Private equity is an umbrella term, that is not clearly defined…
Private equity makes investments in small companies without sales to huge companies like Dell…
… and it can be very hard to understand for outsiders.
In this article we will explain the industry step-by-step in an easy to understand language. Before finishing this article, you will be familiar with and able to distinguish between terms such as seed, venture and growth capital.
In the figure below, the entire industry is outlined and below it, we will dive into each area.
Seed capital is defined as “the initial capital used when starting a business”.
It typically comes from the founders of the business as well as friends and families.
Closely associated to seed capital is the concept of angel investors. These are professional investors that work with entrepreneurs in the very early stages of the company.
Angel investors will typically buy an equity share in exchange for providing capital (funding) to the owners of the business.
Angel investments have come to prominence in the US through the TV show shark tank and most of the investments made in the program can be characterized as seed capital.
In terms of start-up, seed capital is often referred to as “Series-A” capital (i.e. the first capital).
Use of seed capital
Seed capital is typically used for prototype production and research as well as the first market studies for the product.
As an example, consider an IT firm working on new and revolutionary software. The company will need extensive testing and needs testers of its software. While the potential in the software is likely huge, there can be several issues. No one can be sure the market will like it, and thus testers are needed. This is expensive and this is where seed capital from angel investors comes into the picture.
When Microsoft was founded in 1975, an investment into the company would represent a seed investment with a huge payoff.
Luckily for Microsoft, the company was founded by the founder’s own money and they thus received a huge payoff (i.e. Bill Gates being the world’s richest man for some time)
However, most seed investment ultimately fails and thus, high returns are needed for seed investors to compensate for all the misses.
Venture capital does not have a “Websters-dictionary-like” definition as seed capital does.
However, it is usually defined as “capital used to grow a proven concept”.
Venture capital is typically provided by venture capital firms. These firms are specialized in identifying companies with strong management and a strong concept, which can grow and deliver attractive returns.
Venture capitalists will like seed investors typically buy an equity share in exchange for providing capital (funding) to the owners of the business.
Like angel investments, venture capital has also come prominence in the US through shark tank. Although we will clearly categorize most investments on the show as seed, there have also been several venture capital investments.
Use of venture capital
Companies receiving venture capital will have proven its concept and need additional capital to grow and scale their business aggressively before someone else does.
In the age of smartphones, there have been many high profile examples of companies that have grown incredibly quickly with the use of venture capital. These include but are not limited to concepts such as Uber and AirBnB and before that, Facebook.
A common theme amongst these companies have been economies of scale. The larger the user base of the company, the easier it is to make money.
This can be illustrated by Facebook acquiring a new user. It costs basically nothing for Facebook to get this new user, however, there is a huge revenue potential in this user. The same applies for Uber and AirBnB.
Growth capital is at the junction between venture capital and buyout capital. The widely used definition of growth capital is: “capital used to fund a transitional event”.
What is a transitional event?
The answer is very simple – it can be a lot of things! However, usually growth capital is used to expand operations into new markets or to finance significant acquisitions.
As such, the difference between venture capital and growth capital can sometimes be hard to spot. However, growth capital firms will be later in their life cycle and will usually look to do double or triple revenue in a number of years.
In contrast, companies attracting venture capital will usually experience exponential growth.
Another contrast is, that growth investors will seek to take a significantly larger equity stake with the norm being 25-30% of equity being acquired.
Use of growth capital
Companies receiving growth capital are beginning to look like companies you picture in your head when someone mentions the word “corporation”.
However, they are probably not as big, and does not have a small army of corporate functions in HR, payroll, and so forth.
What they are instead are small middle market companies, with products, revenue and usually, profitability.
The funny thing is, that these companies are also the same companies we just covered. Facebook, Uber and AirBnB have all received what we would categorize as growth capital.
Growth capital to these companies were provided when the companies actually needed to start making money. Venture capitalists are very good in helping companies grow and less profilic in helping companies become profitable.
Becoming profitable and making more money per user were thus the transitional events in these companies that attracted growth capital. These variables are exactly what growth private equity firms often specialize in.
Private equity buyouts
Remember the 1987 movie “Wall Street”? The one with Gordon Gekko. That’s private equity buyouts for you.
The 1980’s are long gone.
Today Private equity buyout firms can be defined as: “Acquiring the majority position in a mature company”.
These are the real corporations you see every day. They are what you think of when you think of a company and they come in all sizes. It ranges from small companies in rural communities with 100 employees to mega companies like Dell and to revisit the 1980’s, the famous buyout of RJR Nabisco.
A lot has happened since Gordon Gekko and the 1980’s. He was depicted as the stereotypical evil capitalist and a corporate raider, who acquired a company in a hostile takeover, battling management.
Today, Private Equity firms usually look to partner with management and are much more concerned about their reputation in the industry. While there is still huge amount of money in the game, it is much more controlled and orderly fashion.
One of the distinguishing features in buyouts is the use of debt. Usually, seed, venture and growth capital will be provided as equity only and they make minority position.
Buyouts, as the name implies, buys out the current owners and take a majority stake in a company. During ownership, the private equity buyout fund will look to make operational and strategic improvements, before selling the company again after 3-7 years.
Role of private equity buyout firms
Private equity buyout firms are integral in the economy to small and middle market businesses. A relatively large proportion of companies with an enterprise value in the range of $50-2,000m are owned by private equity firms.
There are really no companies that could not be a potential for buyout firms, so we will name a few just to give an example within different sectors with the private equity fund in parenthesis: Build a bear (Catterton Partners), Pandora (Axcel) and PetSmart (BC Partners).
So how large is the private equity buyout industry? Funny, you should ask. According to Forbes, 2014 saw $3.5 trillion of deals globally involving buyout firms.
The 2015 film, The Big Short revolves around different kind of hedge fund managers. In the movie, three different hedge fund managers take a position in a listed instrument. In this instance, it was in the derivatives market, but it could also be stocks and bonds.
In fact, the underlying instruments on which they were taking a position against in the movie were sub-prime debt.
The movie highlights very well what hedge fund managers does: They analyse the market in an effort to try and find securities, that are not priced correctly. As hedge fund managers take both short and long positions, both prices that are too high and too low are of relevance to the manager.
Hedge funds can invest in any security, as long it is listed and there is a public market for it. These can be giants like Apple or Microsoft, or small “mom-and-pop” stocks, that few has ever heard about.
In this regard hedge funds are vastly different from seed, venture, growth and buyout investors. The latter four invests in the non-public market and partner with firm management.
Hedge funds, on the other hand, take passive positions and “waits” for the market to change its pricing. It should be noted, that some hedge fund managers try to change the company in some way (as an activist investor), however, this is not the norm.
If the price of the stock move in the expected direction, the hedge fund makes money. If not, it loses money.
Role of hedge funds
Hedge funds brand themselves as “absolute return” investors.
For the rest of us, this means that hedge funds should make money both in a rising and falling market. As hedge funds takes both long and short positions, this should be possible.
However, during the Financial Crisis, many hedge funds did not perform as advertised and as such, whether hedge funds deliver value to investors is significantly more debatable, than for the other four categories covered.