Private Equity Fund : Meaning and How Does it Works?

Q: Who are the players in the private equity market?

The players in the private equity market are issuers or firms (where private equities invest in), intermediaries (which are private equity funds themselves), and investors (who are contributing capital to private equity firms).

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What is a Private Equity Fund?

A private equity fund is a shared or collective investment scheme that invests across equity and debt instruments. Investors of PE funds directly invest in private companies. It is an alternative investment option for HNIs and institutional investors. Thus, instead of investing in conventional assets like stocks, bonds, gold, real estate, government securities, etc., they can explore private equity funds. Since a private equity fund invests in companies that have a good potential to scale up, the prospective returns can be higher.

Private equity capital doesn’t trade on the stock exchange. Thus, the fund is not open to every individual for a subscription. This type of investment follows general investment criteria or particular investment criteria that are specific to an industry.

Private equity fund requires a higher investment amount, and the holding period is long-term. Thus, HNIs and institutional investors must have a long-term investment horizon and must be able to afford a large investment corpus.

The average tenure of a PE fund is between 5 to 10 years and also gives an option for an annual extension. After the tenure, the fund is closed, and the funds are returned to the partners. A group of investment experts from a private equity firm raise and manage the funds. They use the funds for large-scale purposes like making acquisitions, raising new capital, funding new technology and start-ups, investing in other private companies, etc.

Private equity funds offer a great chance to earn a high rate of return. However, the risk is high as well. Since the investment is done in private companies, the returns largely depend on the decisions made by the company’s management and its success.

Private Equity in India

Private equity (PE) and venture capital (VC) in India roared back from a slowdown caused by a pandemic in a big way in 2021. The PE-VC market reached about $70 billion in investments, and there was a lot of deal activity and a similar increase in exit momentum.

India’s investments grew 96% over 2020, which was faster than most major economies, including China (excluding the Jio and Reliance Retail deals).

India had a big year in 2021, and the market is likely to slow down a bit as it tries to build on its successes and move into a new phase with higher deal values, more exit opportunities, and a larger pool of high-quality assets.

Over the years, more than $200 billion capital was injected into India through Private Equity. PE has played a significant role in the growth and development of many Indian start-ups. Thus, the companies were able to fuel employment opportunities in the country.

India still remains attractive for various emerging businesses for raising capital across e-commerce, pharma, tech, financial services, health care, and IT sectors.

How Does a Private Equity Funds Work?

A private equity fund invests a pool of money raised by a group of investors or a private equity firm in private companies. The money is then put into a company or group of companies that have the potential to grow in the near future.

The idea is to give access to funds to companies that are struggling financially or that need money to grow or keep doing business. Since the company has the potential to get back on, a cash infusion can help them. Private equity investors step in at this point.

Private equity investors want to enjoy a return on their money as the company’s operations get better and it starts making money. But investors usually don’t participate in the company’s operations and decisions. However, they can give advice to the company’s leaders and strategize with them.

When the company turns around, the private equity investors can get their money back and exit their holdings.

Different Private Equity (PE) Investment Strategies

The following are different private equity investment strategies:

Venture Capital

The term ‘venture capital’ refers to a fund that makes investments in start-ups and small businesses with little or no access to external financial markets. These new businesses are typically only getting started, but they have great growth potential in the near term. VCs are a popular source of capital for start-up businesses that have promising growth and innovation. They don’t have any debt, and when the business is right, the returns can be significant. VCs have significantly contributed to the growth of start-ups in India.

Growth Capital

Growth capital funds private companies that lack the necessary assets. These are businesses that are unable to expand further using traditional finance methods because they lack the necessary assets.

Leveraged Buyouts

Leveraged buyouts differ from venture capital funds. In leveraged buyouts, the fund makes investments in larger businesses with added leverage (stake holding). Furthermore, compared to VCs, more money is invested.

When a business borrows a sizable sum of money in the form of loans and bonds to acquire another business, the transaction is known as a leveraged buyout. The goal of owning a significant share in a business for the long term is to manage the finances of the business to produce a sizable return. The PE companies reduce their interest once a reasonable value has been created and exit the company.

A leveraged buyout uses debt to pay for the acquisition. Only a small portion of the financing must be provided by the company carrying out the LBO (usually, debt financing accounts for about 90% of the cost).

A leveraged buyout’s investment goal is to produce returns greater than the interest on the loan incurred. This is an excellent way for the company doing the LBO to produce big returns with little cash at risk.

Turnaround Situations

When a business can’t pay off its existing debt, private equity capital can be a crucial source of funding. In this situation, the fund capital may be used, along with management-led turnaround measures, to stabilize the company’s balance sheet.

Advantages and Disadvantages of Private Equity Funds

Advantages

The following are the advantages of PE funds:

Funding: PE funds are a source of capital for companies that are debt free. Emerging companies can get access to a large corpus through seed funding. Thus, private equity is often a preferred way to raise money for start-ups and emerging businesses.
Untapped Market: Private equity is a highly untapped market with good potential for growth. The market comprises unlisted companies, unicorn start-ups and companies that weren’t doing well on the stock market and later became private. Thus, the wide options offer great investment potential.
Accountability and Selection Process: Private equity funds are managed by experts who follow a stringent select process while picking companies to invest in. They also take into account the risk factors and adopt risk-mitigating strategies. Furthermore, the management team is accountable to the shareholder for protecting their shareholder rights.
Returns: Since PE funds invest in emerging businesses, the potential for growth is very high. Thus, shareholders can enjoy significant returns in the long term.

Disadvantages

The following are the disadvantages of PE funds:

High Risk: As the PE fund invests in private companies, success largely depends on the company’s performance and management decisions. Though the potential returns may be high, there is a high risk of losing capital as well.
Closed Ended: PE funds don’t trade on the stock exchange, and hence liquidity may be a cause for concern. Also, these funds are closed-ended schemes that do not accept new subscriptions.

Frequently Asked Questions

What is the difference between Private Equity, Venture Capital and Hedge Funds?

Private equity funds put their money directly into businesses by providing funds to private companies to fund their financial obligations and be part of the growth story.
Venture Capital is a type of private equity and a type of financing where new businesses and small businesses get access to finances. VCs finance companies that they think will grow in the long run.
Hedge funds are a kind of alternate investment that uses pooled money and different strategies to make money for their investors.

Can individuals invest in private equity?

Mostly, accredited investors and qualified clients are the only ones who can invest in a private equity fund. Institutional investors like investment banks, public and corporate pension funds, endowments, insurance companies, foundations, wealthy families and high net-worth individuals can invest in PE funds.

Who are the players in the private equity market?

The players in the private equity market are issuers or firms (where private equities invest in), intermediaries (which are private equity funds themselves), and investors (who are contributing capital to private equity firms).

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