Money Essentials: How Does Private Equity Work?

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The e-commerce boom in India has led to a sudden gush in private equity (PE) investments. According to a report by PricewaterhouseCoopers (PwC), PE investments increased from $9,700 million to $11,500 million from 2013 to 2014. We’ll help you break down the core concepts of PE.

So what do start-ups and reputable giants have in common? Well, they both need investment (money) to run and expand their business.  Some of the distinctive ways of raising money are 1) Borrowing from banks 2) The company can also sell shares and raise a substantial amount of money from the stock exchange.

But not all companies are on the lookout for just money. Smart companies look for smart money. These companies also look for expertise to help their business flourish. To put it simply, private equity is an investment provided by high net worth individuals in return for an equity stake in a company. This equity is not publicly traded on the stock market. A private equity investor becomes part of the company that they invest in.

The core objective of a private equity fund is nurturing the business over the long term. It could be – 1) help the business expand exponentially; 2)help a business and stop it from closing down; 3) help the company buy another company/companies; 4) it could also be as simple as turning a potentially good idea into a great product that generates revenue.

So where does the money come from? Well, private equity fund managers typically raise money from banks, pension funds, venture capital companies and savings accounts. They also invest their own money sometimes. This means they have a direct stake in the company’s victory and hence an incentive to work even harder to help the company perform better.

A private equity fund was previously called as a Leverage buy-out (LBO) fund. An example of how private equity works – say a group of investors find that a struggling technology start-up has great potential. These investors pool in their money and raise 5 million dollars (hypothetical). They then acquire an additional leverage of 10 million dollars from a bank. Using this total of 15 million dollars, the investors buy out the company. Using their expertise, the investors streamline the company and try and improve the efficiency of the business. Streamlining could involve sacking under-performing employees, selling of redundant assets, introducing new innovative products/services etc.

Say seven years later, the investors realize that they have successfully overturned a salvageable company into a cherry (a cherry is a top performing company). They decide to sell their equity for a substantially bigger amount – 30 million dollars. After paying back the bank, they pocket the remaining profits.

This is how leverage buy-out works and this is what private equity funds work. Not many people realize that they could be indirectly invested in a private equity fund since one of the private equity investors might also be invested in a pension fund that you may have invested in.

Private equity funds have tremendous potential in developing countries too, where business activities grow at a rapid pace. According to a report by PricewaterhouseCoopers (PwC), PE investments in India could touch $40 billion by 2024.

While there are exceptions, private equity helps to build better business which is good for the employees, pensioners and the economy as a whole.

Somesh Chandran

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