Private Equity - Types of Financing

What is Private Equity (PE)?

PE is one of the source of financing for an enterprise. It is an investment in equity of a company that is not listed in a stock exchange. The difference between PE and Venture Capital (VC) is that VC investment is made in the very early stage of a company’s life cycle. VC is a part of private equity.

Concept of PE investment

PE investment is highly illiquid, it needs monitoring, and its price is not driven by the market.

Private Equity Investor (PEI) provides funds to the company and in return gets equity shares. Unlike an equity shareholder of a public limited company who can trade in stock exchange, PEI cannot do so as they are not listed in a stock exchange. Hence, PE investment is highly illiquid.

PEI gets return on investment in the form of capital gains which is directly linked to performance of the company. PEI has to monitor the functioning of the company because these entities are not regulated by regulators. PEI is treated as an insider while banks that provide loans are treated as an outsider.

PE pricing is not market driven and therefore it has to be favourably negotiated with other investor.

What are the benefits of PE investments?

PE investment provides certification, networking, skill transfer, and financial benefits to the company.

Generally, PE investment is based on thorough scrutiny. Access to PE funds certifies that the company is of high quality. PEI has to constantly monitor the working of the company for sustainability and growth. PEI apart from financing provides networking access, and transfers of knowledge and capabilities.

What is seed financing, start-up financing, and early financing?

The first three stages of the company’s life stages are seed financing, start-up financing, and early financing.

Seed financing focuses on Research and development (R&D) of a product/service. Successful R&D generate patents and upon necessary approval they become products. Seed financing follow 100/10/1 rule which denotes that if 100 ideas are screened 10 are selected for funding and ultimately 1 alone would be successful.

In start-up financing stage, PEI provides funds to the enterprise to buy fixed assets.

In early growth financing, financial needs are normally met by banks but if the need is huge it is met by PEI/VC. VCs provide seed, start-up, and early growth financing. PEI provides hands on approach by providing all necessary support for the sustainability and growth of the company.

What is expansion financing, replacement financing, and vulture financing?

Expansion financing is financing the growth process of the enterprise. It can be internal growth in the form of investment in new assets, increase in working capital or external growth through mergers and acquisitions. PEI provides money and if required acts as advisor and consultant.

PEI screen and scout the market, negotiate with potential target and provide funds to venture backed company and receive shares. PEIs also provide legal and taxation related support.

Replacement financing is financing a company that is in matured stage. The deals can be in the form of leveraged buyouts (LBOs), Private Investment in Public Equity (PIPE), and Corporate Governance deal.

In LBOs, the role of PEI is to identify the potential target. The acquiring company creates a separate entity called ‘Special Purpose Vehicle’ (SPV) to raise funds from banks and PEI. Banks provide debt while PEIs provide equity.  SPV’s asset (cash) is utilized to buy Target Company’s equity. These deals can be through negotiation, hostile takeover, or public offer.

PIPE is buying shares of public company and selling it to another buyer not related to the company. These deals are not through stock exchange.

Vulture financing is financing a company when it is in decline stage. It can be for restructuring the business or during distress. PEI provide finance for buying assets such as brand, patent, expensive machinery either to sell or to use them.

 Next, we shall discuss on PE formats.