What are private equity and venture capital?

Private Equity and Venture Capital Firms (General Partners, GPs)

Private equity is medium to long-term finance provided in return for an equity stake in potentially high growth companies, which are usually, but not always, unquoted. Generally speaking, regardless of whether a private equity fund is listed or not, their activities are similar. Investment opportunities are sourced and screened by private equity firms (also known as general partners, or GPs) in order to arrive at a valuation. The transaction will be financed using equity provided by LPs and in some cases debt raised from banks. The GP will then actively manage the investment for the holding period (typically five to ten years), seeking to generate operational improvements in order to increase the value of the company. In many private equity transactions, the managers at the portfolio companies will be retained and offered an equity stake in the company, in order to align the interests of both parties. This is one of the main reasons why private equity ownership is thought to be a very effective model with regards to corporate governance. Returns are realized for investors through exiting the deal; this can be through floating the company on a public stock exchange (IPO - initial public offering) or a secondary buyout, whereby the portfolio company is sold to another private equity firm.

Venture capital firms back concepts or ideas brought to them by entrepreneurs, or young companies looking for financing to help them grow. Since businesses at the concept stage are nascent, venture capital investors will take a disciplined approach to evaluating not only the viability of the business idea, but also the motivation and background of the entrepreneur. Ultimately, venture capitalists look for bright ideas and intelligent entrepreneurs who they believe will see their idea through to success, in exchange for a proportion of equity which fits the risk of the investment and amount of capital required.

Investors (Limited Partners, LPs)

Private equity and venture capital firms raise funds from institutional investors such as those below, as well as private equity fund managers themselves. Just as these investors seek to minimise risk by diversifying their portfolio and investing across the whole range of asset classes, private equity and venture capital have varying levels of risk associated within their investment strategies. The general partners will seek to minimise this by investing across a range of industries so as to reduce their exposure to market and economic conditions which may affect one sector more than another.

Pension Funds

Pension funds constitute the largest category of investors in private equity and venture capital funds and the largest proportion of funds raised are buy-out funds. Ultimately many of the investors are members of the wider public who contribute to pension schemes and collective saving funds and purchase pension products.

Endowments

These are generally funds created to aid the work of certain non-profit organisations; often universities. 

High Net Worth Individuals

Individuals who have large amounts of investable financial assets, typically over £1million.

Insurance Companies

Significant investors into private equity, which have large amounts of capital from premiums received.

Sovereign Wealth Funds

State owned investment funds that generally have huge amounts of capital to invest.

Family Offices

A professional firm that manages the investments, trusts and business affairs of a wealthy family.

Fund of Funds

These typically invest into many different private equity funds. This helps to spread the risk of the investments made whilst maintaining healthy returns. Smaller investors which do not have access to larger private equity funds due to capital constraints, often invest into fund of funds to increase their exposure to the asset class.

Investee Companies (Portfolio Companies)

There are various routes that companies and entrepreneurs can go through to raise finance for various business activities such as growing the company through more product lines and increase spending on R&D to develop services. These include raising debt, raising equity on public markets, or appealing to private equity. Companies at all stages of their maturity, from a business concept, to a multinational conglomerate may seek to raise funding in order to develop the business; these, and other factors will determine the route they choose.

Direct Investments

Investors may sometimes choose to invest directly into a business without investing into a private equity fund or a fund of funds. Investors may feel they have the expertise, or that risk is low enough for them to invest directly.

Seed

Investment to allow a business concept to be developed, perhaps involving the production of a business plan, prototypes and additional research, prior to bringing a product to market and commencing large-scale manufacturing. Seed investments are mainly undertaken by venture capital firms, although business angel capital is often considered. With a business angel on a company's board, it may be more attractive to a venture capital/private equity firm when later stage funds are required.

Start-up

Financing provided to companies for use in product development and initial marketing. Companies may be in the process of being set-up or may have been in business for a short time, but have not yet sold their product commercially. Although many start-ups are typically smaller companies, there are an increasing number of multi-million pound start-ups. This again is mainly an investment by venture capitalists.

Expansion

Sometimes known as 'development' or 'growth' capital, which is provided for the growth and expansion of an operating company which is trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital.

Replacement Capital

A minority stake purchase from another private equity investment organisation or from another shareholder or shareholders.

Buyouts

Financing to enable the current operating management and investors to acquire or to purchase a significant shareholding in the product line or business they manage from a larger entity. It can also mean the purchasing by a private equity firm of a significant, often majority stake in a business from the original owners who will stay on to manage the company with a reduced equity stake. Buyouts range from the acquisition of relatively small formerly family owned businesses to £100 million plus buy-outs. The amounts concerned tend to be larger than other types of financing, as they involve the acquisition of an entire business.