Understanding Private Equity Funds

Understanding private equity funds and what they can do for your business may be invaluable if you are contemplating sources of additional financing. Private equity investments play a huge role in sustaining entrepreneurship, funding over 50,000 deals valued at several billion dollars each year. What exactly is private equity? How do businesses attract such funds? What do private equity investors bring to the table and what do they expect in return? Answering these questions is the first step to understanding private equity funds.

By definition, private equity funds come from… well, private sources. We’re not trying to act smart here! Sources of private equity are usually high net worth individuals, those who have a few million dollars in loose change and looking to invest it into businesses with solid growth potential. Usually, the money from a core group of investors called the general partners is consolidated and a partnership firm is formed to manage the investments. Other entities such as pension funds and financial institutions are also invited to participate, most likely as passive financial investors. The fund is invested as equity for a limited time frame into several companies which are chosen on the basis of stringent criteria. Typically, private equity funds last about 10 years, by which time they would have exited most of their investments through various means.

An important part of understanding private equity funds is to recognize what makes them tick. Private equity investors are on the lookout for firms that can deliver significantly high returns; however, this usually means that they have to assume higher risk. It is widely observed that not all investments come up trumps, and therefore investors have to be prepared to lose their shirts with some. However, as long as the fund makes a profit on the whole, their purpose is largely served. Fund managers are compensated with a management fee, which is a percentage of the amount in the kitty, and a share in the profits. In truth, however, what they’re really after is an opportunity to eventually sell their stake at an enormous premium which could be three to five times their initial investment!

If you think that private equity financiers are merely sources of risk capital, you’re way off base. You can be sure that they will take an active interest in your business, especially since there’s a few million dollars involved. However, that’s not always a bad thing. Partners of private equity firms usually bring a wealth of experience, and could add value in terms of building long term strategy, forging alliances or bringing new customers.

Private equity funds run through hundreds of proposals from hopeful business owners, before short-listing a lucky handful that catch their interest. Therefore, understanding private equity funds’ expectations from target companies is of essence, if you want to be among the chosen few. If you don’t know any investors, talk to agencies such as Funding Post which bring entrepreneurs and financiers in contact with each other. Typically, the decision criteria for investing in a business involve market potential, growth opportunity, long term sustainability, exit opportunities and most important, quality of management. You will certainly be required to make a very detailed and well thought out presentation, outlining your vision for the future of the business. But even more critical is the impression you make on the investors, and whether you can convince them that you have what it takes to deliver. It is well known that investors would rather back a brilliant management team with a mediocre idea than the other way around. And that, in a nutshell is what private equity is all about.