Private equity is an asset class that involves the use of equity securities and debt to purchase shares of private companies or those of public companies that will eventually be delisted from the public stock exchanges. In 2014, the aggregate capital raised by private equity and venture capital funds was $495 Bn. With 79% of LPs looking to either maintain or increase their allocations to private equity in the next 12 months, it is clear that appetite for this asset class remains strong. Here are 7 private equity strategies investors should know.
7 Private Equity Strategies All Investors Should Know
1. Venture Capital
Venture capital refers to investments made in startups and young companies with little to no track record of profitability. Venture capital investments are made with the goal of generating outsized returns by identifying and investing in the most promising companies and profiting from a successful exit. Venture capital is a growing asset class. According to the National Venture Capital Association (NVCA), new commitments to venture capital funds in the U.S. increased from $17.7 Bn in 2013 to $30 Bn in 2014.
2. Real Estate
Private equity real estate involves pooling together investor capital to invest in ownership of various real estate properties. Four common strategies used by private equity real estate funds are:
- Core: Investments are made in low-risk / low-return strategies with predictable cash flows.
- Core Plus: Moderate-risk / moderate-return investments in core properties that require some form of value added element.
- Value Added: A medium-to-high-risk / medium-to-high-return strategy which involves the purchasing of property to improve and sell at a gain. Value added strategies typically apply to properties that have operational or management issues, require physical improvements, or suffer from capital constraints.
- Opportunistic: A high-risk / high-return strategy, opportunistic investments in properties require massive amounts of enhancements. Examples include investments in development, raw land, and mortgage notes.
3. Growth Capital
Growth capital investments are made in mature companies with proven business models that are looking for capital to expand or restructure their operations, enter new markets, or finance a major acquisition. Typically, these are minority investments, and companies that take on growth capital are more mature than venture-funded companies. Such companies generate revenue and profits that may not be enough to fund big expansions, acquisitions or other investments. While growth equity may sound similar to venture capital and control buyouts, there are some key differences.
4. Mezzanine Financing
While some companies might take on growth capital to finance their expansions, mezzanine financing is an alternate way. Mezzanine financing consists of both debt and equity financing used to finance a company’s expansion. With mezzanine financing, companies take on debt capital that gives the lender the right to convert to an ownership or equity interest in the company if the loan isn’t repaid in a timely manner and in full. Companies that take on mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan.
A key reason why a company may prefer mezzanine financing is that it allows it to receive the capital injection needed for business without having to give up a lot of equity ownership (as long as it’s able to pay back its debt on time and in full). Another advantage of taking on mezzanine financing is that it may be easier to receive traditional bank financing since it’s treated like equity on a company’s balance sheet.
On the flip side, there are some disadvantages to companies that take on mezzanine financing. Since mezzanine financing is not collateralized, the lender takes on greater risk. Therefore, mezzanine financing is typically conducted by unconventional lending institutions versus standard lending institutions. As a result, interest rates and terms can be much higher than traditional debt financing.
5. Leveraged Buyouts (LBO)
Leveraged buyouts are conducted when a company borrows a significant amount of capital (from loans and bonds) to acquire another company. Private equity firms make buyout investments when they believe that they can extract value by holding and managing a company for a period of time and exiting the company after significant value has been created.
Leveraged buyouts typically utilize debt to finance the buyout, and the firm performing the LBO has to provide a small amount of the financing (typically around 90% of the cost is financed through debt).
The goal of a leveraged buyout is to generate returns on the acquisition that will outweigh the interest paid on the debt. For the firm that’s performing the LBO, this is a way to generate high returns while only risking a small amount of capital. Oftentimes a financial sponsor is involved and the assets of the company being acquired are used as collateral for the debt. Private equity firms will then either (1) sell off parts of the acquired company or (2) use the acquired company’s future cash flows to pay off the debt and then exit at a profit.
6. Special Situations aka Distressed PE
Special situations funds specifically target companies that need restructuring, turnaround, or are in any other unusual circumstances. Investments typically profit from a change in the company’s valuation as a result of the special situation. Examples of special situations include: a large public company spinning off one of its smaller business units into its own public company, tender offers, mergers and acquisitions, and bankruptcy proceedings. Besides private equity funds, hedge funds also implement this type of investment.
7. Fund of Funds
A “fund of funds” (FoF) is an investment strategy whereby investments are made in other funds rather than directly in securities, stocks, or bonds.
By investing in a fund of funds, investors are granted diversification and the ability to hedge their risk by investing in various fund strategies. Unfortunately, funds of funds may be costly because investors are subject to an additional layer of fees. In addition to the management fees and a performance fee that’s charged at the underlying individual fund level, investors have to incur additional fees at the FoF level.
AUM by Strategy
While private equity and venture capital assets under management reached a new high in June 2014 with $3.8Tn, there has also been an increase in dry powder. Below is a graph highlighting the breakdown in assets under management by strategy. Buyouts, real estate, and venture capital are the top 3 private equity strategies with the highest assets under managements. In addition, there has been a rise recently in fundless sponsors and search funds as a result of an increasing amount of dry powder.
Below is also a graph from Nordic Capital that quickly illustrates some of the differences between the various private equity strategies.
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