PE/VC EXPLAINED

DEFINITION

Private equity (PE) is the provision of equity capital by financial investors - over the medium or long term - to non-quoted companies with high growth potential.

Venture capital (VC) is, strictly speaking, a subset of PE and refers to equity investments made for the launch, early development, or expansion of a business. It has a particular emphasis on entrepreneurial undertaking rather than on mature business.

PE covers not only the financing required to create a business, but also includes financing in the subsequent development stages of its life cycle. When financing is required by a management team to buy an existing company from its current stakeholders, such a transaction is called a buyout.

PE and VC may refer to different stages of the investment but the essential definition remains the same: it is the provision of capital, after a process of negotiation between the investment fund manager and the entrepreneur, with the aim of developing the business and creating value.

PE firms have a main goal: seek out companies with the potential for growth and with the aim to put in place the capital, talent and strategy needed to permanently strengthen the company and raise its value. PE is often categorised under the umbrella of 'alternative investments', complementary to the stock and bond portfolios traditionally used by investors.

Source: European Private Equity & Venture Capital Association (EVCA)


SUITABILITY

Each business has its own ambitions, abilities and needs and not all will be suitable for private equity (PE) / venture capital (VC).

PE/VC is an option entrepreneurs consider when they want to:

  • create a business;
  • improve and develop export performance;
  • exploit the creation and innovation of their team;
  • recruit highly qualified personnel;
  • sell part of all of their company;
  • change the size of their business and take over one of their competitors;
  • launch a new product;
  • improve their management capacity;
  • liquidise some of their assets.

A PE/VC firm can bring to entrepreneurs:

  • Long-term capital, solidly underpinning their company's growth;
  • increased visibility with bankers, suppliers and clients;
  • a partnership, sharing the risks and the rewards;
  • an investment fixed within the framework of a negotiated contract;
  • the adoption of high-performance management standards;
  • strategic and operational support along with financial advice in times of crisis;
  • assistance with subsequent financing operations;
  • alliances due to the investor's network of contacts and portfolio of investments;
  • a partial or total exit strategy.

A PE/VC firm is generally looking for:

  • High growth, competitive products or services;
  • in the case of disposal or transfer, a loan capacity and recurring profits;
  • a quality and stable management team, capable of turning the negotiated goals into reality;
  • solid management procedures, either already in place or able to be quickly put in place;
  • a transparent legal structure where personal and professional assets are not entangled;
  • an agreement on the investor's exit, with or without the head of the company.

Source: EVCA


THE MODEL

Sources of Funding

Private equity (PE) and venture capital (VC) firms raise their funding from institutions and, in some cases, high net-worth individuals. PE investors seek exposure to long-term investments with stable performance returns. VC sits higher on the risk‐reward equation. As a result, VC investors are looking for higher reward outcomes to offset the higher risk profile. PE and VC fund managers often invest some of their own capital, too.

The PE and VC managers of the fund are described as general partners (GPs) because they manage the fund and are liable for its legal debts and obligations. The investors are described as limited partners (LPs) in the fund because their liability for debts and obligations of the fund is limited to the amount of their investment in the fund. LPs are passive investors because they are precluded from getting actively involved in the management of portfolio companies.

The Investment Model

Globally, a typical PE and VC fund structure involves a collective investment vehicle (CIV), such as a limited partnership or a trust. PE and VC funds raise capital by securing capital commitments from investors. These are pledges of capital to the PE or VC fund. The GPs invest the fund’s capital across a set of investments that fit the fund’s investment mandate or focus. Capital is gradually drawn down from LPs over the life of the fund through a series of “capital calls” as and when investments are made (typically during the first five years).

A PE firm may operate a number of funds, and each fund typically will invest in a number of companies. PE and VC firms generally coinvest a certain amount of their own money to further align the interests of investors and fund managers. Once an acquisition has been made, a representative of the PE or VC firm usually joins the company board and actively works with the investee company during, and often after, the investment period.

