How Does Private Equity Work?

Raising Capital for a Business - Introduction

What is common to both the startups and the corporate giants? They both need investment to run and expand their business. The most practiced ways of raising money include borrowing from banks and selling the company's shares at the stock exchange.

Private Equity (PE) - The Concept

However, not all companies look for simple cash. The smart ones target efficient money as well as the expertise to help their business flourish. Many turn to PE, an investment by high net worth individuals in return for an equity stake in a company. These shares are not publicly traded on the stock market. Such an investor becomes a part of the company he/she puts money in.

The Purpose

The core objective of a PE fund is to nurture an enterprise over the long-term. It could be:

- helping the business expand exponentially;

- preventing a business from closing down;

- assisting the company in buying other companies; and/or

- converting a potential idea into a great revenue generating product/service

Financing Sources

Private equity managers typically garner money from banks, pension funds, venture capital firms, and savings accounts. They also invest their own money sometimes. In effect, they have a direct stake in a company's success. This is an effective incentive for these managers to strive for the company's gains and in turn theirs.

The Procedure

Private equity used to be called LBO (leverage buy-out), a term well explained by the following example. Say, a group of investors comes across a struggling technology startup, but with promising prospects. Convinced, these investors pool their money and raise 5 million dollars. Then they procure an additional 10 million dollars from a bank. With this total of 15 million dollars, the investors buy out the company. Employing their expertise, they streamline it and infuse efficiency in the business productivity. Note that the streamlining process may involve sacking underperforming employees, selling redundant assets, introducing new innovative products & services, and more. Say, seven years later, the investors have successfully overturned a salvageable company into a "cherry" (a top performing company). They decide to sell their stake for 30 million dollars, a significantly grown amount. After repaying the bank, they pocket the remaining profits.

This is the way such equity work. However, many people do not realize that they could be indirectly investing in PE, if a private equity investor owns a stake in the same pension fund they had.

This investment has a bright future in the developing countries, where the business is rapidly booming. According to a report by PricewaterhouseCoopers, PE investments in India could reach 40 billion dollars by 2024.

While there are exceptions, private equity mostly helps build better businesses, which is beneficial for consumers, employees, pensioners, and the economy as a whole. They play an integral role in fueling any startup ecosystem in the world and are certainly here to stay.