Private equity is finance provided in return for an equity stake in potentially high growth companies. However, instead of going to the stock market and selling shares to raise capital, private equity firms raise funds from institutional investors such as pension funds, insurance companies, endowments, and high net worth individuals. Private equity firms use these funds, along with borrowed money and their own commercial acumen, to help build and invest in companies that have the potential for high growth.
Private equity carries a different connotation depending on where you are in the world. In Europe private equity represents the entire range of the investment sector that includes venture capital and management buy-outs and buy-ins. Conversely, in the US, private equity and venture capital are treated as separate types of investment and both are generally seen as mainstream sources of capital for businesses. This in part reflects the higher level of sophistication of US scene as compared to Europe.
Often the source of confusion, in Europe venture capital is a specific component of the private equity industry and refers to when funds used to invest in companies in the seed (concept), start-up (within three years of the company’s establishment) and early stages of development. In turn, private equity denotes management buy-outs and buy-ins, whether it is classified as small (less than £10m equity invested), mid (between £10m £100m invested) and large (greater than £100m equity investment).
In general venture capital funds invest in companies at an early stage in their development when they often have little track record of profitability and are cash-hungry. In contrast, private equity funds invest in more mature companies with the aim of reducing inefficiencies and driving business growth through often increased margins and/or new sources of revenue growth.
Private equity is simply one method of corporate ownership. Sometimes the governance structure and the aligned interests of owners and management make it easier and quicker to develop companies or turn them around.
Some of the findings from the “Private Equity portfolio company performance through the recession” report, sponsored by the BVCA and produced in 2011 by academics from the Centre for Management Buy-out Research (CMBOR) and the Credit Management Research Centre, provides an insight as to the robustness of private equity backed investee companies. Here, the financial performance of a sample of private equity -backed buyouts was tracked from 1995 and the start of 2010, and compared to a matched sample of private companies, non-PE-backed buyouts and listed companies. One of the key findings was that private equity-backed buyouts show a stronger economic performance in the period before and during the recent recession than a matched sample of private companies and listed companies. In addition to robust interest coverage on debt and higher gross margin, private equity-backed buyouts show a 5% higher return on assets and 14% higher productivity in the recession period than before it.
This is a company in which a private equity or venture capital firm invests. The portfolio company (can also known as the investee company) is said to be a part of the total holdings of the private equity or venture capital fund. In that sense, those individuals who manage the private equity or venture capital fund also referred to as the General Partners therefore hold a controlling stake within the respective investee company.
Following two decades of strong growth, the UK private equity industry is playing an increasingly significant role as a revenue generator within the financial and professional services industries. The UK is the largest European centre for the management of private equity investments and funds (Private Equity, The City UK, 2011). It is second only to the US in terms of global importance.
According to the BVCA’s own Performance Measurement Survey 2011 (PMS), there are 501 funds managed in the UK by the BVCA-member firms eligible for the Survey. We therefore, believe this makes it the most comprehensive dataset to date and the most complete country specific survey on the aggregate performance of private equity funds in the world.
Further analysis based on data collected by the BVCA from its members as part of the Report on Investment Activity 2011 indicates that private equity funds managed in the UK currently back around 3,800 companies, employing around 1.2m people on a full-time equivalent basis (FTEs) across the world. Of these, around 515,000 FTEs are employed in the UK.
The performance of private equity-backed companies significantly strengthens the UK economy and improves our international competiveness. Therefore, this indicates that the benefits of private equity and venture capital are felt beyond the immediate investors to the asset class and to the wider society. The economy as a whole gains from the new and innovative technologies and companies created within small and medium-sized enterprises, or the firms requiring capital so they can expand abroad, or those companies that have unfortunately come under hard times and require rescue/turnaround capital and expertise to lead them on to a new and sustainable path.
According to the latest annual report on the performance of the largest UK companies owned by private equity firms in 2010 as recommended by the Walker Guidelines, revenue, profit, and employment grew in the year 2010 as compared to the previous year. Employment in the economy as a whole declined by 1.3%, but private sector employment saw a rise of 0.9%, versus 0.2% growth for portfolio companies. Labour productivity at these companies also saw a modest improvement.
