nitinpahuja
Nitin Pahuja
By YAJNESH BHAT &
DIVYA VASANTHARAJAN
Recently, newspaper headlines seem to be featuring Private Equity (PE) investments or buyouts almost everyday. So why are we witnessing a sudden growth in this form of corporate financing? The occurrence of this phenomenon can be attributed to the sudden spurge in mergers and acquisitions and other macroeconomic factors where PE firms are primary participants in the consolidation process across sectors. So how exactly do PE firms work?
Private Equity (PE) commonly refers to equity capital that is made available to companies or investors, but not quoted on a stock market. PE firms form a corpus fund (a pool of money); which is raised in private markets, through investments by Financial Institutions and High Net-worth Individuals (HNWI’s). This corpus is usually a bulk amount of money.
Passive institutional investors invest in PE funds, which are in turn used by PE firms for investment in target companies. There are many categories of PE investment such as leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others.
When PE firms acquire majority stake, they exercise a large measure of control & influence over their investments. PE firms run by investment bankers and consultants contribute with significant financial and industry expertise. They try to turn the fortunes of the company around by providing superior management and technical inputs. They are well-known for cutting costs and streamlining operations through hard decisions such as retrenchment of the workforce.
They usually acquire companies through Leveraged Buy-Outs (LBOs) or invest minority stakes in companies. In LBO acquisitions, they inject a modest amount of equity and the remainder is financed through borrowings in the loan or bond market. Usually, the acquired company's assets are used as collateral for the loans of the PE firm. The loans are paid back from that company's cash flow.PE funds exit by way of an initial public offering (IPO), or trade sale or secondary/tertiary buy-outs (i.e. sale to another private equity house). Thus, they earn handsome returns on their investments.
Globally, PE has developed into a matured asset class. In terms of governance, management focus, and strategic decision-making, the private-equity model is superior to that of publicly held companies.
Some of the largest private equity firms are Blackstone, KKR and Vestar Capital Partners, etc. and some famous private equity businessmen are David M. Rubenstein (The Carlyle Group), Robert Rosner (Vestar Capital Partners) etc.
Not everyone today wishes to play it safe with a regular nine-to-five job. The need to be one’s own boss is no longer restricted to the wayward dreamer. Every manager today aspires to be an entrepreneur and this has brought with it the need for financing these projects. Such start-ups are more often than not extremely risky for, business ideas need to have acceptance in the market and the ability to sustain the demand in the future. So what we need is long-term financing for very risky ventures with high growth potential – Venture Capital.
Venture Capital (VC) is a type of PE capital typically provided by professional external investors to startup companies.VC investments are usually high risk, but offer the potential for above-average returns. Venture capitalists are persons who make such investments and are the executives in the firm. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies.
A VC fund is a pooled investment vehicle (often a limited partnership) that invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. VC can also include managerial and technical expertise. Most VC comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies/ventures, with limited operating history, and which cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.
Investors in venture capital funds are known as limited partners. This constituency comprises both HNWIs and institutions with large amounts of available capital, such as state and private pension funds, insurance companies, and pooled investment vehicles called fund of funds. This VC model was pioneered by successful funds in Silicon Valley through the 1980s. It helped cut exposure to management and marketing risks of any individual firm or its product.
In a typical VC fund, the partners receive an annual management fee of 2% of the committed capital to the fund and 20% of the net profits of the fund called carried interest. A fund may run out of capital prior to the end of its life hence, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged.
VC are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in as few as one in four hundred opportunities presented to it. If a company does have the qualities that a VCs seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise VC as funds are most interested in only such opportunities.
VC funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt especially for intangible assets such as software, and other intellectual property, whose value is unproven.
VC can be used as a financial tool for development, within the range of small and medium enterprises (SME) finance, by playing a key role in business start-ups, existing small and medium enterprises and overall growth in developing economies. VC acts most directly by being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies.
Now the question: ‘Why the rise in PE and VC?’
It can be explained as follows:
• Large Influx of money into equity.
• Many institutional investors opting for alternative investment to boost their returns.
• Large demand for capital.
• Growth in investor risk-appetite.
• Increase in number of entrepreneurial start-ups.
Going forward the trend would be towards higher risk-taking abilities resulting in sharpened entrepreneurial acumen. India’s demographic profile also suits this trend with more youngsters coming within the earning bracket. Greater awareness blended with an adventurous bent of mind would result in the younger generation following new business ideas to satiate their risk urges. This backed by the change in educational system from the staid theory-oriented education pattern to the more practical forms will help develop skill-sets for entrepreneurship. We, therefore, envisage a leaping growth in the venture capital and private equity segments that would cater to such entrepreneurial requirements.
