Private equity as off-market equity

The term private equity refers to over-the-counter equity capital. This is equity capital that is not tradable on the stock exchange. This capital is provided primarily by capital investment companies that specialize in this venture. They are also called private equity companies (PEG). The capital is generated through various channels. As financiers serve banks, insurance companies and more rarely persons with a corresponding private fortune. The investment is mainly aimed at medium-sized companies, but sometimes also includes large corporations.

 

 

Where to invest private equity?

Off-market equity is invested with companies that have a balanced risk-return ratio. Ideally, they have high or constant returns. The capital is usually spent only for the current business, an additional need for research or development of products is often excluded. A transaction of equity takes place by means of a so-called leveraged buy-out (LBO), i.e. a high proportion of debt capital. The leverage effect is that there is an increase in equity for the PEG. The only condition is that the return on total capital must be higher than the interest on the borrowed capital used.

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Why invest in private equity funds?

Funders for private equity companies benefit from the possibility to participate in the capital market without being liable if the target company fails financially. You also remain anonymous through the financing of the fund. They have the disadvantage that they have to pay additional fees for managing the fund and that the PEG has a disproportionate profit share. Finally, the companies also help managers to buy their companies, for example. This process is also known as a management buy-out (MBO). Nowadays, industrial companies and insurance companies have already decided to act as PEGs.

Venture capital – a special form of private equity

Venture capital is a special form of equity capital. In this case, the money (for the money definition) is provided to young innovative companies that have great growth opportunities with their products, but also take on great entrepreneurial risks. This is called venture capital. The following characteristics are characteristic of venture capital:

• It concerns companies that have just been founded or are still in the middle of being founded.
• It is about new industries that are still in their infancy.
• The returns are not yet foreseeable at the beginning of the venture. Disproportionately large returns are just as possible as total losses.
• The investor not only provides money, but above all know-how, from which the usually inexperienced young start-up founders can learn.

The economic relevance of private equity companies

In 2000, private equity companies accounted for around 3 percent of corporate acquisitions. By 2004, the figure had risen to 14 percent. The economic volume had thereby an extent of 294 billion dollar. In order to buy up particularly large corporations, private equity companies formed bidding syndicates.

The financial market crisis has had a strong impact on the business of private equity companies. In 2009, the transaction volume in the German region amounted to just 1.1 billion. Euro. This corresponds to a decrease of more than 80 percent compared to the previous year. Worldwide, the volume of transactions that became known in 2009 amounted to 9 billion. Dollar. 120 billion two years earlier. dollars.

How private equity companies operate:

The first phase

First the companies collect the money of the investors in private equity funds. With the money from the fund they then buy the majority of a selected company. In most cases, the companies use not only the money from the fund, but also additional loans. Since the company uses the loan as leverage to increase its return on equity, this is also referred to as a leveraged buyout. The loans are usually taken over by a company established specifically for this purpose.

Then the target companies are merged together with the acquiring company and the loans. The purchased company thus pays a large part of the purchase price itself (merger buy-out).

The second phase

This is followed by the second phase, which lasts between two and seven years. In this case, the private equity company itself intervenes in the management of the company. In order to meet the fund's return targets, measures are implemented to increase short-term profitability. In this way, the company should be made attractive for a quick resale. In addition, the company allows the target company to take out further loans, at the cost of which it then distributes special payouts to itself (recapitalizations).

The third phase

The third phase follows. The target company is sold and the PE company leaves the management again. This can be the case, for example, after an IPO or after an off-market resale. It is also possible to sell the company back to the former shareholders.

The regulation of private equity funds

The financial market crisis has led to greater regulation of various investment funds. The AIFM Directive (Alternative Investment Fund Managers), which was adopted by the European Commission in December 2010, is particularly relevant here. By 2014, it had been transposed into national law in all EU member states.

This Directive regulates all those alternative investment fund managers that are not subject to the UCITS Directive. Among other things, this stipulates that all funds are subject to supervision by the German Federal Financial Supervisory Authority (BaFin). In addition, private investors are no longer allowed to participate in hedge funds. In this way they should be protected from risky investments.

The leveraged buy-out

Private equity transactions are in most cases a leveraged buy-out. This means that the investment is largely realized through debt capital. This is the case even if the company has collected financial equity capital. The leverage effect is of particular relevance for the buyer's expectation. As the use of own funds is low, the return on equity is particularly high. The important thing here is that the return on total capital is higher than the interest on borrowed capital. This in turn requires that the company's cash flow is sufficiently high to repay its liabilities.