How to Invest in Private Equity

Compared to stocks, mutual funds, or ETFs investing in private equity may not be so appealing to many investors. This could be a result of a lack of interest or misinformation about investing in private equities.  For investors who have well mastered the private equity market and know the right way to go about investing in private equity, this type of investment offers lots of benefits such as raising substantial amounts of capital and using all or part of the capital as collateral to borrow higher amounts of capital to either expand an existing company or purchase another profitable company to resell it when the value increases. It’s all about the strategies used to maneuver the market. Private equity is all about raising funds for privately owned businesses or startups for the purpose of business expansion, business development, improving balance sheets, and making multiple expensive acquisitions. The overall goal behind private equity is income generation for expansion and development.

What is Private Equity?

Private equity is a type of investment that has to do with raising capital for companies. Both the capital raised and the private company are not publicly listed on an exchange, however, the funds and firms responsible for equity investments are publicly listed on major stock exchanges for the sake of investors who would rather buy equity shares from these funds than get involved directly in equity investments. A more comprehensive definition of private equity is this “private equity…is a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange.”

Private equity capitals can be broken into five parts, namely;

• Venture Capital

• Development or Growth Capital

• Buyout Capital

• Mezzanine Debt

• Restructuring Capital

How does Private Equity Investment Work?

Only investors that have been qualified by the Securities and Exchange Commission (SEC) can invest in private equity. This type of investment isn’t bound by the same requirements that oversee publicly traded companies. By all implications, the public policy demands that only investors who have been accredited by the SEC as accredited investors and have the required level of sophistication (money) can invest in private equity. The sophistication level for singles is an income of $200,000, and $300,000 for joint couples. Asides meeting the sophistication demand, other benchmarks for becoming an accredited investor by the SEC are either having a net worth of at least $1 million with the exclusion of your home’s equity and/or you must be affiliated to the company you are investing in either as a partner or an officer.

Once an investor has been fully accredited, the next step to take is finding the right equity fund to invest in—usually, investors don’t get their desired equity fund. This is so because there are different levels of participation provided by different funds which include the amount for capital commitment. Long-time investors have better chances of getting into particular successful equity funds compared to new investors. Just like every other investment, as a new or old-time investor, it is best to run a background check on selected funds before committing your money to them. Some long-time funds which may be suffering a financial downturn or having reputation issues are usually in a hurry to accept funds from any investor; committing your money to such funds as a new investor may not be such a good idea. Private equity investment can be divided into three major parts for better understanding.

Buying: It is at this point that a strategy for acquisition is created to determine the right approach for capital generation. Once the capital has been generated, a purchase is being made and the acquisition deal finalized—that is, using the capital to purchase a target entity.

Changing: This step is important for investors who are less interested in owning a company for a very long time. Once an acquisition deal has been finalized, and the new management (the investors) has taken over the company undergoes major changes and restructuring to enhance its performance and profitability. The change may involve renaming and rebranding. In most cases, a new management team is introduced and certain costs are cut.

Selling: Once all the necessary changes and innovations have been made, and the company currently performs at a profitable rate, it is then put back on the market to be resold at a higher value. Once the sale has been made, the private equity investors share the profits.

What Investment Purposes Does Private Equity Serve?

Private equity serves a number of purposes for investors, and the overall purpose to bring about positive change in a company. Investing in private equity can be considered necessary in the following ways;

• To grow and expand a new business: Most startups fall under this category as business ideas and business plans may fully be on the ground but the required capital to kick off or take the business to the next level may be short. Growth capital investment gives room for growth.

• To restructure, innovate, or fund a project: From time to time, most businesses have particular projects and targets to execute within a given time such as restructuring or making certain innovations in the business operations that would help the business make more profits or generate more income.

• To Fund an Acquisition: More experienced private equity investors often use the capital gotten from private equity investments to purchase other profitable companies, or assets and resell them when their value appreciates. 

• To Delist a Public Company: Delisting a public company means taking a public company private. A public company can be reconverted into a private company for various reasons such as detachment from public entities and regulations that bind public companies. By going private, a company can focus on long-term growth without the influence of public forces.

Ways to Buy Private Equity

Due to the uncertainties attached to private equity investments, some investors would rather invest through certified brokers or brokerages by buying shares of the firms that manage the funds and are publicly listed on major exchanges. Examples of such companies are the Blackstone Group and KKR. The implication of investing through these firms is that there are management fees attached to it. The management fees differ by the various firms.

Private equity investments are not designed for everybody as the minimum investment amount required by most private equity firms is $25 million. Though some firms go as low as $250,000 which is still on the high side for the average investor. As an average investor still interested in investing in private equity you can do so by investing in private equity exchange-traded funds. Private equity ETFs tacks the performance index of publicly traded companies that invest in private equities. Through the private equity ETF investors can buy individual shares on the stock exchange with no worries about the requirements if minimum investments. Average investors can also buy shares of private equity is through the funds of funds. The fund of funds is made up of the shares of private firms that invest in private equities. Through a fund of funds, these private firms are able to improve cost-effectiveness a lower the expected minimum investment. 

Another way investors can invest in private equity besides direct investment, private equity ETFs, and funds of funds is by purchasing the shares of public companies that invest in or manage private equity funds. By buying the shares of such companies, investors are able to partake in some benefits attached to private equity investments. Investing through public companies would not only help you diversify your portfolios but also hedge risks through the equity manager. The issue with investing through a private equity ETF or a fund of funds is the area of high management fees compared to directly investing in equity. Some firms have charges attached to each purchase or sale of shares.

