Private Equity: What You Need To Know

May 3, 2023
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Private equity and equity funding are two terms that often confuse most people as they sound the same. However, they are entirely different. Equity funding is the practice of selling a piece of a company's stock in order to generate capital. In private equity, as compared to public equity, buyers buy shares in a business that is not openly traded on a stock exchange. The money could be used for expansion, acquisitions, or a combination of these by the business requesting it.

What is private equity?

Private equity refers to funds that are not traded publicly. It is made up of funds and investors who put money into privately held businesses or who participate in buyouts of publicly traded companies, leading to the delisting of their shares of stock. Capital for private equity comes from both institutional and individual buyers, and it can be used to do things like purchase new machinery, increase working capital, and strengthen the balance sheet.

Private Equity Investors

Investment is channeled through a private equity company, which receives funding from private equity investors. Individuals, venture capital firms, trade groups, and large organizations like pension funds and insurance businesses are all possible sources of money.

Investment by shareholders who become part-owners of the business and whose returns are tied to the company's financial success.

The private equity industry is focused on making a profit. At some time, private equity investors will want to cash out of their investment and look to maximize their return on investment or return on money. One goal of the transaction is to allow the private equity owner to get out. This means that private investors will likely look for businesses where they believe management can be strengthened or where assets can be put to better use.

Debt could be used to finance the private equity venture. In this model, as opposed to private equity investors, the financiers take on the company's performance risk. For instance, if the new endeavor fails, the financiers might not get paid back and might have to resort to the company's current assets as collateral.

When buying businesses that they intend to reorganize and then transfer for a profit, private equity firms frequently turn to loan funding. One of the primary ways private equity companies increase profitability for owners is through the use of debt funding, which lowers the tax obligations of corporations.

As a result, there are typically three distinct types of debt, with the highest-risk and highest-reward categories belonging to "junior" debt (which has no priority over senior debt in terms of cash flows or assets) and "mezzanine" debt (which ranks just below senior debt and has a rate of return roughly equivalent to the prime rate). Each level of debt (senior, intermediate, and junior) may be placed in its own Special Purpose Vehicle (SPV) to shield investors.

It is possible to have a holding company (a "Holdco") that buys the junior debt, an intermediary vessel (an "Intermediate") that buys the mezzanine debt, and a real running company (a "Bidco") that buys the superior debt.

The claim's proximity to the properties gives it a priority.

A typical private equity transaction

Private equity investment funds are pools of money amassed from many different sources, including large financial institutions like pension funds, and sold to individual buyers. Private equity investment funds do not run any businesses of their own but instead, make investments on their behalf.

Investment management is handled by a private equity firm, which also plays a pivotal role in sourcing potential investors and target businesses. When credit is required, the private equity firm will establish connections with lenders and handle the portfolio company's investment to maximize the investor's return when they sell their stake. (or the underlying portfolio investment company).

Private Equity Firm

Private equity (PE) firms, also known as private equity funds, are pools of capital that seek to make investments or acquisitions in businesses. The company's sole activity consists of acquiring and divesting businesses for investment reasons.

Money for private equity comes from limited investors/ partners (LPs). Institutional investors, such as pension funds, foundations, funds of funds, and other businesses money, are common LP investments. (which are simply investments that invest in other funds, not in companies). PE companies also attract the investment of wealthy people.

LP funds are managed by general partners (GPs). General Partners (GPs) run the day-to-day business of the company, including dealing with investors and running the businesses that have been purchased. (which become known as portfolio companies after acquisition).

Private equity firms earn money by collecting a yearly management charge of 2% to 3% of the assets under control and by keeping a portion of the earnings made from the sale of portfolio businesses (the "carry").

The management and day-to-day operations of the private equity fund fall under the purview of the private equity company.

The private equity company may seek the counsel of an outside fund manager or financial adviser.

Investment advisors receive an administration charge, and the private equity company earns 'carried interest' if the fund is successful.

The portfolio company is also responsible for paying the financial adviser a portfolio company commission.

Rules for Deals Involving Private Equity

Governed by a number of statutes and regulations, including:

  • The Companies Act,
  • The Collective Investment Schemes Act (No. 45 of 2002),
  • The Banks Act (No. 94 of 1990),
  • The Financial Advisor and Intermediary Services Act (No. 37 of 2002),
  • The Financial Markets Act (No. 19 of 2012),
  • The Income Tax Act (No. 62 of 1962),
  • The Trust Property Control Act (No. 19 of 2012) and
  • The Trust Property Control Regulations (No. 28 of 1956).

Private equity firms can also register with SAVCA (the South African Venture Capitalist voluntary association).

