Level 1 CFA® Exam:
Private equity funds invest in shares of private and public companies. When the fund invests in a public company, the aim is to withdraw the company from the stock exchange. Private equity funds typically take control over the company they invest in.
Private equity funds may take different forms. There are 3 main categories of strategies employed by private equity funds:
- leveraged buyouts,
- venture capital,
- growth (development) capital and other strategies.
Leveraged Buyouts (LBOs)
One of the most frequently used strategies is leveraged buyout (LBO), which generally takes place when a fund borrows a lot of money to acquire a company and purchase its outstanding shares. If the target company is a publicly traded company, in the majority of cases after LBO it becomes private and is no longer listed.
As a rule, in LBOs the debt/equity ratio is high because of the heavy borrowing used to finance the acquisition. The purchase of shares of the target company may be financed through bank loans or high-yield bonds. Sometimes a financial institution (e.g. a bank) assumes a part of the risk in return for a share in profit (such instruments as bonds convertible to stocks or bonds with warranties are used). This kind of strategy is called mezzanine financing.
Before we wrap up the bit about the leveraged buyout, let’s say a word or two about management buy-out and management buy-in:
Management buy-out is when the purchase is made by the managers of the company, so the target company’s management is involved in the acquisition.
Management buy-in is when the external team replaces current managers.
Venture Capital (VC)
Venture capital (VC) is the other most commonly used private equity strategy, next to the leveraged buyout. VC usually entails investment in the equity of the companies that are in the early stage. The earlier the stage of development of the portfolio company, the higher the rate of return required by the VC fund.
Other strategies include growth (developed) capital. Growth capital is equity financing to grow companies more mature than in the case of venture capital. The fund usually has a minority share (no-controlling interest) in the company.
Now that we have discussed the basic types of private equity, we should consider their objectives. Of course, the obvious goal is to earn money from the investment.
To earn money, first you have to take some risk and invest money in a particular company. However, to realize the profit you also have to exit the investment. The exit of the private equity fund from a portfolio company is not necessarily easy. Private equity fund's portfolio companies aren't usually public companies and so their sale can be problematic.
Exit strategies include:
Into the category of private capital, we can also include private debt which can take different forms, e.g., direct lending, mezzanine debt, venture debt, or distressed debt.
Direct lending involves private debt funds that collect money from investors and lend them to companies that need financing. Direct lending is a solution e.g. for borrowers having difficulty with taking bank loans. From the perspective of the investors (lenders), in the case of direct lending the debt is generally senior secured debt with covenants that protect investors.
In the case of mezzanine debt, the money lent to companies by investors takes the form of credit that is subordinate to senior secured debt but senior to equity. Hence, the yield required by the investors in the case of mezzanine debt is higher than in the case of direct lending. Mezzanine debt is often used with LBOs, recapitalization, and acquisitions. Moreover, it very often includes warrant and conversion options that allow debt-to-equity conversion if predefined conditions are met.
Venture debt is used as a financing tool for startups and the like. It can accompany venture capital which is mainly equity financing. Venture debt could be used for example by a company that needs capital to grow but is afraid of further diluting its equity. However, very often venture debt, just like mezzanine debt, can have embedded options, e.g. to buy the company equity.
Finally, distressed debt is used to finance mature companies with financial difficulties.
- There are 3 main categories of strategies employed by private equity funds: leveraged buyouts, venture capital, growth (development) capital and other strategies.
- Management buy-in is when the external team replaces current managers.
- When it comes to VC, the sources of financing, and the stage of development of start-ups, we can enumerate the following stages: angel investing, seed-stage financing, early-stage financing, later-stage financing, and mezzanine-stage financing.
- Private equity exit strategies include: trade sale, initial public offering (IPO), special purpose acquisition company (SPAC), secondary sale, recapitalization, and write-off (or liquidation).
- Direct lending involves private debt funds that collect money from investors and lend them to companies that need financing.
- In the case of mezzanine debt, the money lent to companies by investors takes the form of credit that is subordinate to senior secured debt but senior to equity.
- Venture debt is used as a financing tool for startups and the like.