What is and how does private equity work? (Beginner's guide)

Here we tell you everything you need to know about private equity, such as what it is and how it works to invest in private equity funds. 

What is private equity? 

Private equity is a form of investment that buys unlisted companies or delists listed companies by buying them out of the stock market. The aim of private equity is to invest in companies with high growth potential and sell them after their value has increased significantly. 

There are private equity funds where many players, such as pension funds, insurance companies and private investors, have come together to gain greater purchasing power. 

How does private equity work? 

Below we explain what a private equity process normally looks like. 

Raising funds (fundraising)

Private equity firms create funds, so private equity funds, which they use to buy majority or larger minority stakes in unlisted companies that they think will grow well. Private equity funds usually have a fixed lifespan of, for example, 10 years. 

Looking for suitable investments (deal sourcing)

Looking for companies to invest in, which are perceived to have good growth potential, is called deal sourcing. Examples of companies with high growth potential are companies with good business ideas but without the capital needed to grow quickly and substantially. 

You buy the company (acquisition)

When one or more companies with growth potential are bought, it is called an acquisition. If the purchase is made with borrowed funds, which they often are, it is called a leveraged buyout. By borrowing money for the buyout, the return on the private equity fund can be maximized while the risk exposure is greatly increased. 

You create value (value creation)

Value creation means focusing on increasing the value of the acquired companies by as much as possible. Practical measures in this phase include optimizing and expanding operations, and making acquisitions of competitors. 

Exit strategy

After several years, the company or companies are sold by the fund. This can happen through, for example:

• Initial public offering (IPO).
• Sale of the company to a larger company.
• Sale of the company to another private equity fund.

Repatriation of capital

When the company or companies are sold, the capital left over from the transaction is distributed among the owners of the PE fund. In connection with this, the PE company usually charges a fee called a performance fee, or carried interest. 

What are the benefits of private equity? 

Benefits for investors

Key benefits of private equity for investors are that: 

• You get a good opportunity to see your capital grow, but there is never a guarantee of return.  
• You benefit from the expertise and support of other investors in the same fund. 
• You get a good opportunity to influence the companies in which the PE fund invests, which provides good opportunities to make changes that affect the company positively. Boards in PE-owned companies usually have a strong focus on growth, which benefits all parties. 
• The PE fund can step in and support companies that they consider particularly important, such as battery companies and electric car companies, thus creating a more sustainable society. 

Benefits for businesses

Key benefits of private equity for businesses are that: 

• The company receives the capital it needs to grow, for example to develop new products or expand into new markets. 
• The company benefits from the expertise of all the experts involved in the PE fund. 
• The company will be able to make the changes needed to achieve economic growth, such as hiring new staff and purchasing machinery. 

What are the disadvantages of private equity investments?

• Investors take a big risk when a lot of capital is invested in one or a few companies. If one or more companies fail, there is a high risk of losing all or a large part of their investment. 
• Transparency in private equity funds is generally low. Mainly because they do not have the same high transparency requirements as listed companies which can lead to difficulties in understanding the riskiness of their investment. 
• Private equity investments require patience, so they often extend over a longer period of time such as 5-10 years, or until sufficient returns are generated. 
• Sometimes there is too much focus on short-term profits, and if the company is highly leveraged, the investment is considered particularly risky. 

What investment strategies are available? 

Common investment strategies for private equity funds are buyout and growth capital. Below we explain how these strategies work. 

Buyout

Buyout is the most common investment strategy for private equity funds. It focuses on investing in mature companies that are well established in the market and have good profitability. Typically, the fund takes control of the company's management and runs it in an active way with a focus on growth. 

Growth capital

The growth capital investment approach means that the PE fund invests in an established company that is profitable and needs money to grow, but at the same time does not want to give up control of the company. 

This requires less active ownership as there is no control over the company, but even though the fund does not control the company, the PE fund will provide important advice, tips and networking opportunities that benefit the company.

Risk-taking is described as slightly higher compared to buyouts as the PE fund does not control the companies it invests in.

Why do some companies want to be private?

Companies that are private rather than listed are by no means disadvantageous to invest money in. There are many advantages to keeping your company off the stock exchange, such as 

• Ongoing costs are reduced because the reporting and legal fees that listed companies have to pay in order to have their company listed on the stock exchange do not have to be paid. 
• More time can be spent on developing the company instead of dealing with the extra administration that an IPO requires. 
• Private companies do not have as high reporting requirements and therefore do not have to disclose things like upcoming investment plans and products to the media and private individuals, and by extension competitors. 

What are the differences between private equity funds and venture capital funds?

• Private equity funds typically invest in mature companies, while venture capital funds invest mainly in startups. 
• Private equity funds focus mainly on restructuring and streamlining, while venture capital funds normally focus on innovative solutions. 
• Private equity funds usually invest larger amounts than venture capital funds, mainly because mature companies are usually more expensive to invest in compared to start-ups. 

Frequently asked questions

Below we answer frequently asked questions about private equity and private equity funds. 

Who invests in private equity funds? 

Private equity funds usually have investors with large access to capital such as pension funds and insurance companies. Few individuals have the capital required to buy into a private equity fund. 

How are private equity investments regulated? 

In Sweden and the EU, private equity investments are regulated by the Alternative Investment Funds Act. The supervision that exists is handled by the Financial Supervisory Authority in each country. 

How high are the returns from PE investments?

European private equity investments typically have a return of around 15 % according to a study by Invest Europe.