What is the private equity firm?
A Private equity firm can be defined as a company that invest huge amounts of capital known as the private equity fund in the stakes of a private firms. In other words, private equity firms invest in classified equities of working companies through application of various investment strategies. From the definition, private equity means capital that is not traded in the stock exchange markets (Bruining et al. 593).
In most cases, private equity firms raise private equity capital from institutional investors and devote the capital in public firms that face delisting from the stock exchange through buyouts.
Private equity capital is normally used in the expansion of working capital of the acquired firm, make acquisitions, finance research and development as well as new technologies. In addition, the private equity capital can be invested in strengthening the balance sheet of an acquired company.
As indicated, private equity firms are often institutional and recognized investors committed to long-term returns on investments. Since private equity firms invest in companies that are almost collapsing, they often require longer periods for the acquired firms to turn around in order to start earning back investments.
In most cases, private equity firms normally apply venture capital, leveraged buyouts as well as capital growth as the investment tactics (Bruining et al. 595). Leveraged buyouts are the situations where private equity firms invest in a nearly collapsing public firm risking delisting from the stock exchange market. Leveraged buyouts involve purchasing huge debts of the firm with the hope of reselling once financial conditions have improved.
The injected funds are used to improve financial statements as well as prospects of the firm. Essentially, Private equity firms are perceived as the sponsoring companies since they provide funds for investments. In other words, private equity firms support other companies through the provision of financial assistances. In most cases, private equity firms normally raise funds, which they invest in private equities depending on the applied investment strategy.
How and when did private equity firms first started?
Prehistory of private equity firms
Investments in private companies can be traced back to the beginning of industrial revolution when investors were involved in private acquisitions and mergers.Merchant bankers in the financial industry were often involved in making small investments on privately held companies. In addition, financial institutions were acquiring other firms particularly in the mining industry as well as other profitable firms in public sectors (Chemmanur et al. 4039).
Such acquisitions were equated to the current industrial buyouts where private equity firms buy large public corporations that are nearly collapsing. In fact, the buyouts and acquisitions continued throughout the first half of the 20th Century before the development of the current venture capital.
In addition, the first half of the 20th Century was characterized by legal limitations on banks and other financial institutions that constrained the transactions involving private acquisitions (Chemmanur et al. 4039). Moreover, such regulations restricted the flow of capital from the merchant banks to the private firms.
In fact, the private equity firms started to come into existence after the denunciations of financial regulations that put limitations on the flow of capital. Besides, the lifting of the regulations also led to the emergence of venture capital. Venture capital provided funds as well as other factors that contributed to the growth of private equity firms particularly after the Second World War.
The emergence of private equity firms
Private equity firms emerged in 1940s when the development and growth of venture capital and leveraged buyouts were at the peak. In fact, the venture capital and leveraged buyouts were considered part of the private equity firms. Davila, Foster and Gupta argue that the growth and development of venture capital and leveraged buyouts also led to the development of private equity firms 691.
The venture capital provided funds that were greatly required at the time for the development of private equity firms. In addition, leveraged buyouts were part of the capital markets where institutional investors used to participate in the establishments of private equity firms.
Even though venture capital and leveraged buyouts grew and developed in analogous and unrelated paths, they offered suitable market for the establishment of the private equity firms (Bruining et al. 595).
Private equity industry developed particularly in 1946. The established and well-structured venture capital market during the time led to the development of private equity firms. The venture capital provided the much needed funds as well as technical expertise in the management of private equity firms (Bruining et al. 595). The establishment of venture capital brought to an end the shortage of funds that was required for the development of private equity firms.
As indicated, the widespread of equity firms particularly after the Second World War was due to organized private equity market. However, during the period, the equity market was still underdeveloped resulting into the shortage of sources of long-term financing for private equity firms. Due to this inadequacy, the private sector took the opportunity to develop new markets for private equity firms.
