What is private equity and how does it work?

As per Venture Intelligence, a research focused on company financial, valuations and transactions, Private Equity-Venture Capital (PE-VC) firms invested $63 billion in Indian companies during 2021, registering 57% growth over the $39.9 billion invested during 2020. Companies like Flipkart, Hexaware Technologies, MphasiS, Encora and Byju’s received the largest private equity investments. Confused, what is private equity and how does it work? Let’s understand the different aspects of private equity. 

What is private equity and how does it work?
What is private equity and how does it work?

What is private equity?

Private equity is an alternative mode of private financing and consists of capital that is not publicly traded on a stock exchange. Private equity involves funds and investors that directly invest in private companies, typically in mature businesses in traditional industries in exchange for equity, or ownership stake. Private equity investment comes primarily from high-net-worth individuals (HNWI) and accredited investors, who can dedicate substantial sums of money for extended time periods.

Private equity highlights

  • Private equity (PE) is a form of financing, away from public markets, where an investor directly invests capital in a company or engages in buyouts of such companies.
  • Valuations of private equity are not set by market forces.
  • Private equity firms charge management and performance fees from investors.
  • Entrepreneurs and company founders can access private equity investments as an alternate form of capital. 
  • Leveraged buyouts and venture capital (VC) investments are two key forms of PE. 
  • Unlike venture capital firms who only invest in startups, PEs invest in mature companies as well that seek funds to enhance their performance. 

Advantages of PE investment

Private equity offers many advantages to mature companies as well as startups:

  • Private equity allows companies to access liquidity as an alternative to conventional funding mechanisms, including high-interest bank loans.
  • Private equity, such as venture capital, provide conceptual and startup funding.
  • PE financing helps delisted companies deploy unusual growth strategies outside the knowledge of markets. Because these companies don’t face pressure of publishing their quarterly earnings.

What is a private equity firm?

A private equity firm is a type of investment firm that invests in businesses with a goal of improving their value over time and selling them at profit. Just like venture capital (VC) firms, PE firms raise pools of capital from limited partners and invest in promising private companies.

However, unlike VC firms, private equity firms usually acquire a majority stake – 50% ownership or more – of companies they invest in. PE firms take majority ownership of several companies at once.    

How does private equity work?

Private equity firms pool money from institutional investors and accredited investors to form the fund. Then they invest that capital into a promising company or group of companies. They also invest in stressed assets, in leveraged buyouts of companies with the intention of improving its business. Listed below are the most popular types of private equity funding.

  • Leverage buyouts: This is the most popular form of private equity funding. A private equity firm completely buys out a company with the intention of increasing its value over time before eventually selling the company for a profit or conducting an IPO. The private equity firm creates a special purpose vehicle (SPV) for funding the takeover. Typically, they use a combination of debt and equity to finance the transaction. The debt financing can account for 90% of the overall funds.
  • Distressed funding: In distressed funding, PE firms invest money in troubled companies with underperforming business units or assets, with the objective of improving business by making necessary changes to their operations or management, or selling their assets for a profit. The assets can be physical machinery, real estate, intellectual property, etc.
  • Fund of funds: With this investment strategy, investors diversify risk by spreading investments across multiple funds, primarily mutual funds and hedge funds. Funds of funds can be better investment options for smaller investors who want to gain access to a range of different asset classes or for investors who don’t have expertise to make single manager recommendations.

As per current income tax law in India, fund of funds are treated as non-equity funds and taxed accordingly.

  • Real estate private equity: In recent years, there has a spike in this type of funding in India. Commercial real estate and real estate investment trusts (REIT) are typical areas where funds are deployed. Commercial real estate funds require higher minimum capital for investment as compared to other asset classes in private equity.   
  • Venture capital: VC is a common term, a form of private equity in which venture capitalists (also known as angels) invest funds in startups or relatively young companies. Venture capital takes on several forms, depending on the stage at which the fund is deployed.     

Irrespective of the type of funding, private equity investors aim to gain returns from their investment in the company. After the company improves its performance and accumulates fortune, private equity investors can exit with their returns.

PE market in India

India is home to the 3rd largest startup ecosystem in the world. Indian startups raised funds of sizable ticket size from various domestic and global private equity investors. India is known as a fertile land of emerging businesses, attracting capital funds, and massive stimulus programs in Fintech, IT, telecom, banking, healthcare, financial services, e-commerce, etc. 

The Indian private equity market has become a hot investment destination. Investors made 25-30% annual returns in the last 5-6 years by investing in Pre-IPOs. However, it may be risky to invest your hard-earned money without market research and investment guidelines. SBNRI is an online platform exclusively designed to cater investment and transactional needs of NRIs living around the world. The investment experts at SBNRI guide NRIs throughout the investment process. 

To ask any question related to NRI investment in India, you can schedule a call by clicking the button below or download SBNRI App from the Google Play Store or App Store. You can also use the SBNRI app for investment in stock market/ mutual funds, Pre-IPO, Asset Finance, Commercial Real Estate, Indian Startups Funds, NRI account opening, etc. To ask any questions, click on the button below. Also, visit our blog and YouTube channel for more details.

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