What is Private Equity? Definition of Private Equity, Private Equity Meaning and Concept

Definition of venture capital or private equity refers to investment strategies that invest in the capital stock of a private company (which are not listed on the stock market), such as issues of private shares or issues related to the capital stock of private companies.

Investments in venture capital are usually associated with greater risk than investing in stocks on the stock market, but also (perhaps because of this) returns are also usually higher. Another characteristic of this type of investment strategy is that the investment horizon is usually long-term, having a fairly high illiquidity component.

Characteristics of venture capital

In summary, we can conclude that venture capital broadly has the following common characteristics:

  • Invests in unlisted companies. In fact, the idea that arises from venture capital is, on the one hand, to finance small and medium-sized companies (through capital injections) and, on the other, to make the investment of those who lend these funds profitable. The brokerage commission (which can be fixed or variable) is what the venture capital entity takes. There may be exceptions in which you invest in an unlisted company, but it is not usual.
  • The investment horizon is between 4 or 10 years, and can be extended if the state of the economy where said company operates requires it (external factors).
  • The profitability of this type of investment is usually around 20% ( IRR ). It comes from the difference between the purchase price and the sale price plus dividends, although normally when investing in companies in a period of expansion, they reinvest the profits.
  • Venture capital invests in companies in the growth phase for the most part.
  • Apart from the funds that are injected and that serve as financing to the company, a professional from the venture capital entity normally sits on the board of directors.
  • The management team is, in most cases, what makes the difference in the companies under investment. Well, it is the only guarantee that the venture capital professionals selected by companies have. It is not the only thing he looks at, but also the business plan of the company and its future cash flows.

In the venture capital process, there are three particularly important moments that always occur in the same way.

  • Fundraising: The money is collected by the venture capital entity that will be used to invest in the portfolio companies.
  • Investment: Through the venture capital fund.
  • Divestment: This is one of the most important points in the whole process. There are several ways in which a venture capital entity has to get out of the capital of the company.
    • Sale of the shares on the stock market through an IPO (through a public offer for sale )
    • Shareholders who were already in the company can buy back the shares from the venture capital company.
    • Shares can be sold to a third party in a private transaction.
    • It may be the case that the company is liquidated due to insolvency.

Investment types

The four different types of investment that fall within the realm of venture capital include:

  1. Venture capital : Capital financing for companies in their first phase of life, startups.
  2. Leverage buyouts (LBO) or leveraged purchases: In this case they are public companies that are privatized by repurchasing public shares by borrowing money (financing).
  3. Mezzanine financing: A mix between private debt and equity financing.
  4. Distressed debt or distressed debt: Private equity investments in established companies that have financial problems or difficulties.

The structure of venture capital

In the structure of a venture capital, there are four interrelated parts:

1. Investors.

2. Venture capital entities.

3. Venture capital funds.

4. Portfolios of venture capital funds.

This structure may seem confusing, but the term "venture capital investment" appears at all four levels. To clear up some doubts, we have to understand the structure of private equity.

The entities equity have the role of intermediaries in the financial markets. On the one hand, they raise funds (from those investors who wish to obtain a high return) and on the other, they manage the investment of those funds. These firms operate with one or more venture capital funds. Limited partners, generally institutional investors and to a lesser extent wealthy individuals, provide the majority of the fund's capital. In this way, the partners invest in the venture capital fund instead of directly in the company. Each of the venture capital funds has a portfolio or portfolio of companies in which they invest the funds raised.

The Limited Partnership Agreement of the venture capital fund defines the legal framework of the association and it describes the terms and conditions for all parties involved in the fund.

The life expectancy of the fund is usually between 4 and 10 years with a possible extension of up to three years. The fund's shares are not registered with the Securities and Exchange Commission (SEC-), so they cannot be traded in public markets, that is, the stock market.

A venture capital fund invests in companies that are in a period of expansion, in this way what it does is sit on the board of directors one of its professionals from the venture capital entity to take the reins of the company and achieve make it more efficient.