The markets offered cheap and long-term sources of capital for existing and newly established firms (Bruining et al. 595). In addition, the new sources of funds established novel grounds for the startup of new equity firms. Essentially, developments of the equity markets that provided long-term and cheap funds resulted in mushrooming of new equity firms.
In addition, the private sector was responding to an economy that had increased funds particularly from the released wealthy military inductees. In fact, there was need for large firms to absorb such capital. In order to come up with such firms, a private sector that would attract large institutions was required. During this time, technical and managerial skills to manage the funds were also inadequate (Chemmanur et al. 4039).
The American Research and Development Corporation (ARDC) was established in 1946 to research on equity firms and their markets as well as to provide adequate advice on ways through which such firms could be developed. In addition, the ARDC was also tasked with the responsibility of raising funds for investments in equities. Moreover, ARDC was to provide training on the private equity management skills needed for the success of private equity firms.
ARDC was majorly formed to boost private equity investments and became the first institution to raise capital and invest in equity. In addition, ARDC took advantage of floating funds from wealthy individuals.
The corporation tapped the floating funds and invested in other areas including mergers and acquisitions that were equally profitable. Besides, ARDC invested in venture capital and was credited as the architecture of the current ventures capital (Chemmanur et al. 4039).
The growth and development of private equity firms from 1946-1980
The growth and development of private equity firms were at a slow progress in the first 36 years since the establishment of private equity firms. In fact, small volumes of private investments, undeveloped private firms’ management as well as unpopularity of private equity firms marked the period (Chemmanur et al. 4039). The smaller volumes in the private equity investments were due to lack of awareness among the institutional investors.
In fact, institutional investors in the early 1960s and 70s were not aware of the presence of private equity firms. Essentially, most of the institutional investors lacked adequate information concerning the operations of private equity firms. In addition, scarce skills and capital required for the success of private equity firms lacked (Chemmanur et al. 4039).
What are the main functions of private equity firms in the economy?
Attracting investment funds
Like most large firms in the economy, private equity firms have greater roles to play in the economy. Private equity activities normally began by successfully attracting investable funds. In other words, the major function of private equity firm is to attract funds that can easily be invested in the economy (Achraya et al. 368).
Offering alternative investment opportunities to the investors
Private equity firms offer alternative investment prospects particularly where some sectors of the economy perform poorly. Moreover, while attracting investable funds, the private equity firms provide ways through which investors can allocate part of their investments in comparatively complicated, long-term investments.
Probably, sectors where investors can apportion their finances for enduring repayment range from pension funds to sovereign wealth funds. In these areas, individual investors are assured of their long-term benefits through appropriate management practices that private equity firms offer.
Investments in small, medium and large enterprises
Private equity firms offer capital to firms of various sizes within the economy. In addition, private equity firms offer funds to all companies in different stages of their life cycle. In fact, firms that are in infant stages can easily get soft loans in private equity firms. Additionally, Small and Medium Enterprises (SMEs) can also seek expansion capital from equity markets.
Most importantly private equity firms normally fund firms that are just about to be liquidated. Besides funding, such firms are also provided with managerial skills as well as other incentives that would enable their continuity. Moreover, family businesses that need succession arrangement also seek assistance from private equity firms (George et al 215).
Private equity firms provide managerial functions
One of the major functions of private equity firms is the provision of managerial expertise. Industries in which private equity firms invest have increased benefits from the function. In fact, firms that are managed by private equity companies normally benefit from improved information arrangement as well as enhanced business control capacities.
In addition, private equity firms have the capability of introducing performance-based incentives aimed at enhancing performance of the invested companies. Further, private equity firms management tends to have increased control of novel management approaches and provides extensive value added post-investment support.
Increased capital investments
The attraction of investments funds into the economy leads to increased investable funds into the economy. The private equity firms have the capability of attracting investable funds, which increase capital that can be used by other businesses from various sectors of the economy. Statistics indicate that private equity firms have attracted over $250 billion for investment capital in the last financial year (George et al 215).
