What is Private Equity and How Does it Work?

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What is Private Equity and How Does it Work?

In short, private equity is a form of investment where a business owner or a group of investors puts their money to work in a struggling company. These investors use distressed funding to help struggling companies restructure their business models and create a repayment plan. In turn, these investors help those businesses turn around by buying their assets and turning them into profit. Leveraged buyouts are the most common form of private equity investment. Advent specialist will handle these transactions.

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Investing in private companies

Before the 1970s, institutional investors had a hard time making investments in private companies, so the rise of venture capital was a welcome change. But the booming tech industry soon led to an influx of money from investors who wanted to invest in private companies, rather than simply providing debt or other forms of financing. The PE industry had its ups and downs during the tech boom and bust, but it was only in the early 2000s that the industry underwent a new renaissance. After the fall of the financial system, low interest rates and lowered lending standards made private companies look attractive to investors again.

Historically, the US was a better location for private equity, as there were few restrictions on hostile takeovers. However, the practice has spread to Europe and Asia, and buyouts are now commonplace in both regions. In addition, four-fifths of the private equity market flows into buyouts, far outstripping other forms of private equity. Buyouts are now capable of absorbing billions of dollars, and this increase in allocations has helped buyout funds.

Structure of a private equity fund

The structure of a private equity fund is quite straightforward, and Fund Managers in Africa are generally familiar with the general elements. There are four main constituent documents – Private Placement Memorandum, Shareholders’ Agreement, Management and Administration Agreement, and Side Letters. Fund managers are often blind to the target companies they invest in, which means that the information about their investments are not disclosed publicly. Fund managers may also work with a third-party administrator to help them manage their funds.

Most private equity funds are organized as limited partnerships, with general partners and limited partners. The general partner has management control over the fund, while the limited partners have only liability for the amount of capital they contribute. Limited partners are wealthy individuals who make investments in portfolio companies in return for a performance fee. The limited partners, in turn, have limited liability and no say in the investment decisions made by the general partner. However, LPs earn performance fees and are often referred to as the “smart money” of the fund.

Leverage

The cost of debt is a major consideration in private equity transactions. Leveraged recapitalisations are often called the ‘cocaine of private equity’. Standard and Poor’s reported in 2006 that the quality of most leveraged finance loans was very poor; a staggering 75% of all lending was rated in the “junk” category. Default rates for firms that opted for leveraged recaps were as high as 6%.

However, while governments are often called on to step in when PE-LBOs are too risky, they don’t necessarily require governmental intervention. In fact, a study commissioned by the Dutch Ministry of Economic Affairs examined three PE-LBO cases to identify the risks and rewards associated with such ventures. In such cases, it was found that shareholders, boards, and management could not refuse a PE-LBO, since the funds are not subject to the same constraints as a traditional public company. Further, because PE-LBO firms do not follow corporate governance, these companies are left to the forces of the financial market.

Investment process

The investment process of private equity (PE) firms involves a variety of activities, but some aspects are common to all. The first step in the process involves completing due diligence, which involves researching the industry, talking with advisors, and building a preliminary financial model. Following this, investment teams would talk to the target company’s management and investment bankers to understand the business better. Then, the team would begin the actual process of working with the target company.

The next step in the process involves assessing the potential of a new private equity party. New investors often have greater risk than established parties because they must perform well and build a track record. Furthermore, they must be careful not to invest in private equity funds that are too risky, as these may lack a history of success. In addition, new investors face a high level of business risk, which means they may have less experience than older parties.