Key points:
- Private equity is equity ownership in a company that is not listed on a stock exchange.
- There are four broad types of private equity: venture capital, growth equity, buyouts and distressed/turnaround/special situations. Each of these types broadly represent different stages of a company's life.
- Investors seek private equity for the high return potential, which also means higher risk.
- Because of the significant ownership stakes that private equity investors take they can influence the strategy and management of their portfolio companies. This can be a significant driver of performance that is independent of general economic conditions.
What is Private Equity
Private equity, once reserved for institutional investors, is increasingly attracting the attention of sophisticated individuals seeking to diversify their portfolios and access high-growth opportunities. But what exactly is it? Private equity represents equity ownership in companies that are not publicly traded on a stock exchange. Companies that are investments are called portfolio companies.
What are the different types of Private Equity?
There are four broad sub-classes of private equity. The sub-classes are broadly aligned with the life stage of the portfolio companies. The sub-classes are:
- Venture Capital (VC): This type of investment is typically made in young, high-growth potential start-ups. VC investors provide capital in exchange for equity, typically non-controlling stakes. Investors will often talk about VC separately from PE more broadly because the risks here are significantly greater as investors are betting on a business idea and the ability of the management to execute that idea. Whereas the other strategies within the PE family are investments in established companies with a proven business model.
Diversification and portfolio construction are key to a successful VC portfolio because it is often just one or two of the portfolio companies that drive performance. Many of the portfolio companies may not generate financial returns and may even end up as failures.
Having sufficient deal flow is also important as the VC fund managers will often need to sift through lots of companies to uncover disruptive companies that have the potential to also be financially successful.
Example: Investments in companies like Uber and Airbnb in their early stages were made by venture capitalists.
- Growth Equity: These investments are made in growing but established companies that are looking for capital to expand or restructure operations, enter new markets, or finance a significant acquisition without a change of control of the business.
Example: Canva is an example of taking growth equity funding to expand its footprint with the acquisitions of Zeetings (presentations), Pixabay and Pexels (stock photography) as well as other companies like kaleido.ai and Smartmockups.
- Buyouts: More mature companies that have attained a steadier state of business are the typical targets of the next type of PE sub-class known as Buyouts. This is when a PE firm buys a controlling share of a company, often by using a significant amount of borrowed money, with the aim of improving its operations and selling it later for a profit.
Examples: At one stage both Hoyts and Myer were portfolio companies of private equity funds.
- Distressed/Turnaround/Special Situations: There are on occasions well-established companies that for one reason or another fall upon difficult times. These types of companies are the targets of distressed/turnaround/special situations private equity investors. These types of investors focus on acquiring distressed companies or those in need of operational or financial restructuring. The objective is to improve the business and eventually exit with a profit.
Example: The purchase of Virgin Australia during COVID-19.
What are the different types of strategies available within private equity?
While we’ve explored the main types of private equity, each sub-class can have a number of different strategies offering unique characteristics and risk/return profiles.
Differences arise because different strategies may focus on particular:
- Geographic regions: some funds target specific regions or countries, while others have a global outlook.
- Industry sector: funds may specialise in healthcare, technology or even niche sectors like renewable energy.
- Company size: such as mid-market or large-market.
What role does private equity play in a diversified investment portfolio?
Private equity is a growth asset (like listed shares) and investors include private equity in their portfolios to boost the long term return potential. Key distinguishing features of private equity investments that attract investors include:
- High return potential, albeit with significant risk and leverage: Some private equity strategies like buyouts often employ significant leverage, that is using debt to finance their investments. This strategy involves purchasing the entire entity and servicing the debt with the acquired company's revenue. While the leverage magnifies investment gains if successful, it can also lead to larger losses if the debt burden becomes overwhelming for the portfolio company to service.
- Expert due diligence: Private equity investors are investing in companies without the strict reporting requirements of public entities and therefore do not have the same level of transparency as publicly listed companies. To manage this risk, private equity investors conduct extensive research and due diligence, carefully examining all aspects of a target portfolio company's operations and financials.
- Diversification, value creation strategies and influence: To enhance the value of their investments, private equity firms focus on value-add operations. This involves implementing strategic initiatives like operational improvements, technological investment, and/or cost reduction. Such activities can potentially be sources of revenue/profit growth that are independent of general economic conditions and can offer significant diversification benefits in an investment portfolio.
Private equity investors are able to implement value creation strategies because investments are usually significant if not controlling stakes that allow the private equity investors to control the company board and therefore directly influence the portfolio company's management and strategy. This is very different to shareholders in listed companies where it is significantly harder to influence the direction of the company and influence is typically limited to a vote at the company's Annual General Meeting.