Concerns about control, openness, and accountability in the private equity business necessitate the implementation of regulations.

The nomination of investors to the board of directors of the portfolio investment company is one example of a governance problem that can emerge when trying to make the portfolio company act in the best interests of private equity investors. As a result of being subject to both common law personal obligations and the requirements of the Companies Act, these members will inevitably find themselves in a position of tension. There is a lack of government supervision and legislation for this type of business because the arrangements between the parties are primarily private.

Pension funds are common institutional participants in private equity funds; as such, the private equity fund must meet the standards outlined in rule 28 of the Pension Funds Act in order to be eligible for investment by pension funds.

Maximums for certain retirement fund investments are spelled forth in Regulation 28. They are meant to serve as a framework for separately managed investment accounts. Regulation 28 stipulates that a unit trust's maximum value may not exceed the fair market value of the assets of the fund that are directly under the control of the trustees, with the following exceptions:

  • insurance policies,
  • that provide any form of guarantee or,
  • where performance is linked to the performance of underlying assets, and the investment of the underlying assets satisfies the requirements of regulation 28.

Broad upper bounds are seen:

  • No more than 75% may be invested in stocks and bonds
  • No more than 25% may be invested in real estate
  • No more than 90% may be invested in a mix of stocks and bonds
  • No more than 5% may be invested in the sponsoring employer
  • No more than 15% may be invested in a large capitalization listed equity
  • No more than 10% may be invested in any single other equity
  • No more than 20% may be invested with any single bank
  • No more than 15% may be invested off-shore

In exceptional cases, the Registrar may grant a request for an exemption from part or all of these limits.

Private Equity Investment Strategies

The two primary forms of private equity financing techniques are;

  • Private equity buyouts, including leveraged buyouts and management buyouts.

In a leveraged buyout, a private equity firm uses a special purpose vehicle (SPV) to acquire a majority interest in the target company's stock while using a combination of loans secured by the target company's assets and equity to pay for the acquisition. Senior debt, mezzanine debt, and junior debt are the most common types of debt taken on by a special purpose vehicle, with the SPV and the target business being jointly and severally responsible to the investor. Key management for the target business would then be secured by the private equity firm, either through the target company itself or through the recruitment of key managers. Compliance with section 44 of the 2008 Companies Act is necessary if the target company's assets are to be used as security for a loan used to purchase shares in the target company. This section mandates that the following conditions be met before such financial assistance can be provided:

  • The board authorizes the company to provide such financial assistance;
  • A special resolution of the shareholders is passed;
  • The solvency and liquidity test is met;
  • Fair and reasonable financial terms

It's a financial problem whether or not the SPV can subtract the interest it pays on the debt when figuring out how much tax it owes under subsection 24J of the Income Financial Act. The phrase "management buyout" refers to a takeover of a designated business by the company's upper management. As part of the acquisition funding, a private equity firm may work with the target company's management to establish a "special vehicle company" to purchase the target firm's stock. The SPV will have two shareholders—the private equity fund and the company's administration, with the latter owning a larger stake. If the purchaser is willing to foot the bill for the acquisition, the deal can be structured as vendor financing.

  • Venture Capital

Investment capital with a high potential for both loss and gain is known as venture capital and is typically offered to new and tiny businesses. For cutting-edge innovations like gadgets and merchandise, it's a must-have. If a purchaser purchases stock in a venture capital firm, they can offset their costs under Section 12J of the Income Tax Act. The private equity firm is likely to engage in the venture company through the issuance of transferable or convertible preference shares, the value of which lies in the fact that their holders receive dividends before other shareholders.

Cumulative preference shares, non-cumulative preference shares, and cumulative convertible preference shares are all possible types of preference shares.

The venture investor will likely demand input into business strategy, membership on special boards or groups, access to regular financial reports, and the ability to veto specific purchases or other actions taken by the company. A separate agreement between the company and the investor may be necessary for the investor to participate in meetings, confer with management, receive financial statements, have rights of pre-emption or rights of first refusal with respect to the company's shares, enter into a restraint of trade with respect to management, maintain Trade Secrets, have representations and warranties that the Financial Statements are true and correct, and have covenants and conditions precedent.

CONCLUSION

The goal of private equity is to capitalize on differences in efficiency between government-owned and privately-owned businesses. Without the transparency provided by public marketplaces, private companies may be valued less accurately, resulting in lower profits. Private equity can reduce exposure to public market risk and cycle risk, making it a useful tool for portfolio diversification. Most people who engage in the stock market do so through index funds, which put a set percentage of their money into each company that makes up a specific benchmark.