Private Equity as Source of Risk Capital for Small Business

Private equity and the categories businesses that can be attractive to private-equity firms

Private equity is a term that is used to refer to the long and medium-term finance that is provided to unquoted company that has a potentially high growth rate in exchange for an equity stake in the company. The term private equity also has varied applications. To some commentators, it refers only to the buy-out, buy-in investment sector. In other markets such as Europe, but not the USA, the term ‘venture capital’ is commonly used to cover all stages that relate to confidential impartiality (Bender 2014). In classified fair play, shareholders make unswerving savings or coup d’états in non-publicly listed corporations. However, if such direct investments or buyouts are made in listed companies, the companies are immediately delisted. Private equity is commonly used to finance start-ups, injection of capital into a growing company, or even in the acquisition of a mature company. In other cases, such financing is used to strengthen a company’s balance sheet. The five categories of private equity endowments include enterprise resources, expansion funds, mezzanine investment, coup d’état, and special situations.

In venture capital, financing is done in the early stages of high-potential growth companies such as those in the high-tech industries such as Information and Communication Technology and Biotechnology (Atrill 2014). This category has three main stages, which include seed funds commencement resources and development capital finances for relatively young companies. Often referred to as risk investment, enterprise asset has the highest risk of loss, but at the same time, the highest potential for maximum returns. The second category of private equity is referred to as development capital. Growth capital is used to finance important milestone transitions or transformations for a company (Thompson & Martin 2005). A company that attracts growth capital financing is already able to generate revenue, although it is not enough to finance events such as expansion, acquisitions, or other investments. Another category of private equity is referred to as mezzanine capital (Gompers & Lerner 2010). In this financing, an organisation receives capital as a subordinated debt or preferred equity instrument that is in many cases used as a last resort to fill any gap in a firm’s capital structure.

Buyout is another category of private equity. It refers to the process where an equity financing leads to a change of ownership, management, or a company strategy. In the buyout system, the financier acquires a significant share or a controlling stake in the company (Oanda, Chege & Wesonga 2008). A good example of such buyouts is in the case of acquiring a listed company with the aim of delisting it through public-to-private-transaction. Buyout requires large capital bases. Hence, it is financed through the fund’s equity and borrowed capital. It involves mature firms that are facing consolidation, expansion, or turnaround challenges.

The last category of private equity is the special situation. In this category, various special situations that arise in a company include secondaries, which refer to the sale of the existing private equity investment to another financial investor or a limited partner. Another example is the distressed fund, where investors purchase a company’s debt with the view of acquiring a controlling stake. They hope that profits will be achieved through the reorganisation of the company’s operations and balance sheet.

One of the key reasons for private equity investment is the desire of the investor to attract high returns from companies that have a high potential for growth where the investment is used to stimulate this augmentation. In other words, for companies to be attractive to the private equity investment, they must show the potential for high growth. This potential translates to high returns for the investors in the short and long-term period (Davidoff 2009). Some of the firms that are exceedingly attractive to private equity financing are mostly found in the power segment, information and expertise subdivision, and the media and leisure area. Firms in these sectors have a very high potential for growth and elevated rates of return (Cumming & Johan 2013). In most cases, these companies are highly attractive to investors since they have high potentials of being market leaders in their segments. Start-ups or young companies in this sector can easily take over a market through first-mover advantage in a fast growing market.

Another key factor that makes businesses attractive for private equity is a clear exit strategy for the investors. In most cases, shareholders want to participate in a business and leave it within an average of 5 years. As such, having a clear exit strategy such as an initial public offering, private placement, acquisition, a merger, or a management buyout is essential for a company to attract private equity financing (Davis et al. 2011). Lastly, the most important factor is the ability of a business to offer significant financial returns. Many investors are looking for profits of more than 50%. Hence, if a company proves that it has the potential to achieve such returns, it becomes easy to attract private equity financing (Axelson, Stromberg & Weisbach 2009). Consequently, the attractiveness of a business to private equity financing can be broken down into three areas that include sectors such as the energy sector, the availability of an exit strategy, and the potential for financial returns.

Key issues for the board of directors to take into account when deciding whether to use private equity finance

The decision of whether to use private equity finance or not is not an easy one. It requires a deep consideration of various factors before it can be agreed upon. One of the most and vital things for the board of directors to put in mind is that private equity finance is not the only source of financing and that it is not always the best source of financing for any business. Sometimes, it comes with a heavy cost to a business and hence the need to consider various options before settling on this one.

