BGF explains: What is private equity and how does it work?

We explain how private equity firms are structured, their approach to investing, and why entrepreneurs may or may not choose this type of business funding.

8 February 2022

Private equity (PE) is a method of business funding which is used by a range of businesses to help them grow. Typically a form of medium to long-term funding, private equity funding is popular, with an unprecedented amount of deal activity in the PE sector during 2021.

But what exactly are the characteristics of private equity, how do private equity firms work, and what are the advantages and disadvantages of PE compared with other forms of funding?

What is private equity?

Private equity is a form of financing in which a PE firm invests money in a business in exchange for an equity or ownership stake. Private equity is typically a majority investment, in which the investor buys a controlling stake – more than 50%; however, some PE firms also do minority investment.

Private equity can be extremely beneficial for both parties when the conditions are right. Businesses can receive the investment and expertise they need to reach the next stage of their growth quickly, while the PE investor can potentially achieve a significant return upon exiting the investment.

Private equity differs from venture capital as it is generally more suited to more mature businesses, often supporting management buyouts, rather than younger businesses or startups. Private equity investments are typified by the PE firm working in close partnership with the existing management team to achieve a highly defined common goal – be this quick growth, greater efficiencies or something else.

However, private equity is not right for every business, and with more alternative forms of investment now available, many companies are looking towards funding mechanisms that give them more control.

What do private equity firms do?

Private equity investments are made by companies in command of large investment funds. A PE firm typically has two main activities: raising money and making investments in high-potential private companies.

Raising capital

Private equity firms raise most of their capital from what are known as institutional investors. These include pension funds, sovereign wealth funds and insurance companies, among others. (Some PE firms additionally raised money from individuals, typically high-net-worth investors.)

The PE firm’s investors pay management fees to the firm and are known as limited partners. They contribute the majority of the funding towards a firm’s fundraising goal and own the majority of shares in the investment company; however, they only take on a low level of risk in investments. The rest of the shares are owned by general partners. These are individuals at the firm who do not contribute significant funding but are actively involved in both raising capital and making investments, and who take on full market liability.

Once a PE firm’s funding target is met, the capital is ready to be invested in companies with strong growth potential.

Making investments

Private equity firms focus on investing in private companies with high potential for growth. A PE deal may simply involve a straight swap – cash in exchange for equity – which is the same arrangement as in a typical venture capital deal. However, PE firms are known for often pursuing another kind of deal, which is a leveraged buyout.

Leveraged buyouts involve a PE firm using a large amount of borrowed money to pay the acquisition costs. The target company’s assets may be used as collateral for the loans. A private equity investment aims to improve the profitability of the company, helping reduce the impact of the debt over the course of the partnership. However, leveraged buyouts will not be appropriate for all businesses.

Private equity investments are typically short to mid-term in scope. The goal is to grow a company quickly with strategies such as acquisitions, new product development or international expansion. Because PE firms are obliged to provide returns to their limited partners according to an agreed timeframe, they typically try to realise the value of their investments relatively quickly – this can vary but an investment period of three years is not uncommon.

Most PE investors take a non-executive role, while assisting with executing the growth plan of the business and building a stronger leadership team.

What are the types of private equity investments?

Private equity deals are common throughout the market; businesses of all sizes can be beneficiaries.

Early-stage private equity

Frequently associated with venture capital, early-stage private equity deals generally focus on start-up companies with high potential to grow from a low base. Whereas venture capital companies tend to target businesses with big ideas that may be pre-revenue, early-stage PE funding usually aims to establish a business that has already developed a strong user base or begun to turn consistent revenue.

Large private equity deals

Large companies can also receive private equity funding. In fact, huge private equity deals seem to be becoming more common. There are many reasons why PE might be right for large companies, for instance those turning over £100 million a year or more. They often centre around the specific expertise a private equity firm can bring in devising new models and products, thereby increasing the value of the brand. Acquisitions can be another strategy.

Mid-market private equity

The middle of the private equity market accounts for the majority of PE deals in the UK. Mid-market private equity is characterised by the size of the deal (generally between £10m and £300m) and the size of the company receiving investment (typically a turnover of between £5m and £100m).

Companies in the middle market for private equity often target growth through mergers and acquisitions, expanding into new markets or strengthening the leadership team, among other strategies.

Is private equity the best form of funding for my business?

Private equity can prove transformative for businesses that wants to growth quickly, but it may not be right for everyone. A business should consider what its plans for growth are, while understanding the motivations of the PE investor in terms of investment returns and timeline.

Then there is the question of control. Most PE deals involve handing a majority equity stake to the investor. Some entrepreneurs may be unwilling to do this, in which case minority investment may be a more suitable choice.

A business should also consider what investment period would be appropriate for them. A private equity firm will typically want to exit its investment within a few years. If a business would prefer funding that is more long-term in nature, with the possibility of significant follow-on funding, another option is patient capital.

Patient capital from BGF

At BGF, we occupy a unique position in the investment landscape of the UK and Ireland. We never look to take overall control of the companies we invest in and always invest in new companies on a minority basis. As an investor of patient capital, we do not set arbitrary timelines or exit deadlines, nor do we impose drag-along rights on any new investment. We allow our portfolio companies to grow at a pace that suits them, supporting them over an investment period that could last anything from months to many years.

Over the last decade, we’ve backed more than 450 British and Irish businesses, helping them achieve ambitious growth plans. Learn more about how we could propel your business to the next stage in its growth journey by talking to our team today.

The information contained in this article is for general information and use. It does not constitute any form of advice and is not intended to be relied upon in making any investment decision. Independent advice should always be sought as to whether a particular transaction is suitable having regard to your personal and financial circumstances.

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