The expanding private markets industry is an alternative source of finance that benefits innovation, wealth creation, the sustainability of operations, and the economies in which they operate. This 'How To Invest' article explains the most common private equity strategies.
Venture capital (VC)
Venture capital typically involves less mature companies, start-up companies, or companies in early-stage development. Often, venture capital is provided for investments applied towards a new technology, biotechnology, new marketing concepts, or new products that do not yet have a proven record of accomplishment or steady revenue streams. The entrepreneurs developing these companies require capital that is hard to access from, for example, the banking system. Venture capital is characterised by a higher risk and investment attrition rate but occasionally can provide outstanding returns.
Growth capital typically involves minority investments in mature companies that are looking for capital to expand or restructure operations, finance a major acquisition, or enter new markets. Companies involved in growth capital typically can generate revenue and operating profits but cannot generate enough cash to fund major expansions, acquisitions, or other investments. This lack of scale can make it difficult for these companies to secure capital for growth, making access to growth equity critical. By selling part of the company to a private equity manager, the primary owner does not have to take on the financial risk alone but can share the risk of growth with partners in exchange for some value in the company.
Private equity investing encompasses a broad spectrum of investment opportunities that covers most stages of a company’s life cycle.
Leveraged buyout (LBO)
This is the most common strategy within the private equity sphere and the biggest allocator of capital. An LBO refers to the acquisition of a public or private company that has a relatively mature business. Here is a simple explanation of how it works:
A good analogy for an LBO is taking out a mortgage on a property. The purchaser of the property must provide an initial cash outlay (the cash equity stake) to cover a portion of the sale price. The remaining financing of the property is then covered by a mortgage, for which the property being purchased serves as collateral. Similarly, when executing an LBO, a portion of equity provided by the private equity fund covers part of the purchase price of the company being acquired, and the remaining financing is covered by a bank loan(s), for which the acquired property serves as collateral.
An LBO may effect a change of ownership, management, or company strategy by acquiring a significant portion or majority control of a business. Often, this can result in the delisting of a public company or the ‘carve-out’ of a division from a larger enterprise. The private equity firm completing the LBO, also known as the financial sponsor, will either exert control or have a significant involvement in managing the company. These financial sponsors are actively involved in the development of the business and are not passive investors like shareholders in a public company. Private equity firms are temporary holders of assets and, as such, look to monetise their investments through a sale of those assets either through an IPO, a sale to a strategic (industrial) buyer, or a secondary sale to another private equity firm.
Private credit strategies
Private debt accounts for a substantial portion of the private markets (approximately 10%–15% of total assets under management), with most private middle-market companies having at least some privately provided debt. Investor demand for debt funds is on the rise. Depending on factors like interest rates, regulations, and the business cycle, investors view private debt as a less risky way to dive into private equity or diversify their assets. Private debt includes any debt held by or extended to privately held companies. It comes in many forms but most commonly involves non-bank institutions making loans to private companies or buying those loans on the secondary market. A variety of investors, or private debt funds, are involved in the space. Strategies within private debt include:
- Direct lending across the capital structure, from senior loans through to subordinated credits
- Mezzanine lending, which is a combination of debt and equity options
- Distressed debt & special situations (see below)
- Real estate from development through to core stages
Distressed & special situations
This is a broad category that refers to investments in the equity or debt securities of financially stressed companies. This sector has grown in importance over recent years, as banks have pulled back from such rescue lending situations, mainly due to regulatory changes. The term ‘distressed’ includes, but is not limited to, the following sub-strategies:
- Distressed-to-control or loan-to-own: where the investor acquires new debt securities, anticipating that he or she will gain control of the company’s equity following a restructuring.
- Rescue lending: providing liquidity to stressed companies in times of heightened market turbulence in return for preferential investment conditions.
- Special situations (or turnaround): where an investor provides debt and equity investments to companies undergoing significant challenges. Special situations may include mergers and acquisitions, bankruptcy, and more.
Private equity real estate involves pooling together investor capital to invest in the ownership of various real estate properties. Four common strategies used by private equity real estate funds are:
- Core: investments 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 that involves the purchase of a property to improve and sell it 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.
Infrastructure as an asset class is defined as any ‘real asset’, such as power stations, electricity distribution networks, airports, roads, bridges, etc., or anything that is conducive to building and maintaining society and is vital for a functioning economy. Private markets managers use their stable and patient capital to invest in new and existing infrastructure assets.
The private secondary market provides liquidity to private equity investors, allowing them to sell their positions in private equity funds and liquidate equity stakes in private companies. Specialist private equity firms raise pools of capital to play the part of the secondary buyer of such stakes from a variety of private equity investors. Such transactions are often completed at a discounted price to the prevailing net asset value. Please note that the sale does not involve the underlying assets but rather the funds that own those assets.
Impact investments are investments made with the intention to generate positive, measurable social and/ or environmental impact alongside a market-rate financial return. Impact investments seek to address the world’s most pressing challenges in sectors such as sustainable agriculture, renewable energy, the blue economy, nature conservation, microfinance, and affordable and accessible basic services, which includes housing, healthcare, and education. Impact investments may be made in both emerging and developed markets and are accessible through various private markets strategies, including venture capital, growth, leveraged buyouts, private debt, and real estate assets.
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