The first issue that the board of directors of a business must consider is the performance of the business and its future prospects. In this case, the questions that should be asked include whether the business is growing at a high rate or whether it has the potential for high growth (Davies & Crawford 2014). The second question should be focused on whether the company has a robust management team that is ambitious enough to keep this growth. A high growth rate for a company means that the business has to be prepared to handle the increased demands that come along with an expanded business (Acharya et al. 2013). Another important factor is the competitiveness of the company in its industry. For example, the board of directors must consider whether the company has unique competitive products or services, or whether it has a selling point that other companies do not provide. In addition to these considerations, the human resource of a company is very vital. The board of directors must consider whether the management team has the skills and experience in the industry where the organisation operates (Lerner, Sorensen & Stromberg 2011). Such considerations ensure that the company is aware of its strengths and weaknesses in its business and management segment before accepting private equity finances.

The second issue to consider is whether the company needs private equity financing. The motivation for asking this question is because private equity financing means selling and losing a portion of the company to other people. As such, it is important for a company to consider these questions thoroughly. Firstly, there is the need to critically consider the reasons why the company needs financing (Grant & Jordan 2012). This goal can be achieved through the scrutiny of both external and internal financial resources that are available to the firm and whether such finances are working optimally for the company. Firstly, for internal finances to work optimally, there is a need to be sure that cash flow management is good to avoid wastage and other unnecessary hindrances to the availability of finances in the firm. There is also the need to have a good system of forecasting cash flow in place (Metrick & Yasuda 2010). For example, by ensuring that customers pay promptly, the company will ensure adequate flow of income into the company, which can effectively eliminate the need for private equity financing. Another important step involves the company having adequate controls of its credit procedures where suppliers are paid on time (FitzRoy, Hulbert, & Ghobadian 2012). Other measures include maximising sales and controlling overheads to a minimum. In the event that managing overheads becomes difficult, a decision to hire a financial advisor by the board of directors should be highly welcome. Another option is hiring a contractor to help the company to reduce or eliminate the need for external financing.

Lastly, in the event that the company still needs external financing, it must consider the pros and cons of each financing avenue before settling on the private equity financing (Lerner & Schoar 2005). For instance, if the company can raise most of the required finances, it will be better to use loans for financing, despite the risk of debt that comes with it. However, if the company demands high amounts of finances, it will have to opt for equity financing, which is not a debt, unlike loans (McLaney & Atrill 2015). Equity financing is payable only on profits that the company makes and hence it is not a cost to the company. In addition, there is no limit on how much finances can be accessed through private equity financing. Hence, it acts as a very important avenue for getting large financing for major activities of the company such as expansion, introduction of new products, and new markets (Phalippou & Gottschalg 2009). Consequently, when the board weighs all options that are available to the company to avoid private equity financing, it becomes apparent that equity financing is the option of accessing finances to propel the company forward to better profitability and more stability in its industry. However, it is important also for the company to be very careful on which private equity financiers it allows to invest in. The firm must consider record of accomplishment, experiences, financial capability, ability to pull other investors, and other factors to ensure a long-term and a successful investment where each party, especially the business, will benefit (Kaplan & Stromberg 2008). Without such considerations, private equity financing can easily turn out to be the undoing of a potentially good business.

Factors that a private-equity firm will take into account when assessing an investment proposal

Private equity firms are made of smart and highly professional investors whose main aim is to make a profit from their investments. As such, before a firm qualifies for private equity financing, investors put many decisions and issues into consideration. Firstly, private equity financials look for a company’s market position and sustainable competitive advantage. Such companies may be market leaders (or have the potential to become market leaders) based on their business models (Melicher & Norton 2011). For instance, companies, which operate in a market segment that has elevated joining obstacles, elevated adjusting expenses, and well-built client associations, are good candidates for private equity financing. On the contrary, companies, which are in market segments that have low barriers to entry or have no competitive advantages, can be easily be driven out of the market. Hence, they are not attractive to private equity due to the high risk that is involved in their financing.

The secondly most important factor that private equity financiers consider is the avenue for growth that a company has in store. For instance, companies that have multiple avenues for growth and a balanced and diverse growth strategy are very desirable as opposed to others that rely on just one growth driver (Grant 2013). These growth factors include expansion through fresh merchandise, latest places, new clientele, and amplified infiltration to the existing client base. Such factors are key indicators that a company is likely to record increased revenues and profits, which will translate to better returns for the company.

