Key Private Equity Investment Strategies
The process of understanding private equity is fairly simple, but the execution is rather difficult. The aggregate capital that has been raised by venture capital funds and private equity will soon reach one billion dollars. While this may seem enticing, it is not easy to be successful without proper private equity investment strategies.
Venture Capital (VC)
This private equity model references equity investments in riskier transactions that could yield a high reward. This often alludes to young companies and startups that have a little track record of profits. The firms investing in these companies aim to take advantage of potential at a very attractive price. Then, as the investee grows and expands, as does the investor’s returns. This asset class has seen rapid growth in recent years. In 2018, there was over $80 billion in new commitments – a significant increase from the $18 billion raised in 2013.
Venture capital firms are often times confused with angel investors, however, they have a few key differences. First, VCs are a group of individuals that are part of a larger firm or corporation. On the other hand, angel investors work alone, investing their own money. With that being said, venture capitalists can typically provide a larger amount of financing. Venture capitalists also invest with an eye to revamp an entity to help it flourish by providing advice and counsel, whereas angel investors primarily only offer financial support.
Growth capital regards institutional investors that finance more mature and established companies with a great track record of success and an excellent business model. These companies are looking for additional funds to restructure or expand their business operations. They also fundraise to make major mergers or acquisitions.
These investments are minor compared to the size of the company. This private equity model is largely used to generate growth capital by companies that are more mature than venture-funded companies. The companies may not generate sufficient profits or revenue on their own to support these substantial expansions.
Real estate is another avenue of raising private equity capital. This asset class involves a group of investors pooling to invest in properties. The four different strategies utilized here include:
In the stock market, the term ‘core’ is used interchangeably with ‘income.’ Core real estate investments are investments made in low-return/low-risk properties that generate regular cash flow.
Core plus investments are a tad less conservative. This investment is in the moderate return/moderate risk category. Apart from the cash flows associated with the previous model, this type aims to take a value-added element approach as well. Core plus owners may be able to increase cash flows by making small improvements in management, the physical property, or the quality of tenants.
Value-added investments are medium-to-high return/medium-to-high risk. This strategy is all about buying properties with little to no cash flow but that great potential. This type of strategy is applicable to properties that have substantial capital constraints, management issues or need physical improvements.
Opportunistic investments are high risk/high return. This strategy involves acquiring properties that require a lot of enhancements, even more than value added. It may take years for investors to start seeing returns from these investments. Some types in this category include mortgage notes and raw land. Typically, these investments have limited partners due to the high risk involved.
Mezzanine financing divulges from the other investment strategies on this list because it consists of both debt and equity. Companies acquiring debt capital provide the lender with the option of converting to an equity interest or full ownership in the company if the funds are not appropriately repaid.
It is critical for companies that seek mezzanine financing to be evidently profitable, have a good reputation, and established the product or service.
The primary reason behind why so many choose this growth equity option is the ability to get capital injection without having to lose the equity ownership – provided the debt can be repaid in full and on time. Since mezzanine financing is seen as being similar to the equity position on the balance sheet of a portfolio company, this option can also garner easier financing assistance from a bank.
There are also downsides to this type of financing. This is primarily due to the lack of collateralization of assets. This puts the lender at a major risk. Therefore, this is typically undertaken by less conventional lending institutions. On the other side of the deal, the target company typically has to shell out a larger interest rate and abide by stricter terms.
Leveraged Buyout (LBO)
Leveraged buyouts can be highly rewarding. In this asset class, the company takes up a large amount of capital – through bonds and loans – to acquire other companies. These private equity firms utilize debt instruments to comprise of a majority, if not all of the purchase price. They invest in private companies, help manage and improve them, and then exit once they feel they have generated enough returns.
The buyout is leveraged with as much as 90% debt and only 10% being contributed by their own funds. Since there is high utilization of debt, it can result in substantial interest payments for the target company.
The idea of a leveraged buyout is to make enough returns on the acquisition to offset the interest cost. Many private equity firms choose this option because it can generate a substantial amount of return while only risking a small portion of their capital. PE firms raising capital through leveraged buyouts may also sell a portion of their acquisition for a profit while holding on to the remaining portion to reduce debt.
