Here we tell you everything you need to know about private equity, such as what it is and how investing in private equity funds works.
What is private equity?
Private equity is a form of investment in which unlisted companies are bought up, or listed companies are delisted by buying them out from the stock exchange. The aim of private equity is to invest in companies with great growth potential and sell them after the companies' value has increased substantially.
There are private equity funds in which many players, such as pension funds, insurance companies and private investors, have joined forces to gain greater purchasing power.
How does private equity work?
Below we describe what a private equity process normally looks like.
Raising capital (fundraising)
Private equity firms create funds, that is, private equity funds, which they use to buy majority or larger minority stakes in unlisted companies they believe will grow well. Private equity funds usually have a fixed lifetime of, for example, 10 years.
Looking for suitable investments (deal sourcing)
Looking for companies to invest in that are perceived to have good growth potential is called deal sourcing. Examples of companies with great growth potential are companies with good business ideas but without the capital needed to grow quickly and substantially.
Buying the company (acquisition)
When one or more companies with growth potential are bought, this is called an acquisition. If the purchase is made with borrowed funds, which is often the case, it is called a leveraged buyout. By borrowing money for the acquisition, the return on the private equity fund can be maximised, while the risk increases considerably.
Creating value (value creation)
Value creation means focusing on increasing the value of the acquired companies as much as possible. Practical measures in this phase include optimising and expanding the business and acquiring competitors.
Exit strategy
After a number of years, the fund sells the company or companies. This can happen through, for example:
- An initial public offering (IPO).
- A sale of the company to a larger company.
- A sale of the company to another private equity fund.
Returning capital
When the company or companies have been sold, the capital remaining from the deal is distributed among the PE fund's owners. In connection with this, the PE firm usually takes a fee known as a performance fee, or carried interest.
What are the advantages of private equity?
Advantages for investors
Important advantages of private equity for investors are that:
- You have a good opportunity to see your capital grow, but there is never any guarantee of a return.
- You benefit from the expertise and support of the other investors in the same fund.
- You have a good opportunity to influence the companies the PE fund invests in, which gives good opportunities to make changes that affect the company positively. Boards of PE-owned companies usually have a strong focus on growth, which benefits all parties.
- The PE fund can step in and support companies it considers particularly important, such as battery companies and electric vehicle companies, thereby helping to create a more sustainable society.
Advantages for companies
Important advantages of private equity for companies are that:
- The company gets the capital it needs to grow and, for example, develop new products or expand into new markets.
- The company benefits from the expertise of all the experts in the PE fund.
- The company gets the opportunity to make the changes needed to achieve financial growth, such as new hires and purchases of machinery.
What are the disadvantages of private equity investments?
- Investors take a large risk, as a lot of capital is invested in one or a few companies. If one or more companies perform poorly, there is a high risk of losing all or a large part of the investment.
- Transparency in private equity funds is generally low, mainly because they do not have the same strict transparency requirements as listed companies, which can make it difficult to understand the risk in your investment.
- Private equity investments require patience, as they often stretch over a longer period such as 5–10 years, or until a sufficient return has been generated.
- Sometimes there is too much focus on short-term profits, and if the company is highly indebted the investment should be regarded as particularly risky.
What investment strategies are there?
Common investment strategies for private equity funds are buyout and growth capital. Below we describe 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. The fund normally takes control of the company's management and runs it actively with a focus on growth.
Growth capital
The growth capital approach means that the PE fund invests in an established, profitable company that needs money to grow but does not want to give up control of the company.
This requires less active ownership, as the fund does not control the company, but even so the PE fund will provide important advice, tips and networking opportunities that benefit the company.
The risk is described as somewhat higher than with buyouts, as the PE fund does not control the companies it invests in.
Why do some companies want to stay private?
Companies that are private rather than listed are in no way disadvantageous to invest in. There are many advantages to keeping a company off the stock exchange, such as:
- Running costs fall, because the reporting fees and legal fees that listed companies must bear to keep their company listed do not have to be paid.
- More time can be spent developing the company instead of dealing with the extra administration that a stock market listing requires.
- Private companies do not have equally strict reporting requirements and therefore do not need to disclose things such as upcoming investment plans and products to the media and the public, and ultimately to competitors.
What are the differences between private equity funds and venture capital funds?
- Private equity funds normally invest in mature companies, while venture capital funds mainly invest in startups.
- Private equity funds focus mainly on restructuring and efficiency improvements, 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 than startups.
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 access to large amounts of capital, such as pension companies and insurance companies. Few private 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 law on alternative investment funds. Supervision is carried out by the financial supervisory authority in each country (in Sweden, Finansinspektionen).
How high is the return on PE investments?
European private equity investments normally have a return of around 15% according to a study by Invest Europe.
