Private equity

What exactly does private equity mean?

The term private equity refers to private equity capital. The term is made up of the English words private and equity. Private equity is the counterpart to public equity. This means that investments are made in companies that are not yet listed on the stock exchange. In most cases, investments or participations in unlisted companies are made via private equity companies that specialize in this form of investment. Investments are usually made via a fund. The investment period usually extends over 3 to 10 years.

How do private equity funds work?

Private equity companies invest the money collected from their investors in private equity funds. They then use these funds to buy shares in various companies in order to spread the investment risk. However, these companies are usually financed not only by the private capital of the investors, but also by external lenders such as banks or insurance companies. The aim of these investments is to make companies more successful and profitable in order to ultimately aim for an exit and achieve high returns. In addition to capital, private equity companies therefore also contribute a great deal of expertise and networks to the target companies in which they invest. In this way, they help the companies to grow profitably and ultimately benefit themselves. The knowledge that private equity companies bring to companies ranges from management know-how and sales expertise to extensive networks. In return for their capital and support, however, they demand regular reporting to check whether the target company has reached agreed milestones. The achievement of a milestone usually lays the foundation for further financing rounds.

Which companies do private equity companies invest in?

The investments of private equity companies can take various forms, usually depending on the phase the target company is currently in. There are various forms of private equity, e.g: Venture capital, growth capital, management buy-out financing, turnaround financing or leveraged buy-out financing.

Venture capital

Venture capital financing, also known as venture capital, involves investments in very young companies that are associated with a high level of risk.

This form of investment is particularly interesting for start-ups, as venture capital companies also invest in companies that are not yet profitable and where the risk of making a loss on the investment is particularly high. However, such investments are still attractive for venture capital companies because, in addition to a high risk of loss, there is also great potential to achieve very high profits and returns if the start-up is very successful.

The prerequisite for a venture capital investment is usually a proof of concept, i.e. initial success or the feasibility of the business idea. The scalability of the target company also plays a major role. If a company or start-up has a business idea that can be easily transferred to other markets (can be easily scaled), it is much more interesting for investors. This is particularly the case with business models in the IT sector, as these can be easily transferred to other countries without having to relocate entire factories, for example.

Characteristics of venture capital investments:

• Mostly in very young companies (start-ups)
• Investment is associated with high risk
• High profits possible
• Venture capital companies provide management expertise
• Target company must already have a proof of concept
• The target company's business model should be easily scalable

This form of investment is particularly popular with founders, as they usually lack the private assets to finance their business idea and it is also very difficult to obtain outside capital, for example from banks, in the early stages of founding a company.

Growth capital

Growth capital is private equity capital that is invested during the growth phase of a company. Here, private equity companies invest in existing, larger companies that are in the process of adding new divisions to their existing business model or expanding internationally. Growth capital can be very helpful here, as in addition to the financial resources, the knowledge of private equity companies can also help companies to grow.

Turn Around

Turn-around financing is when private equity companies invest in companies that are currently in a restructuring phase. The capital provided by private equity companies is intended to help finance this restructuring and give the company long-term financial stability. Here too, the aim of private equity companies is to achieve the objectives and increase the profitability of the target company in order to aim for an exit after a few years and thus generate profits from the investment.

Buy-out financing

If a private equity company acquires a majority stake in unlisted companies with the aim of selling them at a profit after some time, this is referred to as buy-out financing. There is leveraged buy-out and management buy-out financing.

Management buy-out

In a management buy-out, established companies or parts of these companies are taken over by the existing management. As the individual managers often do not have the necessary private assets, they turn to private equity companies that provide capital for the management buy-out. Both the management and the private equity investors then have a stake in the target company.

Leveraged buy-out

A leveraged buy-out is the purchase of established companies with stable cash flows by private equity companies. The special feature here, however, is that the private equity companies themselves raise outside capital during the purchase.

The reason for this is the so-called "leverage effect". Private equity companies buy target companies using borrowed capital and thus achieve a higher return. If the interest that the private equity companies have to pay on the borrowed capital is lower than the total return on capital, the companies make a profit and this is known as the leverage effect.

A simple example illustrates this:

Suppose a private investor is interested in acquiring a brewery with an annual gross profit of €400,000. The brewery's net profit after deduction of taxes is €300,000 (exemplary tax rate of 25%). The investor now buys the brewery for a purchase price of € 4 million and thus achieves a return on equity of 7.5%. This is calculated by dividing the net profit by the equity invested. In this example, € 300,000/ € 4 million = 7.5 %.

If the investor now uses debt capital instead of equity capital for the purchase, he can increase the return on equity. For example, he uses only € 500,000 equity for the purchase of the brewery and obtains the remaining € 3.5 million from borrowed capital. After deducting taxes from the gross profit (€100,000 at a tax rate of 25%) and deducting interest on the borrowed capital (here: €175,000 at an interest rate of 5%), this results in a net profit of €168,750. If this is now divided by the equity of €500,000 invested, the return on equity is 33.75%. The investor was therefore able to increase his return on equity by using borrowed capital.

Although he has no higher profit for this one investment, he can divide his available equity between several companies and thus achieve a higher profit overall due to the leverage effect and the increased return on equity.

Example: Brewery

Alternative 1:

Purchase price: € 4 million

Annual gross profit: € 400,000

Annual net profit: € 300,000

Return on equity for purchase through equity: € 300,000 / € 4 million = 7.5%

Alternative 2:

Purchase price: € 4 million

Original annual gross profit: € 400,000

Equity used for the purchase: € 500,000

Debt capital used for the purchase: € 3.5 million

Interest on borrowed capital (interest rate 5%): € 175,000

Gross profit: 400,000 -175,000= 225,000

Net profit: 225,000 -56,250 (taxes)= € 168,750

Return on equity for purchase with borrowed capital: €168,500 / €500,000 = 33.75%

Investment strategies of private equity companies

The investment strategies of private equity companies naturally differ depending on the phase of the company (see: Venture Capital). However, it can generally be said that companies with high and stable cash flows and market entry barriers for potential competitors are particularly popular targets for private equity companies.

What does a private equity company earn?

A private equity company earns its money through profit participation in the acquired company as well as through a management fee on the purchase price. The management fee is calculated regardless of whether the private equity company's investment is positive and helps the target company to make a profit and grow or not. This has been criticized in some quarters.

Private equity criticized

In Germany, private equity companies have been criticized on several occasions and were referred to by the then SPD chairman Frank Müntefering in 2005 with the metaphor "locust". The term comes from the fact that, like swarms of locusts, they simply want to grab the profits from companies and then quickly move on to the next company. Private equity companies have been accused of being primarily concerned with increasing the value of the company and making their own profits, not with the companies themselves or their employees.

However, it should also be taken into account that investments for private equity companies often represent a high risk and that they provide the target companies with the necessary capital, which they may not be able to obtain without their help. In addition, private equity companies can also help companies to develop positively due to the knowledge they contribute and, for example, help companies in crisis to emerge from the crisis. Therefore, both perspectives should always be taken into account before forming an opinion.