Generally private equity seeks to create value over the long-term, whereas hedge funds have a shorter horizon more in line with movements in the stock markets. Private equity investors usually buy and own all of a company and so have a strict alignment of interests with the managers of the company – this ensures the investors and the company achieve its growth potential over time and indeed they only succeed if the company does well and their investment can be realised.
Hedge funds are pools of capital that invest in stocks, bonds or commodities and do not usually purchase a controlling interest in a company. Hedge funds try to capitalise on short-term market movements, using complex trading strategies involving options, derivatives and other financial instruments. In some cases, hedge funds bet against the shares of the companies they do not own (i.e. short selling), hoping to profit from falling prices.
Having worked through six economic downturns since 1978, private equity has the ability to respond to changing market and macro-economic conditions. As a result of the credit crunch of 2007/8, capital-constrained banks no longer lend money like they have in the past. With this shortage of capital, large deals have become scarce. Because private equity is an incredibly flexible industry, it has the ability to respond to the rapidly changing market conditions. The report “Private Equity portfolio company performance through the recession” shows that during the recent recession, productive efficiency and profitability was stronger than comparable private firms and listed companies during the recession period. This evidence supports the view that private equity is resilient to the downturns in economic conditions.
A sustainable business is one that is capable of continuing into the future. Social and environmental factors have a fundamental impact on the sustainability of a particular business. Some within the industry are actively targeting investment opportunities arising from social and environmental shifts. For example, new types of clean technology can make more efficient use of natural resources, water and renewable energy.
The industry as a whole is well-positioned to proactively embed social and environmental analysis into investment decisions through extensive due diligence and its inherent medium- to long-term focus. The active engagement of fund managers with their portfolio companies and focus on growth does add value. With companies eager to trumpet their green credentials, private equity and venture capital will only enhance their portfolio companies by aligning their business strategy to this global trend. More insight on the attitudes and practices regarding environment, social and governance (ESG) issues prevailing amongst the BVCA member base can be found in a survey of around 80 senior industry professionals produced in November 2011 and entitled 'Evolving views of sustainability'.
All private equity and venture capital firms in the UK are regulated by the Financial Services Authority (FSA). in response to the increased demands of its investors and the self-recognition of the industry for it to do more, in November 2007, the industry set up an additional self-regulatory regime. The Walker Guidelines and the supporting Guidelines Monitoring Group (GMG) provide a set of rules and established oversight and disclosure comparable to those faced by FTSE 350 companies.
The Walker Guidelines are completely voluntary and apply to private equity firms that invest in large companies: in a public to private transaction where the market capitalisation, together with the premium for acquisition of control, or in a secondary transaction where enterprise value at the time of the transaction is in excess of £350; and those that have raised more than 50% if their revenue in the UK or have more than 1,000 employees. Through their annually published reports our member firms have gone further than anywhere else in the world in reaching for greater transparency. These reports can be accessed at http://www.walker-gmg.co.uk/?section=11664
We have over 25 years of experience representing the UK private equity and venture capital industry, which is the largest European centre for the management of private equity investments and funds. We express the needs and thoughts of our members to domestic policymakers, the media and to regulatory and statutory bodies here, across Europe and the world. We promote the industry to entrepreneurs and investors, as well as providing services and best practice standards to our members. We are the industry body representing the majority of the UK-based private equity and venture capital funds and their advisors, with over 500 members as of December 2011.
The ultimate aim of private equity investors is to create value. As such, they look for high quality management teams with a credible plan to grow their business. Private equity investors are long-term investors and work with the company’s management to improve the company’s performance and strategic direction by aligning incentives, improving business plans, making operational improvements and strengthening corporate governance. With this mentality to buy and help build, coupled with a disciplined approach to organisational governance, private equity investors display a nimbleness and adaptability that raises the value of their investment and ensures that value can be realised in the future.