Another important factor that companies consider is the level of capital expenditures. In this factor, private equity financiers look for companies that have low capital expenditures. Fr example, some companies require continuous reinvestment to be successful. In such cases, it becomes highly difficult for private equity to achieve any returns (Kaplan & Schoar 2005). Consequently, such companies that have high capital expenditures are unattractive to the private equity, which looks for businesses that require no continuous capital injections. The implication is that the company is a position to generate its income and revenues to attain profits for the investors.

Private equity firms also consider the industry trends for the company in which they are considering to invest. In this case, market analysis is a critical factor since it indicates whether the market segment is booming, or declining (Campbell, Edgar, & Stonehouse 2011). For example, some market segments such as those that focus on technology or pharmaceuticals are highly lucrative. If the company offers a differentiated and high-quality product in this segment, the growth can be exponential. In such a case, such companies become highly attractive to private equity firms. Hence, they have a higher capacity to attract private equity financing (Lynch 2012). On the other hand, companies that operate in declining or stagnating segments do not guarantee the high returns that private equity firms require. Hence, they are not priority choices for private equity firms.

The other important factor that private equity firms consider before investing is the management team. A good management team is a vital factor for a successful company (Lerner, Sorensen & Stromberg 2011). Such a team has a high motivation and the will to take the company to the next level. Hence, the team is the highest and most valuable asset for any organisation. It is worth noting that while a private equity firm can provide finances for a myriad of activities to another firm, only a strong management team can translate such financing to profitability and high returns to the organisation and its investors. Consequently, a strong management ensures that a company is in a better position to grow and ensure good returns to the investors. This factor is highly considered and desirable to potential private equity financiers.

Private equity firms also consider the steadiness and reliability of cash flows. Indeed, this aspect is one of the most vital investment criteria of consideration. The reason for the importance of this factor is that private equity firms typically need a target that includes reliable cash flows that can meet their required interest payments. For instance, a bad cash flow that results in missed debt payment can lead to losses on PE ownership through the bank takeover. Such a situation must be avoided at all times (Acharya et al. 2013). Consequently, while doing due diligence, private equity firms must be sure that the cash flows are steady and reliable to increase the chances of high returns for the private equity firms.

To effectively identify the factors that private equity firms need to consider before investing in a certain industry, a thorough due diligence process is critical. In this case, private equity firms carry out a detailed analysis of a firm to ensure that such investments have a high potential for returns. Such due diligence involves questions that relate to competitive landscape and market position, industry growth trends, customer and supplier base, capital requirements for the business, financial performance from both past and projected records, quality of earnings, debt status of the company, normal working level of capital, tax structure, and information technology (Axelson, Stromberg & Weisbach 2009). Others considerations such as the legal status of the company, including contracts and benefits plans among others are also part of the thorough due diligence that private equity firms put into consideration.

Company examples

Private equity has been used to grow companies exponentially in their market segments. The success stories are abundant. However, it is worth noting that not all private equity financing deals work as expected. Losses often arise. A good example of success story is Facebook. Since the company started in 2004, the social media network tech company has attracted a whopping USD$1.3billion in private equity financing. The resources have propelled it to the world’s largest social media network site. Attracting such finances is not easy. It can only mean that investors who supplied their resources in the company saw the potential it had and hence made the choice of investing their money in Facebook (Thompson & Martin 2010). With the recent IPO of Facebook, the company has been able to ensure high returns for investors. The figure is estimated to be at more than 53%, which is a success story. Another example of private equity financing is that of Burger King where Goldman Sachs Capital Ventures invested USD$23billion buyout in 2002 (Lerner, Sorensen & Stromberg 2011). Although this initial buyout failed due to the breakdown of Burger King to meet its performance obligations, the two companies later agreed on a buyout of USD$1.5billion.

Not all private equity deals are smooth. After considering all factors, private equity firms often end up making losses, when things do not work out as expected. For instance, one of the largest private equity deals involving Energy Future Holding collapsed spectacularly after the company filed for bankruptcy protection in 2014. Previously, the company had undergone USD$45 billion buyouts. The figure is one of the biggest in the world. However, the company could not change its fortunes for the better. The situation led to its eventual bankruptcy protection filing.

While private equity financing is becoming a common aspect of the current business world, it is obviously not as easy as just investing money in a company. Instead, the financing mode is a thorough and vigorous process that requires a company to make sure that it indeed requires such financing before inviting other shareholders. In addition, the process requires the private equity firm to carry out proper due diligence to ensure that the company where investment is directed to has the potential to offer high returns on investment among other major factors. Companies that are highly attractive to private equity firms include those that operate in high growth market segments such as technology, energy, and pharmaceuticals. However, as discussed above, other important factors must be considered.

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