This form of investment is very different to those of other investment types, such as listed equities where the manager merely makes a transaction via a computer screen and then passively watches the performance. After an average period of five to seven years, PE and VC funds exit investments to realise a return for investors. Most divestments take place via trade sales. Some are secondary sales (to another PE or VC firm) and some are divested via a share market listing (or Initial Public Offering or a share buyback.

Source: Australian Private Equity & Venture Capital Association Limited (AVCAL)


INVESTMENT STAGES

Funds can vary widely depending on the different stage in a company's life cycle, which can be defined along the following lines, keeping in mind that the boundaries between the different stages can be blurred:

  • Seed
    Seed financing is designed to research, assess and develop an idea or initial concept before a company has reached the start-up phase.At this stage, investors are mainly business angels. They are often entrepreneurs or former directors who join a project to help get it off the ground and contribute some of their personal funds.
  • Start-up
    Start-up financing is used for product development and initial marketing. Businesses may still be in the creation phase or have just started operations and have not yet sold their product commercially.
    When the product has taken shape, forming the basis of a real "business plan", a certain number of venture capital professionals will join the entrepreneur and assist him with setting up the business. At this stage, the capital is mainly required for research and development of the product and to train personnel. The risk of failure for these companies is high and investors need to be stringent in their choice of projects.
  • Post-creation
    At this stage, the business has already developed its product and needs capital to begin making and selling it. It has not yet generated any profits.
  • Expansion/Development
    In the case of expansion, the business has reached or is approaching breakeven. This is a period of high growth and capital is used to increase production capacity and sales power, to develop new products, finance acquisitions and/or increase the working capital of the business.
    Getting through this period often requires many rounds of financing, during which the company has to ensure that its growth is balanced. Professional investors are most attracted if a significant amount has already been invested in a company, if the company already has a history of development and if its is already operating with a robust structure in place. This stage includes bridge financing and rescue or turnaround investments.
  • Transfer/Succession
    The total or partial retirement of the head of a company is often an opportunity to implement a leveraged operation (capital contributions in the form of both debt and equity) to undertake a buyout or a buyin. These can also happen when a large company disposes of a business unit, or when shares held by family member are repurchased or, eventually, when investors from previous stages of development exit the business.

The existing management team (in the case of a buyout) or a new team (in the case of a buyin), assisted by financial investors, creates and finances a holding company that then borrows debt to acquire the target company. The dividends produced by the target company then enable the holding company to repay its debt. The structure of this operation means that it applies only to an established company or business unit, with a positive and/or predictable cash flow.

Buyouts (or buyins) allow a company to carry on trading, facilitate generational change at the top of a company, enable restructuring more efficiently by injecting fresh capital and protect jobs whilst safeguarding employees' shareholdings. The contribution of the private equity investors is not simply financial: they support the company management by bringing in their knowledge of the industrial sector, their network of contacts and their long-term commitment. The amounts invested are typically substantial and big investment funds have specialised in these operations for many years.

Source: AVCAL


EXIT

Exits are at the heart of private equity and venture capital business. It should not be interpreted as a lack of interest in the company nor as a sign that the investment was only motivated by the desire for short-term profits. The goal of the investor is to help create or develop a business that will allow him to dispose easily of part of his equity stake.

Exit strategies differ depending on the size of the company, the sector in which the company operates and the stage of the company's development. The experience of the investment manager and his network of contacts will help him to achieve the best possible exit for him and his own shareholders as well as for the other shareholders in the company.

There are different ways in which a PE/VC investor can exit from an investment including:

  • Trade sale;
  • Entrepreneur or management team repurchase;
  • Exploit the creation and innovation of their team;
  • Sale of the investment to another financial purchase (called a secondary market investor);
  • IPO (initial public offering): flotation on a public stock market;
  • Liquidation.

As with the investor's entry into the company, the valuations undertaken during a partial or total exit will vary depending on the type of operation, the number of shares disposed of, the sector involved and the characteristics of the company.

Source: EVCA