In a sense, private equity is the opposite of shareholders’ equity. It involves funding that is not noted on a public exchange. Private equity comes from funds and investors that directly invest in private companies, or that engage in leveraged buyouts (LBOs) of public companies.
Private investors can include institutions (pension funds, university endowments, insurance companies, etc.) or individuals (high net worth families, friends and relatives). Private equity also refers to mezzanine debt, private placement loans, distressed debt and funds of funds. Private equity comes into play at different points along a company’s life cycle. Typically, a very young company with no revenue and no earnings can’t afford to borrow, so capital must be obtained from friends and family, or individual “angel investors.” Venture capitalists enter the picture when the company has finally created its product or service, and is ready to bring it to market. (Some of the largest, most successful corporations in the tech sector, like Dell Technologies and Apple Inc. – began as venture-funded operations.)
Venture capitalists generally provide all equity financing, in return for a minority stake; sometimes a venture capitalist will take a seat on the board of directors for its portfolio companies, ensuring an active role in guiding the company along. Venture capitalists look to hit big early on, and exit investments within five to seven years. An LBO is one of the most common types of private equity financing, and might occur as a company matures.
In an LBO transaction, a company receives a loan from a private equity firm to fund the acquisition of a division or another company. The loan is usually secured by the cash flows or the assets of the company being acquired. Mezzanine debt is a private loan, usually provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often involve a mix of debt and equity in the form of a subordinated loan or warrants, common stock or preferred stock.
Unlike shareholders’ equity, private equity is not a thing for the average individual. To participate in private equity or venture capital partnerships, an investor must be “accredited” (have a net worth of at least $1 million). For investors who are less well-off, there is the option of exchange-traded funds (ETFs) that focus on investing in private companies.