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 sources such as pension funds, endowments, and high net worth individuals. Private equity firms use these funds, along with borrowed money, to invest in underperforming 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.
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 invested), mid (greater than £10m and less than £100m invested) and large (greater than £100m invested).
In general venture capital funds invest in companies at an early stage in their development when they often have little or no track record and are cash-hungry. In contrast, private equity funds invest in more mature companies with the aim to eliminate inefficiencies and drive growth.
Private equity is simply one way of owning a company. Sometimes the governance structure and the aligned interests of owners and management make it easier – and quicker – to develop companies or turn them around. According to research conducted by Cass Business School in April 2008, private equity-backed IPOs (both venture capital and buyouts) accounted for a remarkable 22% of the total number of IPOs on the London Stock Exchange Main and AIM markets. This research also demonstrates that private equity-/venture capital-backed companies floated on the stock market outperformed similar companies that had not received investment from our industry.
This is a company in which a private equity or venture capital firm invests. The portfolio company is said to be a part of the total holdings of the private equity or venture capital firm and, therefore, leads to private equity and venture capital firms being referred to as a holding 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. There are currently nearly 450 private equity funds (or those that fall in this category) in the UK. The industry employs more than 9,300 people, of which over 6,100 are educated to degree-level. Including the financial, professional and business services sectors, there are close to 15,400 professionals across over 1,500 firms engaged either directly or indirectly in private equity-related activities.
The UK industry is the largest and most developed in Europe, accounting for 57% of the total annual private equity investment, and second only to the US in terms of global importance. According to a 2007 report measuring the economic impact of private equity in the UK commissioned by us, it is estimated that companies that have received private equity funding account for the employment of around 3 million people in the UK, equivalent to some 16% of the UK private sector employees.
The performance of private equity-backed companies significantly strengthens the UK economy and improves our international competiveness and, therefore, means the benefits of private equity are felt beyond the immediate investors in the wider society. The economy as a whole benefits from the new and innovative companies created, the mid-sized companies gaining access to funding allowing them to grow, and large companies that are turned around in order to remain competitive.
Public revenues receive significant contributions from private equity-backed firms. It is estimated that in 2007 they collectively contributed £4.6bn in PAYE & NIC, £11.9bn in VAT and a further £4.6bn in excise, etc – a total of nearly £35bn in taxes.
Generally private equity seeks to create value over the long-term, whereas hedge funds have a shorter horizon. Private equity investors usually buy and own all of a company and help it realise its growth potential over time and only succeed if the company does well. Hedge funds are pools of capital that invest in stocks, bonds or commodities; they do not usually purchase a controlling interest in a company. Hedge funds try to capitalise on short-term gains, 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 conditions. As a result of the credit crunch, strained 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. Private equity specialises in long-term investments, making it a growing player in what has become an increasingly uncertain economic environment.
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 and so on.
The industry as a whole is well-positioned to proactively embed social and environmental analysis into investment decisions through extensive due diligence, its medium- to long-term focus, its active engagement with its portfolio companies and its focus on growth and adding 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.
All private equity firms in the UK are regulated by the Financial Services Authority (FSA). However in November 2007, the industry set up an additional self-regulatory environment through the Walker Guidelines and the supporting Guidelines Monitoring Group (GMG) to provide a set of rules and establish oversight and disclosure comparable to those faced by public companies.
The Walker Guidelines are completely voluntary and apply to private equity firms that invest in large companies: those that have more than 1,000 employees; those with non-market transactions valued in excess of £500m (or £300m for public to private transactions) and those that have raised more than 50% of their revenue in the UK. Through their published reports our member firms have gone further than anywhere else in the world in reaching for greater transparency.
We have 25 years of experience representing the private equity and venture capital industry, which currently accounts for some 57% of the whole of the European market. We express the needs of our members to government, 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 400 members.
The ultimate aim of private equity investors is to create value. In turn, 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, revising business plans, making operational improvements and strengthening management itself. With this mentality to buy and build, coupled with a disciplined approach to organisational governance, private equity investors display a nimbleness and adaptability that drives the value of their investment up.
The attraction of private equity investment to a company and to management is the opportunity for management to own a significant portion of their business. Aligned interests foster the sense of ownership that is the core rationale for private equity investment. Besides the infusion of capital, companies also benefit from the experience and insight that fund managers bring to the board room. In fact, according to our 2007 study measuring the economic impact of private equity in the UK, many companies felt that their private equity owners had made a major contribution outside the provision of equity. This included strategic guidance beyond financial advice, providing vital market information and access to their contacts.
The credit crunch has brought with it significant challenges. However, the private equity industry’s agility has also meant it could take advantage of opportunities. As such, it has invested in debt-distressed businesses particularly affected by the downturn. By taking advantage of debt dislocations, 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. In addition, larger private equity firms can establish separate debt funds as a further debt restructuring strategy.
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 markets, private equity investors can focus on creating better revenue generation and greater operational efficiency. In addition to cost reduction, organic growth is now increasing in importance.
It is also critical to establish a structure in which both investors and key managers share a common ownership vision, and are motivated to maximise value. Active ownership, rapid 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 identifies ways to boost their value, venture capital often deals with businesses that have no track record to speak of.
At times venture capital backs concepts or ideas and supports entrepreneurs find and develop their business model in order to reach their goal of high growth and create value. Since the businesses 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 bright entrepreneurs, with the attribute 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 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 when an idea or business concept is born in a university or similar academic setting and transforms into a business. 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.
There is a correlation with venture capital and bright ideas being turned into viable businesses. This is because venture capital invests in concepts or businesses at the very early stages of their development. This relationship is only reinforced in today’s difficult financial climate, as credit becomes scarce and banks become more risk-averse, venture capital becomes an important investment source for businesses or business ideas that have little or no track record.
With one of the best pools of academic and corporate research, access to low cost 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 create strong returns. Significantly today’s fastest-growing technology, including medical research and clean energy companies, are backed by venture capital. Firms backed by venture capital invest more in R&D than other firms – up 12% (over the last five years) compared with 1% for businesses on average.
