owned firms’ management is responsible to an engaged professional shareholder who would have the right to protect and act on their investment.

Now that you know what private equity is, let’s look at some of the reasons why you should consider investing in it.

Who should invest in PE (Private Equity)?

With the emergence of start-ups with significant future development potential, many well-known firms go private in order to raise fresh sources of cash to support their development and expansion.

Only investors with a high net worth and a high-risk appetite should consider investing in PE. Make sure you understand the company’s historical success and managerial competence before making an investment decision.

Also, as previously said, the investment period of a PE is often longer, requiring the investor to have liquid funds on hand in the event of an emergency. The investor must be patient during the investment withdrawal procedure since it can be lengthy and time-consuming.

Conclusion

Many wealthy organizations and individuals are attracted towards to private equity companies. This financial instrument attracts the best and brightest from corporations looking to improve the value of their portfolio firms by investing in PE funds. Individual investors must grasp how value is produced in the Private Equity Market to have a better understanding of PE funds.

Read our article:Alternative Investment funds and its Disclosure Standards

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Akansha Gupta

Akansha is a Delhi-based lawyer who is actively involved in publishing articles on a plethora of aspects of Indian and International laws. She holds Master in law (LL.M) focused on Business Laws from Amity University, Noida. Having expertise in the same, she has authored several publications on legal topics related to corporate, M&A and commercial laws.

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