Private equity firms partner with a wide range of Australian businesses, supporting many of the products and services we know and love. Despite a prevalent myth that private equity is only for large corporations, it’s also used by small and mid-size businesses to launch products, recruit staff, grow their operations, and more.
While publicly listed companies can raise money by selling ownership – or shares – to anyone on a stock exchange, private companies don’t have this privilege. This is where private equity comes in. It’s one of the common sources of capital for small businesses.
But what is private equity and how can businesses use it?
What is private equity?
Private equity refers to a type of financing where a private equity firm invests money into a company that isn’t publicly listed, with the aim of increasing a company’s value before selling its stake for a profit.
Imagine a fledgling printing company struggling to grow due to limited funds. A private equity firm buys a controlling stake of the company – offering capital injection and strategic guidance – which enables it to develop a new product line, hire employees, and expand its customer base. The private equity firm can then sell its stake in the printing company for a profit, making it a win-win for both parties.
But a private equity firm brings more to the table than money and mentorship. They also offer operational expertise, which can help small businesses streamline their processes, boost profit margins, and scale more effectively.
How does private equity work?
Private equity investors identify companies with high-growth potential and raise a pool of capital to invest in them. This pool is called a private equity fund, which is led by a group of limited liability partners, including institutional investors, high net worth individuals, and pension funds.
When the fund reaches its fundraising target, private equity investors close the fund and invest the capital by acquiring equity stakes in promising companies. Private equity firms then work with investee companies to help increase their value. This could take the form of incorporating a new strategy or restructuring the company altogether.
When a private equity firm sells its stake in a company, it normally makes a profit and allocates returns to limited partners that invested in the fund.
What are the three main private equity investment strategies?
A private equity investment isn’t a one-size-fits-all solution. There are many forms of private equity available depending on the stage of the investee company’s lifecycle and investment goals. Having said that, investment strategies typically fall into one of three main categories:
- Venture capital: involves a minority, or non-controlling, investment in early-stage companies or startups with an unproven business model.
- Growth equity: describes a minority investment in more mature companies, which are experiencing rapid growth via a proven business model.
- Buyout: refers to the acquisition of a majority, or controlling, interest in mature companies.
Understanding private equity companies
A private equity company is an investment management firm with an ownership stake in its investee companies. It often has a pool of stakes in multiple companies, known as its portfolio, and the companies that make up this group are called portfolio companies.
Private equity is just one form of alternative investment. Others can include hedge funds and mutual funds.
- Hedge funds make short- and long-term investments in publicly-listed companies, whereas private equity firms typically make long-term investments in privately held companies.
- Mutual funds normally invest in publicly-traded companies where liquidity is offered to investors through daily trading, while private equity firms invest in private companies, which are illiquid assets. Furthermore, mutual funds raise capital from everyday investors whereas private equity funds are raised by accredited investors.
Key functions of private equity companies
Private equity companies play a critical role in the wider financial ecosystem. In addition to fundraising, here’s an overview of their other functions:
- Deal sourcing: private equity firms are always looking for investment opportunities, which are typically found through industry contacts, proprietary networks, investment banks, and other intermediaries.
- Due diligence: private equity firms scrutinise target companies’ financials, business operations, market position, growth potential and potential risks during the sourcing process to discover any underlying issues in the investment opportunity.
- Portfolio management: once an investment has been made, private equity firms manage portfolio companies to improve their performance and increase their value. This can be achieved by measures ranging from strategic direction to exit planning.
- Risk Management: private equity firms manage investment-related risks, such as regulatory shifts and market fluctuations, devising risk management strategies that safeguard investors’ capital and help ensure long-term success.
- Exit Strategies: one of private equity firms' priorities is to profitably exit their investments. Exit routes include everything from a management buyout to publicising the portfolio company via an Initial Public Offering (IPO).
PRIVATE EQUITY FIRMS ARE OFTEN MORE ENTHUSIASTIC IN THEIR SUPPORT OF SMALL BUSINESS AND MAY INVEST MORE MONEY THAN OTHER TYPES OF INVESTORS. THIS CAN PROVIDE A VALUABLE LIFELINE FOR BUSINESSES THAT MAY NOT OTHERWISE REALIsE THEIR FULL POTENTIAL.
Private equity funds
Private equity funds make their money by collecting fees for investment management and performance. To help calculate their fees, they apply the ‘2+20’ rule below.
- Management Fee: irrespective of a fund’s performance, a 2% fee is paid to a private equity company to cover operational costs incurred while managing the investment portfolio, such as travel.
- Performance Fee: conditional upon an investment being sold at a profit, the performance fee consists of 20% of any investment profit, which is paid to the private equity firm's employees to incentivise greater returns.
Both management and performance fees are calculated as a percentage of assets under management (AUM).
Advantages of private equity for small businesses
Small businesses can benefit from private equity in several ways, including:
Capital
Even the most promising small businesses can face challenges securing capital through traditional financing, such as bank loans.
Private equity firms can be more enthusiastic in their support of small business and may invest more money than other types of investors. This can provide a valuable lifeline for businesses that may not otherwise realise their full potential.
Control
With private equity, investors own a part of the company, but the owner(s) retain overall control.
Flexibility
Flexibility is important for small businesses, particularly in terms of how deals are structured, and repayments are made. Private equity firms may offer more advantageous terms than other investors and traditional lenders.
There are three main factors small-business owners should consider before partnering with private equity firms:
- Higher Fees: private equity firms can charge higher fees, which may dip into profits.
- Higher Interest Rates: private equity firms may also set higher interest rates than other investors.
- Loss of Control: although small-business owners maintain control of their company, they must still relinquish some control to private equity investors, who have a say in how the business is run.
Practical tips for small businesses considering private equity
Private equity partnerships are complex and multi-faceted, representing a significant milestone that may shape a business's future. Two major considerations for small-business owners considering entering private equity partnerships include:
- Goal alignment: being at odds with a private equity firm can be a small-business owner’s worst nightmare. It’s important to ensure that there’s alignment between the business goals and the private equity firm’s objectives from the outset.
- Exit strategy: to play the private equity game to win, it’s important to realise that it may not necessarily be a one-time deal. Consider planning for multiple exit opportunities, as multiple exits can equal multiple payouts.
Exploring cash-flow sources for business success
Private equity can be a game-changer for a small business. The injection of financial muscle and strategic expertise can take businesses to the next level. However, it’s critical to ensure that both parties have a shared vision for success, with alignment on key business needs and goals.
After all, private equity isn’t for everyone and there are certainly other cash flow sources to consider. But it’s worth bearing in mind that private equity isn’t just for big businesses, it’s for small ones, too.