MEANING
Private equity funds refer to institutional funds that target investments in privately owned businesses only. Nature, size as well as the structure of the investment can differ significantly when it comes to different transactions but generally, private equity funds always seek to provide capital growth or support buyouts unlisted entities to secure strong returns on behalf of their investors over a pre-determined time or lifetime.
While a venture capital entity is focused on only the start-up enterprises, private equity on the other hand supports established businesses by providing growth and expansion to it as well as backing up the management teams to buyout founders either in whole or in parts. Cases, where these buyouts are partially funded through debts, are referred to as leveraged buyouts. The operating model of a private equity entity varies between funds, while some PE funds target underperforming businesses and turnaround opportunities. At the same time, the level of operational involvement also varies significantly between private equity funds, and finding the right partner to fit in the objectives of any particular business and management team becomes the key.
TYPES OF PRIVATE EQUITY & THEIR FUNCTIONING
Private equity funds in themselves are completely backed up by a range of sources (Limited Partners or LPs) which include institutions such as pension funds, high net worth individuals, insurance companies, banks, and other government bodies. Private equity firms raise money from many institutional investors as well as accredited investors for the funds that are then invested in different types of assets. The most popular and common types of private equity funding are mentioned below:-
Venture Capital Funding: It is a form of private equity transaction, in which the investors ( who are also known as angel investors) tend to provide the capital to entrepreneurs. Depending on the stage or level at which it is provided, venture capital can take several forms and structures. Seed financing refers to the capital invested by an investor to scale and convert an idea from a simple prototype to a final product or service. On the other hand, early-stage venture financing can help an entrepreneur to grow a company further while Series A financing enables them to actively compete in a market or create one.
Fund of funds: This type of funding mainly focuses on investing in other funds. Which are primarily mutual funds as well as hedge funds. They offer a backdoor entry to a PE investor who cannot afford to have a minimum capital requirement in such funds. Critics of such funds point to their higher management fees and the fact that unrestricted diversification may not always result in an optimal strategy to have multiply returns.
Distressed funding: It is also known as vulture financing. In this type of funding, funds are invested in troubled companies with a problem of underperforming business units as well as assets. This funding intends to turn them around by making necessary changes to their overall management/operations or to make a sale of their assets for a profit.
Leveraged Buyouts: This is one of the most popular forms of private equity funding. It involves buying out a company completely in order to improve the financial health of the business and resell it for a probable profit to an interested party or conducting an IPO. Generally, firms use combinations of debts and equity in order to finance the transaction. Debt financing may sometimes account for as much as 90% of the overall funds and might also get transferred to the acquired company’s balance sheet for having tax benefits. PE firms employ a range of different strategies, from slashing employee count to replacing the entire management teams, to turn around a company.
DOCUMENTS INVOLVED
A typical transaction of Private Equity generally includes documents like:-
- Share Purchase Agreement – It refers to an agreement through which the buyer acquires the target company and pays the consideration in cash/ share;
- Shareholders’ Agreement – It is an arrangement among a company’s shareholders that describes the company’s operations and also at the same time outlines the rights of the shareholders along with their obligations. The shareholders’ agreement intends to make sure that shareholders are treated fairly and their rights are well protected. It also governs the management of the group and the relationship between the shareholders until an exit;
- Service contracts – Contracts between management and the group which sets out the terms of their employment post-completion along with any restrictive covenants thereby;
- Debt documents –Security documents, any inter-creditor agreements or facility agreement, etc.;
- Warranty as well as indemnity insurance policies – Insurance covers for liabilities arising from the warranty as well as indemnity claims is widely available and commonly witnessed everywhere, and is becoming increasingly common in Private Equity transactions.
EXIT BY A PRIVATE EQUITY PROVIDER
An exit strategy is an investor’s strategic plan of action to sell his ownership or stake in a company to other investors or another company. An exit strategy gives an investor a way to reduce or liquidate his stake in the venture and, if the business is successful, also make a substantial profit out of it. If the business is not successful, an exit plan enables the investor to limit losses.
When any investor undertakes an investment into any startup or a company in India, he is also analyzing the exit options which are open to him under the Indian laws. It is considered to be a very vital part of making investments, not only for private equity investors but also for strategic business investors. It is very important for an investor to allow himself to be able to divest his holdings and take an exit in the most profitable and expeditious manner possible.
Few of the common exit options that are available to offshore private equity and strategic investors:
- IPO in India– In this form of exit, when the Indian market looks promising and the investor wants a comfortable exit on the stock markets, the investor can exit after an IPO on the Indian stock markets.
- Private Sale– The investor can also take an exit by the way of a sale of its holding in the company to another party who might want to buy that stake for any strategic reason. If the transferee of the stake is an Indian resident, then in that case the pricing requirements of FI Regulations will apply.
- Put Option– It entitles a shareholder who is selling his shares to require the other shareholders to purchase the shares.
- Tag-Along Clause– It typically gives a minority shareholder the right to have its shares bought on the same terms, including price, as the selling shareholder.
- Drag Along with Clause- It gives the selling shareholder the right to compel all the other shareholders to sell to a third party on the same terms as the selling shareholder.
KEY TAKEAWAYS
- Private equity can be referred to as an alternative form of private financing, completely away from public markets, in which both funds and investors are directly investing in companies or engaging in buyouts of such companies.
- Private equity firms make most of their revenue money return by charging various management and performance fees from the investors in a fund and can also make an exit whenever it may find more profitable.
- Among the other advantages of private equity, it is easy to access alternate forms of capital for entrepreneurs and founders of different startups and businesses and creates less stress on quarterly performance.
- The private equity valuations are not set or determined by the market forces.
- Private equity can take on various forms and structures ranging from complex leveraged buyouts to venture capital.
REFERENCES
- https://www2.deloitte.com/content/dam/Deloitte/ie/Documents/Finance/Corporate%20Finance/IE_CF_PrivateEquity_0217_draft2.pdf
- https://na.eventscloud.com/file_uploads/7ac5e54cee7e8662bdc7dd1c1ef47ddb_RoryOrd.pdf
- https://www.in.kpmg.com/pdf/PE_Investing.pdf
- https://www.investopedia.com/terms/p/privateequity.asp
- https://www.law.du.edu/documents/registrar/adv-assign/Yoost_PrivateEquity%20Seminar_PEI%20Media’s%20Private%20Equity%20-%20A%20Brief%20Overview_318.pdf