Fund of Funds (FoF)
A fund of funds (FoF), or a multi-manager investment, is an investment made in private equity funds rather than directly in bonds, stocks, and securities. Fund of funds is often associated with greater investment diversification and lower risk.
Adversely, these funds often succumb to an additional layer of fees, which can leave them costlier than anticipated. Investors may also run into difficulty finding qualified fund managers.
Special situations are abnormal events that have a significant impact on a business’ future. Accordingly, special situation funds are equity funds that are after companies are in said special situations. Most of the profits generated here are through a change in the valuation of the company. Examples include large company spinning off a business unit as its own entity, private equity acquisitions or mergers, bankruptcy proceedings, and tender offers.
This type of investment also common among hedge funds.
Stages of Venture Capital Financing
Among the different investment types, venture capital is usually not an ‘introduction to private equity’ because of its high risk and high reward nature. The likelihood of failure among private companies backed by venture capitalists can be startling. Most of the VC funds tend to make a sizeable number of deals with hopes that one or two become actually successful. This helps the fund compensate for several failed investments while still attaining a profit.
As all in nearly all aspects of business, venture capital financing doesn’t happen in a vacuum nor overnight. Venture capital financing warrants distinct private equity stages:
- Seed stage
- Early stage
- Late stage
1. Seed Stage
The funds involved in the seed stage are relatively low and the business is typically not more than an idea or concept versus a working good or product. The funds raised during this stage are often delegated to research, development, or business expansion.
2. Early Stage
In the early stage, VC investors aim at companies with complete and operating business models. Additionally, the product made by the company has a good demand in the market and the business typically achieves growth of 20-30% every month.
3. Late Stage
The late stage involves established entities looking for high levels of funding to support significant strategic initiatives. So the company is able to get a couple of rounds of financing, they need to have a proven profitable record. The product generated by the company should also have excellent traction in the market.
What is Private Equity Due Diligence?
In life, you probably wouldn’t get married after the first date. You likely would want to spend more time with and learn more about a person prior to making such a weighty commitment. Likewise with investments, every business investor has to look at various factors before signing a deal.
This is often referred to as due diligence. Due diligence is the reasonable care, which is typically in the form of a thorough investigation, taken by a rational individual prior to completing a deal. It is possible to improve private equity asset management by surveying at the following factors during private equity due diligence:
Financial Situation – Many professionals recommend not to make an investment that is more than 5% of your total net worth. This can have a positive effect on cash flow and greatly reduce risk.
Risk Tolerance – Business investments are made with the objective of making money. Since even the best private equity primer investment is prone to failure, there should be a risk tolerance decided upon before completing the investment.
Business Model – The business model of the company should be well understood before making any investment. Any investment is a gamble but it is worth knowing the odds of success before throwing the dice.
Market Trend and Size – Market size plays a huge role in determining the potential of an investment’s success. A great private equity example would be Uber. Uber was able to attract a lot of funding initially considering the huge space in the taxi aggregator model. The analysis of the market size and trend is very difficult and time-consuming, but getting it right can help reap rich rewards from the investment.
Competition – A business’ competition can have a huge impact in terms of profitability. It is vital to analyze aspects like cost, growth rate, pricing, and the quality of the competition in order to make better decisions. Many of the investments go to companies that are in the infancy in their segment. Knowing your opponent helps improve the likelihood of success and helps you stay ahead of the game.
Which Strategy is Best?
The answer to this question is the same as many in business: it depends. As with anything, the success of any investment strategy is contingent upon an excess of external factors such as the economy and social or technological trends.
Comparing VC and PE firms, both have the potential to generate substantial profits. However, PE firms are capable of paying out more than venture capital firms largely due to factors like bigger fund sizes.
Many large buyouts may not be as lucrative since debt with a high yield does not come cheap, but middle market buyouts remain attractive even now. Overall, there is a greater amount of opportunities for seeing growth in emerging markets than in developed markets. The availability of greater profits nationwide has fuelled the growth behind PE firms.