In market-based economy such as US, the private sector is perceived to be the major driver of economic growth. As such, private equity firms play critical roles in attracting and increasing capital for investment in the private sector. Therefore, private equity firms fuel economic intensification through the provision of investment funds. In addition, private equity firms facilitate increased private sector investments thereby inspiring economic growth
New business creation and sustainable investments
The funds invested by the private equity firms result in the creation of new businesses, which in turn lead to the generation of new jobs. In addition, private equity firms invest in businesses that are almost being bankrupt thereby ensuring their long-term sustainability. Such firms are critical for the growth of the economy (Cressy et al. 661).
Besides, sustaining the firms also mean maintaining the existing jobs as well as increasing the prospect of creating novel employment. Essentially, private equity firms promote the creation of new business through the provision of capital and management advice.
In addition, through maintaining the existing firms, private equity firms contribute to the preservation of employment opportunities. Besides sustenance and creation of businesses as well as jobs, private equity firms are also a source of positive externalities.
Positive externalities are benefits enjoyed by the third parties. In fact, increasing the knowledge base particularly in management and entrepreneurship increases multiple benefits that can only be described as positive externalities.
Improved management methods
Private equity firms have the capability of improving the managerial skills of various companies in which they have invested. In fact, the private equity management often has constructive influences on the performance procedures in terms of profitability and growth on firms in which they have invested (Chemmanur et al. 4040). In addition, private equity firms have the capability of ensuring that firms that are collapsing are provided with financial and management impetus in order to enhance their productivity.
Through such measures, private equity firms ensure the survivability of firms across various sectors in the economy. Besides, firms having succession planning challenges often seek assistance from private equity firms. Private equity firms provide appropriate advice on succession arrangement, which ensures long-term sustainability and growth.
Greater innovation
Private equity firms foster innovation through various activity outcomes in the economy. In fact, through the provision of improved managerial skills, firms become innovative and entrepreneurial. One of the ways through which innovation can be enhanced is through investments in research and development. Putting funds on development of new products enhances the innovative culture within the firm.
Private equity firms not only fund research and development on new products and services but also other operation processes undertaken within the firm. Moreover, private equity firms invest in start-up firms that tend to be innovative.
Increased productivity
Private equity firms improve the productivity of businesses through various activities. In fact, there is a direct relationship between increased productivity and economic growth. Increased productivity results from efficient production as well as use of resources (Bruining et al. 601). Essentially, private equity firms promote measures that aid in the efficient production and use of resources.
The private equity firms provide improved management as well as advice on better resources utilization. One of the ways in which firms can improve their efficiency is through appropriate training on management. Acquiring better management skills particularly in efficient use of resources is one of the ways through which organizations improve their productivity, which translate into general economic growth.
In addition, capital accumulation is encouraged through investments made on the fixed assets such as factories, housing units and production equipments. Private equity firms have large pools of capital that can be invested in such fixed assets. Such investments in fixed capital increase labor productivity.
The provision of capital for investments in physical capital contributes hugely to the economic growth. Further, by supporting the formation of new businesses, increased employment opportunities are created. Substantial growth in the economy can only be realized when firms are capable of sustaining the creation of new employment opportunities.
Enhanced competitiveness
Firms with enhanced productivity have increased chances of being competitive at all levels in the market. The reason is that profits earned can be re-invested in other areas that provide the firm with increased competitive advantage. Besides, increased productivity contributes to economic competitiveness when it results in the amplification of firms’ competitiveness both at the local and global markets.
Increased economic competitiveness ensures enlarged economic expansion. Essentially, private equity firms contribute to increased economic competitiveness through enhanced productivity. Besides, increased economic growth is directly associated with trade exports.
Private equity firms encourage economic growth in a number of ways. First, private equity firms support export-oriented companies. Additionally, private equity firms augment the capability of export-oriented companies to develop into worldwide markets.
How do private equity firms operate and make profit?
