Private Equity: What It Is & PE Financing
An introduction to private equity, how it can help business owners, and its applications for private companies.
Feb 19, 2021
What is Private Equity?
The term private equity (PE) refers to investment firms that acquire ownership in non-publicly traded businesses. The PE firm makes operational and financial improvements to the businesses with the aim of selling its ownership later for a profit.
The money invested by PE firms comes from a “private equity fund” that the firm has raised through outside investors. The business can use the private equity investment capital to develop and market new products, purchase equipment, provide liquidity to the owner, or grow the business to new levels.
Private equity financing can be structured with great flexibility. PE is generally structured as an equity investment rather than debt capital, but this can vary depending on the desires and needs of the business and its owner. It can run the range of small investments used for growth capital, to medium-sized investments for new acquisitions or owner liquidity, to a full buyout of the business.
Types of Private Equity Investors and Strategies
Private equity investors typically fall into one of three categories: angel investors, venture capital firms, or private equity firms. Each of these types of PE seeks to provide capital to businesses intended to nurture expansion, develop new products, or restructure the company’s operations, management, or ownership. However, each also comes with its own unique set of goals, preferences, and investment strategies.
An angel investor invests in younger businesses, generally in exchange for minority ownership. Angel investors can be singular investors looking to diversify their portfolio, a group of investors, or even a group of very small investors working together through a crowdfunding campaign. Angel investors tend to focus on smaller investments with high risk and high expected returns.
Venture Capital Firms
A venture capital firm functions similarly to an angel investor, investing in young, fast-growing companies, often with minority ownership positions. However, VC firms tend to invest slightly later in the business lifecycle and seek to invest larger amounts of money compared to angel investors. Venture capital firms invest in risky assets with high expected returns, but these companies typically have proven concepts and need funding to achieve scale before turning a profit.
Private Equity Firms
A private equity firm typically invests in more mature companies which are already earning a profit. Common types of private equity strategies include leveraged buyouts, growth capital, distressed investments, and mezzanine (subordinated debt) capital investments that include equity features, such as warrants. Typically, a PE firm buys a majority stake in the business, but minority positions are also common in other structures depending on the business owner’s objectives.
How Does Private Equity Help Businesses?
Private equity is a tool that can help your business overcome challenges, adapt to internal changes, and grow into new markets. Specifically, PE can be used for:
- Growth and expansion opportunities
- New product development
- Funding of an acquisition
- Cash flow management
- Restructuring of the company’s operations or management
- Retirement or desire of diversification for the current owner
In addition to the cash infusion, a private equity firm’s values, experience, and network can help position a business for continued success. Successful private equity firms have a track record of growing businesses within the same industry, niche, and stage of the business’s corporate lifecycle. They also provide access to their personal and professional networks and advisors to help grow the business. Their prior experience and institutional skillset help identify improvements in current processes or systems to result in a more efficient, profitable, and sustainable business going forward.
A Private Equity Partnership Example
One of the earliest examples of private equity investment in the U.S. dates back to Queen Isabella of Spain. When Christopher Columbus was preparing for his voyage, Queen Isabella provided the capital for his journey to America in 1492.
Let’s explore a modern-day example of what a successful partnership between a business and a private equity firm can look like.
Imagine a mid-sized widget manufacturing company in growth mode—let’s call them Company X. The owner was tackling daily challenges related to inventory and supply chain efficiency, production throughput performance issues, and cash flow management problems.
As the sole owner of the business, this CEO faced a difficult task ahead. If they were to miscalculate developing a new product or restructuring their company, they could lose a significant amount of capital, damage their personal wealth, and inhibit future growth.
So, the CEO identified a private equity partner to invest in Company X by purchasing a minority share and providing industry expertise. The business owner and the PE firm worked together to improve metrics and operations as well as execute a critical agenda for the company’s leadership. Over two years, Company X solved its growing pains and grew by over 15%.
Because of this partnership, the business owner was able to capitalize on their growing business, but with reduced risk to their personal capital. And the private equity firm used its industry expertise to help increase the company’s profitability and sustainability.
If you’re a business owner who’s wary of relinquishing control of your company to the hands of a private equity firm, you’re not alone. But with the right private equity partner, you can cultivate a successful partnership like in the example above that creates long-term growth for your business while achieving the goals unique to you. A private equity investment can help you reduce the risk of your equity, create liquidity, and allow you to share in the upside benefits from continued growth and improvements in your business.