DIVYA VASANTHARAJAN
Recently, newspaper headlines seem to be featuring Private Equity (PE) investments or buyouts almost everyday. So why are we witnessing a sudden growth in this form of corporate financing? The occurrence of this phenomenon can be attributed to the sudden spurge in mergers and acquisitions and other macroeconomic factors where PE firms are primary participants in the consolidation process across sectors. So how exactly do PE firms work?
Private Equity (PE) commonly refers to equity capital that is made available to companies or investors, but not quoted on a stock market. PE firms form a corpus fund (a pool of money); which is raised in private markets, through investments by Financial Institutions and High Net-worth Individuals (HNWI’s). This corpus is usually a bulk amount of money.
Passive institutional investors invest in PE funds, which are in turn used by PE firms for investment in target companies. There are many categories of PE investment such as leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others.
When PE firms acquire majority stake, they exercise a large measure of control & influence over their investments. PE firms run by investment bankers and consultants contribute with significant financial and industry expertise. They try to turn the fortunes of the company around by providing superior management and technical inputs. They are well-known for cutting costs and streamlining operations through hard decisions such as retrenchment of the workforce.
They usually acquire companies through Leveraged Buy-Outs (LBOs) or invest minority stakes in companies. In LBO acquisitions, they inject a modest amount of equity and the remainder is financed through borrowings in the loan or bond market. Usually, the acquired company's assets are used as collateral for the loans of the PE firm. The loans are paid back from that company's cash flow.PE funds exit by way of an initial public offering (IPO), or trade sale or secondary/tertiary buy-outs (i.e. sale to another private equity house). Thus, they earn handsome returns on their investments.
Globally, PE has developed into a matured asset class. In terms of governance, management focus, and strategic decision-making, the private-equity model is superior to that of publicly held companies.
Some of the largest private equity firms are Blackstone, KKR and Vestar Capital Partners, etc. and some famous private equity businessmen are David M. Rubenstein (The Carlyle Group), Robert Rosner (Vestar Capital Partners) etc.
Not everyone today wishes to play it safe with a regular nine-to-five job. The need to be one’s own boss is no longer restricted to the wayward dreamer. Every manager today aspires to be an entrepreneur and this has brought with it the need for financing these projects. Such start-ups are more often than not extremely risky for, business ideas need to have acceptance in the market and the ability to sustain the demand in the future. So what we need is long-term financing for very risky ventures with high growth potential – Venture Capital.
Venture Capital (VC) is a type of PE capital typically provided by professional external investors to startup companies.VC investments are usually high risk, but offer the potential for above-average returns. Venture capitalists are persons who make such investments and are the executives in the firm. Typical career backgrounds vary, but many are former chief executives at firms similar to those which the partnership finances and other senior executives in technology companies.
A VC fund is a pooled investment vehicle (often a limited partnership) that invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. VC can also include managerial and technical expertise. Most VC comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies/ventures, with limited operating history, and which cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.
Investors in venture capital funds are known as limited partners. This constituency comprises both HNWIs and institutions with large amounts of available capital, such as state and private pension funds, insurance companies, and pooled investment vehicles called fund of funds. This VC model was pioneered by successful funds in Silicon Valley through the 1980s. It helped cut exposure to management and marketing risks of any individual firm or its product.
In a typical VC fund, the partners receive an annual management fee of 2% of the committed capital to the fund and 20% of the net profits of the fund called carried interest. A fund may run out of capital prior to the end of its life hence, larger VCs usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged.
VC are typically very selective in deciding what to invest in; as a rule of thumb, a fund may invest in as few as one in four hundred opportunities presented to it. If a company does have the qualities that a VCs seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise VC as funds are most interested in only such opportunities.
VC funding an expensive capital source for companies, and most suitable for businesses having large up-front capital requirements which cannot be financed by cheaper alternatives such as debt especially for intangible assets such as software, and other intellectual property, whose value is unproven.
VC can be used as a financial tool for development, within the range of small and medium enterprises (SME) finance, by playing a key role in business start-ups, existing small and medium enterprises and overall growth in developing economies. VC acts most directly by being a source of job creation, facilitating access to finance for small and growing companies which otherwise would not qualify for receiving loans in a bank, and improving the corporate governance and accounting standards of the companies.
Now the question: ‘Why the rise in PE and VC?’
It can be explained as follows:
• Large Influx of money into equity.
• Many institutional investors opting for alternative investment to boost their returns.
• Large demand for capital.
• Growth in investor risk-appetite.
• Increase in number of entrepreneurial start-ups.
Going forward the trend would be towards higher risk-taking abilities resulting in sharpened entrepreneurial acumen. India’s demographic profile also suits this trend with more youngsters coming within the earning bracket. Greater awareness blended with an adventurous bent of mind would result in the younger generation following new business ideas to satiate their risk urges. This backed by the change in educational system from the staid theory-oriented education pattern to the more practical forms will help develop skill-sets for entrepreneurship. We, therefore, envisage a leaping growth in the venture capital and private equity segments that would cater to such entrepreneurial requirements.