Private Equity & Venture Capital

Private equity is one of the alternative asset classes offering diversification from bonds and stocks. It has traditionally been centred on leveraged buyouts – where the buyer funds the purchase price through borrowing, using the target company’s assets as collateral. However tougher economic conditions and tighter regulatory frameworks have restrained leveraged financial engineering and investors have consequently had to settle for lower returns in many situations.

Venture capital investing, which is non-leveraged private equity investment in a business usually at a seed, early or formative stage (though can also be at a later stage), has seen a high level of growth over the past 15 years or so. Where the investments are made at an early stage in the company’s life cycle, the business models are often unproven and venture capitalists are consequently seeking substantial growth projections.

Private equity is a popular and potentially lucrative alternative asset that is ripe for investment at the moment. The sector has seen significant levels of growth since the 1970s as private equity firms have pooled their funds and resources to open up their options.

Essentially, this alternative asset involves investors and funds making direct investments into private companies, or conducting buyouts of public companies that mean the public equity is delisted. It involves capital raised through retail and institutional investors and is often a particularly popular option for the funding of new technologies. However, the asset class is also used to fund acquisitions, expand working capital or strengthen a balance sheet.

Private Equity Strategies

The crucial thing that sets private equity investment apart as an alternative asset is its single focus on investing in companies that are not publicly traded on a stock exchange. This means that most people will need to go through a private equity firm, a venture capital firm or an angel investor if they want to access the potential profits in this area.

As mentioned, leveraged buyouts are a particularly common strategy employed by private equity firms in this arena. Here’s an example of a simple leveraged buyout in practice:

Simple Capital borrows a total of £5 billion from a bank (or another lender). The company’s own partners and limited partners (this could include rich individuals with a vested interest, pension funds etc) also lend the business £2 billion of equity. Taking this total of £7 billion, Simple Capital acquires all the shares of Classic Industries.

Senior management are quickly replaced, the business is streamlined, assets are sold off and staff are let go where needed. At this point, Simple Capital can look to achieving its objective: an early sale of the business.

If the stock markets are healthy, a quick sale of Classic Industries should result in a decent profit. Let’s estimate that profit at £2 billion. This enables Simple Capital to pay off their original loan and the interest incurred on it.

The remaining profit can then be shared among the partners.

Leveraged buyouts aren’t the only example of private equity strategies in action. Growth capital, mezzanine capital, venture capital and distressed acquisitions all offer excellent approaches to alternative investment and are well worth exploring.