Private equity firms invest in classified equities of working firms through the application of various investment strategies. Actually, investment approaches of private equity firms encompass venture capital, leveraged buyouts and capital growth. Private equity firms are perceived as sponsoring companies since they provide funds for investments.
In other words, private equity firms support other companies through the provision of financial assistances. In most cases, private equity firms normally raise funds, which they invest in private equities depending on the applied investment strategy.
Essentially, private equity firms normally raise investment funds commonly referred to as the private equity capital from various financial institutions particularly pension funds and insurance companies to finance and sponsor investments.
A fee is charged on every investment made. The fees charged together with prearranged share of profit are the earnings of private equity firms on the investments made. In other words, private equity firms get carried interests on every private equity fund put in investments.
In most cases, private equity firms get hold of considerable minority position in some of the firms they have invested. Once the sizeable marginal position has been accomplished, private equity firms optimize the expected outcome of the invested capital. Initial Public Offerings (IPOs) are significant methods through which investment returns are conveyed back to the owner.
Besides, private equity firms get returns on their investments when the firms they manage are sold through mergers and acquisitions. Recapitalizations are also applied in order to realize the gains though at minimal occasions.
In the initial public offerings, shares of the firm are offered to be bought by the public through the capital markets particularly at various stock exchanges. The public offering provides fractional and instantaneous realization of returns to the private equity firm, which is normally the sponsor. In addition, IPOs offer the private equity firms with markets in which they will later sell its shares.
Through mergers and acquisitions, the firms being managed are sold out or merged with performing firms. Private equity firms realize the returns from sales proceeds. In the case of a merger, private equity firms have shares of profits made by the new firms that result from the mergers.
One major characteristic of private equity firms is that they make long-term investments in less liquid assets and have direct influence on the operations of firms. In addition, private equity firms take charge of the firms’ operations in order to supervise any potential risks and accomplish the required development through long-term investments.
What are some of the advantages of private equity firms in terms of disclosure and accounting regulations over other publicly-traded firms?
Private equity firms operate like private companies. Therefore, private equity firms gain from the accruing benefits because of less restricted financial reporting and legal requirement. In other words, private equity firms are not exposed to stringent financial reporting and legal regulations.
The less reporting requirement procedures have increased benefit to private equity firms. The benefits range from increased control of the decisions made to elimination of double taxation on their shareholders.
Greater control of the firm’s decisions
With reduced reporting requirements and substantially decreased pressures from shareholders and markets, private equity firms have increased flexibility in terms of operations.
As such, private equity firms focus attention towards achieving long-term growth instead of quarterly earnings that are part of the financial reporting requirements in other publicly traded firms. In addition, due to reduced shareholders expectations and approvals, private equity firms have the capability of making decisions and taking action without the approval of the shareholders.
Increased benefits from Securities and Exchange Commission (SEC) exemptions
The private equity firms are exempted from some of the Securities and Exchange Commission (SEC) filling requirements as well as other post-offering duties. In fact, private equity firms are exempted from some of the federal financial security regulations and obligations such as reporting on the shareholders’ discussions, investors’ conferences as well as research analysts’ discussions.
Such regulations have been found to be costly, consuming much of the firms’ time and have negative effects on productivity. In fact, most public firms argue that the effects of SEC regulations on the productivity of the firms are unpredictable.
The stringent disclosure requirements of SEC such as filling annual and quarterly reports are generally additional accounting and legal expenses. Therefore, exemptions from SEC regulations have drastically reduced accounting and legal costs for the private equity firms.
Private equity firms reduces the cost of going public
Private equity firms normally reduce various regulatory costs associated with going public. In fact, private firms going public usually go through a range of processes including restructuring as well as implementation of new accounting regulations and procedures. The restructuring process is designed to avoid possible issues that may come about due to SEC filing requirements.
The restructuring process normally involves reforming the structure of the organization and capital, bookkeeping procedures and practices, material convention, equity participation policies as well as the employment conformities.
