Sunday, September 16, 2007

Demystifying Private Equity

For all of the attention that the financial press has bestowed upon the private equity industry, it seems that none of these media outlets have explained what this private equity phenomenon is and how it may relate to everyday leaders of small or midsize businesses. Moreover, these reports often fail to describe what makes private equity a dynamic and growing part of today's economy for businesses large and small.

In spite of what the headlines may lead us to believe, there is far more private equity capital invested in small and midsize enterprises than the handful of massive transactions that are chronicled in the pages of business publications. The private equity market has become an increasingly important source of funds for start-up enterprises, private businesses, firms in financial distress and, more recently, public firms seeking privatization.

This is the first of a series of articles in Winning Workplaces' e-newsletter designed to demystify private equity along with other alternative capital markets, and to provide a roadmap to navigate the financial paths that can be foreign to many of us. Through future articles we will also illustrate how better-informed financial decision making can result in improved work environments and stronger organizational cultures.

Before delving further into the subtleties of capital markets, it is best to start by asking the most basic question: What is private equity? "Private equity" is a term most commonly used to describe the entire universe of venture capital investing, buyout transactions and mezzanine/subordinated debt placements. One may also add that private equity is broad nomenclature for any type of equity or debt investment in which the securities are not freely tradable on a public market.

While this type of capital is not a new concept, the categorization and institutionalization of it are new. Entrepreneurs have turned to friends and family members to secure funds to buy a company or start a new business for as long as there have been corporations. This informal source of capital, the original "private equity," is still believed to be the largest source of private equity to corporate America.

Only in the last 30 years has capital been widely organized into private funds where general partners find, structure and oversee investments on behalf of institutional limited partners. Pension funds, endowments, foundations, insurance companies, wealthy families and other private equity fund investors have recognized that the long-term nature of business growth is not always compatible with the short-term horizons of stock analysts and public investors. Additionally, investors have realized that many of the most exciting and rapidly growing businesses are outside of the public equity markets.

As a result of strong returns to early private equity investors, pools of capital have continued to be organized at a rapid pace with the goal of seeking out long-term investments in companies of all sizes that are in need of capital. There are now hundreds, perhaps thousands, of private investment vehicles that have been formed for this purpose, and some have further specialized to focus exclusively on specific industries, certain stages of companies (ie, start-ups or distressed businesses), particular strips of a company's capital structure (ie, mezzanine debt) or even ownership structure (ie, non-controlling positions or women-owned businesses).

Now that you are armed with a brief background on private equity, you may be asking, "When is institutional private equity the right capital for my company?" Of course, there are numerous factors that one should consider before taking on a private equity partner beyond the financial ones, but putting those issues aside which we will address in future articles let's first focus on the cost of capital. Most forms of private equity and debt will be more expensive than what your local bank can provide. Thus, firms that raise private equity tend to be those that may have difficulty seeking funding from conventional financing sources.

For example, firms may be unable to get bank credit to fund rapid growth; or a bank won't fund the buyout of an existing shareholder; or a business is experiencing an industry down cycle or the establishment of a new initiative; or perhaps a company needs a bridge loan through financial distress. These are all situations where private equity capital may on the surface seem expensive. Yet, it is likely a lot cheaper than the alternatives, such as not growing, staying wedded to an unhappy shareholder, not paying bills or even going out of business.

Private equity comes in all shapes and sizes. In future articles, we will address how to position your company to access capital from these types of outside sources, including private equity, and how capital and the sources of capital can play a significant role in workplace culture.


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