The attraction of private equity investment to a company and to the management is the opportunity for managers to own a significant portion of their business. Aligned interests between the managers and the investors fosters the sense of ownership that is central to the concept of private equity investment. Besides the infusion of capital, companies also benefit from the experience and insight that fund managers bring to the board room.
According to a 2010 survey, entitled’ What do business leaders think about private equity and venture capital?’, conducted by the BVCA, ninety percent of senior portfolio company managers surveyed stated that private equity backing was beneficial to their business, with almost 40% of this reporting that it was highly beneficial.
The credit crunch has brought with it significant challenges. The agility of the private equity industry’s has also meant it can take advantage of opportunities as they present themselves. In this way, private equity firms have invested in debt-distressed businesses particularly affected by the downturn. By taking advantage of adverse market conditions, private equity firms inject more capital to pay off a company’s creditors and clear its debts, sometimes buying back its own debt at a discount. While, some of the larger private equity firms have established separate distressed-debt funds as a further restructuring strategy to take advantage of suitable investment opportunities.
Private equity adds value to a company in a variety of ways. Thorough due diligence sheds light on a company’s strengths and weaknesses alike, and with it comes a sound initial investment rationale. By targeting growth sectors and new markets, private equity investors can focus on creating better revenue generation and implementing programmes that yield operational efficiencies. In addition to cost reduction, organic growth is now increasing in importance as growth by acquisition is becoming relatively harder to undertake.
It is also critical to establish a structure in which both investors and business managers share a common ownership vision, and are motivated to maximise value. Active ownership, effective organisational change and powerful incentive schemes are all part and parcel to the hands-on governance model that includes constant and keen oversight, defined goals and timing, disciplined decision-making and deep resources to match. Ultimately, this approach leads companies owned by private equity to outperform similar publicly-owned companies with relative benchmarks.
As is the case with private equity investors, the ultimate goal of venture capital investors is to create value. However, contrary to private equity, which looks for already established businesses and explores new ways to boost their value, venture capital often deals with businesses that have little track record to speak of.
At times venture capital backs promising concepts or technologies. It also supports entrepreneurs in finding and developing their business model so that they can bring their product to market, satisfy a business or consumer need and create genuine value. Since the businesses are nascent, venture capital investors will take a disciplined and holistic approach in 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 even brighter entrepreneurs, with the desire and motivation to see their idea through to success.
Venture capital-backed companies are at the start-up to expansion stage of their lives and therefore have a huge growth potential. Often with little or no track record, these companies rely on venture capital backing to meet their potential. They often use venture capital funding for product development and marketing, to set up their manufacturing and sales operations and to expand their business by employing new staff.
A university spin-out describes an idea or concept that is born in a university or similar academic setting and is transformed into a feasible product and brought to market. Put another way, it is the commercialisation of academic research that is usually backed by university grants or external funding. Universities usually devote resources through external partnerships, for instance with venture capital firms, so that academics can find entrepreneurial support and financing needed to convert a bright idea into a business. Spinouts are common in areas such as biotechnology and life sciences, and high-tech electronics.
Venture capital invests in concepts or businesses at the very early stages of their development. In today’s difficult financial climate, as credit becomes scarce and banks become more risk-averse, venture capital becomes an important inward investment source for businesses that have little track record and budding technologies.
With the UK having one of the best pools of academic and corporate research, access to R&D in Eastern Europe and a blanket of mobile networks and high broadband penetration permeating the consumer market, UK venture capital is poised to take advantage of the opportunities within Europe and generate strong returns. Significantly, some of today’s fastest-growing technology companies, including medical research and clean energy companies, are backed by venture capital. According to a BVCA’s report entitled “Is venture capital a public good?”which surveys contemporary academic literature on the role of venture capital, we infer that one way to measure the level of innovation in a company is to look at the number of patents it submits. Another report “Benchmarking UK Venture Capital to the US and Israel: What lessons can be learned?” prepared for the BVCA by academics, compares US VC-backed companies to non VC-backed companies. The authors show that the former are more innovative and produce more patents, are faster in developing their products and introducing them to the market.
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