Just like every other investment, private equity investments have some difficulties associated with it such as the availability of buyers and sellers and liquidity issues. In cases where buyers and sellers are available the prices are flexible and negotiable according to how much the buyers and sellers are willing to purchase or sell the equity shares.

Things to Put in Place Before Investing in A Private Equity

It has been established that only SEC accredited investors—institutional investors and wealthy investors can invest in private equity. If you are an investor that meets up to the requirement, there are basic things to put in place before making a private equity investment. There are different approaches to take in evaluating a private equity investment. This is as a result of the different PE firms that differ according to the specifications of the target company or transaction process involved. The total evaluation process can take months or even last up to a year before conclusions are made. With the results gotten from the evaluation, the firm creates and develops financial models that would serve as an investment guide, and evaluate other possibilities that are likely to occur in the course of the investment before final approval and execution.

“The discovery and assessment of the opportunity at the beginning of the process is called “sourcing”—in this phase, the firm locates potential targets and looks at the viability of the investments and the potential returns available.”  

When it comes to sourcing for investment opportunities a lot of efforts must be put into it as it is an important aspect of investing in PE. There are various channels through which a deal can be sourced such as detailed research, cold-calling company executives, industry conferences, conversations with industry experts, and internal analysis networking. All these sourcing channels are referred to as proprietary sourcing. 

Steps to Investing in Private Equity as an Organization

• Non-Disclosure Agreement (NDA) Signing: Intending organizations or investment teams who seek to purchase a company as private equity would be required to sign a non-disclosure agreement by the target company to get confidential and more detailed information about the company from its management. This happens when either the investment team finds a target company through proprietary sourcing or through investment bankers who often put up companies for sale.

• Initial Due Diligence and Management: Once an NDA has been signed and the investment team has received the CIM of the target company, the next step to take is for the investment team to run some initial due diligence to get more findings of the company outside the information already gathered. This usually involves seeking counsel from industry experts and using the data gathered from research and all other used sources to create a financial model to project real-life risks and potentials the company poses. Another useful step in scrutinizing a target company is to get across to investment banks to know the financial implications involved concerning a target company or group of companies. Investment banks also offer representatives of selected organizations that bid the opportunity of sitting with the management team of the target company for a presentation and overview of the company. The investment teams are then given the opportunity to directly interact with and question the management team of the target company. 

• First Phase of the Deal Review:  After the investment team has sat down with the target company’s management team for the initial due diligence presentation, it is expected that the PE investment committee sits together to run a summary of all that has been said so far. Once that is done, the PE investment team will then prepare an investment proposal of not less than 2 pages and not more than 3 pages to the PE investment committee. The deal and proposal are then reviewed by the committee either to update the deal, begin a formal approval process, or other raised important issues. Once the deal has been approved by the committee the investment team can go ahead and prepare/present a First Round Bid and the cost cover (budget) required to execute the deal. The viability of the deal is determined by the decision/action of the investment committee.

• Present a Non-Binding Letter of Intent (LOI): With approval from the PE investment committee the investment team can go ahead with the presentation of a non-binding letter of intent also known as the ‘first round bid’ to the target company. In the LOI, the investment team outlines its proposed purchase price which is usually an amount range rather than an actual amount. It also outlines the key due diligence areas, proposed capital structure, assumptions made, expected timing for the submission of the binding offer, relevant experience and expertise of the PE firm, and necessary authorizations and approvals by the PE investment committee. At the end of the target company, its management sits together to review and scrutinize all the bid offers received from bidding PE investment firms. The bid proposals are scrutinized based on the offer credibility, proposed purchase price, firm’s expertise, and experience. 

• Proceed Due Diligence with Management: At this stage, the PE firms and target company's management may begin working together. In the sense that further precise confidential information would be provided by the target company. This process is called virtual dataroom, and it is only opened to PE bidders who qualify for the first round. The kind of confidential data presented at this stage include board meeting minutes and reports, intellectual property documentation, leased property documentation/agreement, legal entities, employee records, selected financial information (including audit files), and operation records.

• Internal Operating Model: Compared to the first model built on assumptions and part information, the PE investment team can now build a proper internal operating model with the precise and detailed information gotten from the target company—this time around based on reasonable assumptions. The assumptions made at this point is made up of factors such as the number of branches, approximate customers, costs of raw materials, price volume, renewal rates, etc.

• Preliminary Investment Memorandum (PIM): A preliminary investment model is usually made up of the executive summary, company overview, market and industry overview, financial overview, risks and key areas of due diligence, valuation overview, exit, recommendations and proposed project plan. The purpose of the PIM is to summarize the investment opportunity to the PE investment committee.

• Final Due Diligence: Once the PE firm’s investment committee approves of the PIM, the deal team alongside its consultants will proceed with necessary steps to the final due diligence. A proper Financial Binding Bid is then created for the target company. At this stage, the PE firm’s deal team can begin daily interaction with the target company and its investment bankers to get updated on recent developments and happenings in the company as disclosed by the target company.

• Update and Final Approval by Investment Committee: It is expected that the PE firm’s deal team returns to the investment committee to give feedback, an overview, and update on the progress of the deal so far. Depending on the findings made and potentials of the target company, the investment committee will be able to approve the deal appropriately or not approve it at all. The investment team would then be required to proceed with the Final Investment Memorandum (FIM).

• Final Binding Bid and Signing: Once all the requirements have been made and all due processes followed, the investment team goes ahead to create the Final Round Bid which contains the PE firm’s actual purchase costs and other specifications. The final bid would be submitted to the company for review with its investment bankers. After the most preferred bidder has been selected by the target company further negotiations will be made between the seller’s lawyers and the buyer’s lawyers which will advance the deal into a Merger Agreement.