What is private equity investment, what are its types and how to analyze private equity

Most of you know about funds that invest in publicly listed companies. However, some funds invest in companies not listed on the exchanges. Private equity (PE) investment involves the allocation of capital to privately held companies in exchange for equity ownership.

The distinction brings a unique set of opportunities and challenges that appeal to investors seeking alternative avenues for portfolio diversification and long-term growth. In this article, we look at the details of PE investment.

What is private equity investment?

Private equity investment refers to the allocation of capital to privately held companies in exchange for an ownership stake. These are different from investments in public companies, as unlike them, where shares of companies are traded on stock exchanges and available to the general public, private equity investments are made in companies that are not publicly traded.

Private equity investors, often referred to as private equity firms or investors, typically consist of institutional investors such as pension funds, endowments, foundations, insurance companies, and high-net-worth individuals. These investors pool their capital together to form investment funds, which are then managed by professional investment professionals known as General Partners (GPs).

The primary objective of private equity investment is to generate attractive returns for investors by acquiring ownership stakes in companies and actively participating in their management and operations to drive growth and profitability. Private equity firms typically take a hands-on approach to investment, working closely with company management to develop and implement strategic initiatives aimed at creating value.

Private equity market in India

The private equity market in India has witnessed significant growth and evolution over the past few decades, emerging as a key component of the country's financial ecosystem. With a burgeoning economy, a large and dynamic consumer market, and a thriving entrepreneurial ecosystem, India has become an attractive destination for private equity investors seeking high-growth opportunities.

India’s private equity industry has evolved with a broadened investor base that quadrupled from 200 to 800 active investors since the early 2010s, diverse pools of capital, and acceleration in buyout capital for quality assets. The industry has also benefited from the innovative digital infrastructure, supportive regulatory landscape, and deepening maturity of founders and talent.

Some popular PE firms in India are Chrys Capital, Kotak Private Equity, Sequoia Capital, and Blackstone Group.

Types of private equity investors

Here are a few different types of private equity investors:

Venture Capital: It specializes in providing early-stage and growth-stage capital to startup companies with high growth potential. These firms typically invest in innovative businesses in technology, healthcare, biotechnology, and other high-growth sectors. Venture capital investors may also provide strategic guidance and operational support to portfolio companies to help them scale and succeed.
Family Offices: Family offices are private wealth management firms that manage the financial affairs of wealthy families and individuals. Family offices may allocate a portion of their investment portfolios to private equity investments, seeking long-term capital appreciation and diversification. Family offices often take a direct investment approach, co-investing alongside private equity firms or other investors.
Sovereign Wealth Funds (SWFs): These are state-owned investment funds that manage the wealth of a country's government or its central bank. These funds typically invest in a diverse range of asset classes, including private equity, to generate long-term returns and support economic development objectives. Sovereign wealth funds may invest directly in private equity transactions or allocate capital to external private equity managers.
Pension Funds: These are institutional investors that manage retirement savings on behalf of employees. These funds invest in a variety of asset classes, including private equity, to achieve long-term investment returns and meet pension obligations. Pension funds may invest directly in private equity transactions or allocate capital to external private equity managers through fund-of-funds or separate accounts.
Buyout funds: These specialize in acquiring controlling stakes in established companies to implement operational improvements, drive growth, and ultimately exit the investment at a profit. Buyout transactions typically involve acquiring all or a significant portion of a company's equity through a combination of equity financing and debt financing.
Specialized Funds: These funds focus on investing in specific sectors, industries, or asset classes, leveraging their expertise and domain knowledge to identify and capitalize on investment opportunities in niche markets. They may target sectors such as technology, healthcare, real estate, energy, infrastructure, consumer goods, and financial services.

How does Private equity work?

Like any other fund, the goal of private equity is to generate returns for its investors. However, the process here is slightly different compared to other funds. In this section, we look at how PE works by breaking the journey into different steps.

Step No	Stage Name	Description
1	Raising Funds	Private equity firms raise capital from various sources such as high-net-worth individuals, pension funds, endowments, and insurance companies. These funds are typically pooled together into a fund managed by the private equity firm.
2	Identifying Investment Opportunities	Private equity firms seek out potential investment opportunities. These could include distressed companies, companies with growth potential, or companies that can benefit from operational improvements.
3	Due Diligence	Before investing, private equity firms conduct thorough due diligence on the target company. It involves analyzing the company's financials, operations, market position, competition, and growth prospects.
4	Investment	Once a suitable target is identified and due diligence is completed, the private equity firm invests capital into the target company. This investment could take various forms such as equity, debt, or a combination of both.
5	Value Creation	After investing, the private equity firm works closely with the company's management to implement operational improvements, strategic initiatives, and other changes aimed at increasing the company's value.
6	Exit Strategy	Private equity firms typically have a predetermined timeline for their investments, usually around 3 to 7 years. During this period, they work towards improving the company's financial performance and operational efficiency. Once they believe the company has reached its full potential or a favorable market condition arises, they exit their investment.
7	Exit Options	Private equity firms can exit their investment through various means, including selling the company to another company or another private equity firm (trade sale), conducting an initial public offering (IPO) and selling shares to the public, or recapitalizing the company.
8	Returns Distribution	When the investment is exited, any profits generated are distributed among the investors in the private equity fund according to the agreed-upon terms. These profits are typically shared between the private equity firm and its investors, with the firm often taking a percentage of the profits as fees.

How to analyze private equity?

Analyzing private equity investments involves assessing various factors to determine the potential risks and returns associated with investing in a particular opportunity. The process is slightly different compared to analyzing other funds. Here are the details:

Investment Thesis: Understand the investment thesis behind the private equity opportunity. It includes the rationale for investing in the target company, the expected value creation strategies, and the potential exit opportunities (as covered in the above table).

Management Team: Evaluate the quality and experience of the target company's management team. Strong leadership with a track record of success is crucial for executing the investment thesis and driving value creation.

Financial Performance: Analyze the target company's historical financial performance, including revenue growth, profitability, margins, cash flow generation, and capital structure. Project future financial performance based on the investment thesis and potential operational improvements.

Exit Strategy: Evaluate potential exit options and timing. Consider factors such as market conditions, industry trends, potential acquirers, and the likelihood of achieving an optimal exit valuation.

Risk Assessment: Identify and assess potential risks associated with the investment, including industry-specific risks, market risks, regulatory risks, operational risks, and financial risks. Develop mitigation strategies to address these risks.

Before you go: How to invest in private equity?

If you are interested in PE investment, it may not be easy for you to get started easily. One of the biggest hurdles for retail investors is the high minimum investment size. You may have to invest a minimum of Rs 5,00,000 to make PE funds part of your portfolio. Before you take the first step, investors need to understand the regulatory framework governing private equity investments in India, including foreign investment regulations, securities laws, tax implications, and regulatory compliance requirements.