In addition, detailed disclosure documents must also be prepared for the new investors. All the requirements are costly in terms of finance and time. Private equity firms sponsoring public offerings are normally exempted from the detailed SEC requirements thereby reducing the costs of going public.
Reduced chances of disclosing sensitive information
Private equity firms are not required to disclose details of their operations. As such, the chances of revealing sensitive information that can be used by the competitors are reduced. In fact, non-disclosure of the operations and financial outlook of private equity firms are added competitive advantage over other publicly traded firms. Competitors can use the information to point on the weaknesses, which can be used to reduce the firms’ reputations as well as erode the clients and shareholders confidence particularly during the financial turmoil.
Free from shareholders activism
In most cases, regulations require that the financial institutions as well as hedge funds buy over 50% stake in any public firm. Buying over 50% stake mean that the financial institutions can gain control over the operations of the business. As such, the majority shareholder can influence the sales as well as any considerable restructuring.
In fact, public firms that have been taken over by these financial institutions and hedge funds risk losing their entire stake. Since the requirement does not apply to private equity firm, they normally gain minority stake on firms they have invested.
In fact, the firms do not risk losing their stakes to the private equity firms. However, private equity firms gain executive control in order to manage potential risks and realize long-term growth and development of the firm.
Is private equity firm the same as the private equity fund?
Private equity firms and private equity funds are normally being confused to mean the same thing. In fact, private equity firm and private equity fund have been used interchangeably in most of the scholarly articles. However, the two terms are different.
Essentially, private equity firms are companies that make long-term investments on both private and public corporations through the application of various strategies (Cressy et al. 649). Researches indicate that private equity firms commonly apply investment approaches that range from venture capital to capital accumulation.
On the other hand, private equity funds are finances that private equity firms invest on other companies. Besides, private equity funds are a pool of capital that private equity firms collect from institutional and retail investors in order to put in long-term investments through the application of various investments approaches.
The private equity funds earn profits or interests for the private equity firms. In other words, private equity firms earn a carried interest on every private equity fund that is put in investments (Cressy et al. 649).
What are some of the well-known private equity firms and where are they located
Consistent with most current rankings of private equity firms, the most popular and largest equity firms range from the Carlyle group to Bain Capital. The leading firms often make large purchases in form of buyouts. In other words, well known private equity firms invest directly on the companies instead of trading in private equity asset category.
According to the current categorization, the well-known private equity firms include the Carlyle group, which is situated in Washington DC, Kohlberg Kravis Roberts based in New York as well as Goldman Sachs Principal Investments Group that is also based in New York.
Also in the top position in terms of trading volumes include Blackstone Group headquartered in New York, TPJ Capital, which is based on both Texas and California and Bain Capital based in Boston, Massachusetts.
Works Cited
Achraya, Viral, Olivier Gottschalg, Moritz Hahn and Conor Kehoe. “Corporate Governance and Value Creation: Evidence from Private Equity.” Review of Financial Studies, 26.2 (2013), 368–402. Print.
Bruining, Hans, Ernst Verwaal and Mike Wright. “Private equity and entrepreneurial management in management buy-outs.” Small Business Economics, 40.3 (2013), 591–605. Print.
Chemmanur, Thomas, Karthik Krishnan and Debarshi Nandy. “How Does Venture Capital Financing Improve Efficiency in Private Firms? A Look Beneath the Surface.” Review of Financial Studies, 24.12 (2011), 4037–4090. Print.
Cressy, Robert, Federico Munari and Alessandro Malipiero. “Playing to their strengths? Evidence that specialization in the private equity industry confers competitive advantage.” Journal of Corporate Finance, 13.4 (2007), 647–669. Print.
Davila, Antonio, George Foster and Mahendra Gupta. “Venture capital financing and the growth of startup firms.” Journal of Business Venturing, 18.6 (2003), 689–708. Print.
George, Gerard, Jonathan Wiklund and Shaker Zahra. “Ownership and the Internationalization of Small Firms.” Journal of Management, 31.2 (2005), 210–233. Print.