3 Key Types of Private Equity | HBS Online

Alternative investments is one of the fastest-growing fields in finance and is predicted to reach $14 trillion in assets under management by 2023.

The alternative investment asset class comprises any asset besides stocks, bonds, and cash, which are referred to as traditional investments. In an ever-fluctuating market, diversifying your portfolio to include both traditional and alternative investments can be a wise decision.

Unlike traditional asset classes, alternative investments are illiquid—meaning they can’t be easily converted into cash—and are typically unregulated by the US Securities and Exchange Commission (SEC). They also often have a low correlation with other asset classes—meaning they move in opposite directions when the market changes—making alternatives a strong candidate to diversify your portfolio.

Various assets fall into the alternative investment category, each with its own traits, investment opportunities, and caveats. One type of alternative investment is private equity.

Free E-Book: A Manager’s Guide to Finance & Accounting

Access your free e-book today.

What Is Private Equity?

Private equity is the category of capital investments made into private companies. These companies aren’t listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative. In this context, equity
refers to a shareholder’s stake in a company and that share’s value after all debt has been paid.

Private equity firms invest in private companies by purchasing shares with the expectation that they’ll be worth more than the original investment by a specified date. These firms allocate investment money from institutional investors, such as mutual funds, insurance companies, or pensions, and high-net-worth individuals. Some examples of private equity firms include Blackstone, Kohlberg Kravis Roberts & Co. (KKR), and The Carlyle Group.

In addition to funding, the relationship between a private equity firm and the companies it invests in can include mentorship and industry expertise. This can be a great value-add for companies that receive the investments because they’re typically at a point in their lifecycles where growth and change are needed.

Related: 7 Types of Alternative Investments Everyone Should Know

3 Types of Private Equity Strategies

There are three key types of private equity strategies: venture capital, growth equity, and buyouts. These strategies don’t compete against one another and require different skills to be successful, yet each has a place in an organization’s life cycle. Here’s a closer look at each private equity strategy so you can have the full picture when building portfolios.

1. Venture Capital

Venture capital (VC) is a type of private equity investment made in an early-stage startup. Venture capitalists give the company a certain amount of seed funding in exchange for a share of it. Venture capitalists typically don’t require a majority share (over 50 percent), which can be attractive to founders.

Venture capital investing is inherently risky because startups—many of which are little more than ideas at the time of a pitch—haven’t yet proven their ability to turn a profit. Like with any investment, venture capital’s return on investment is never a guarantee. Yet, when a startup turns out to be the next big thing, venture capitalists can potentially cash in on millions, or even billions, of dollars.

For example, consider Snap, the parent company of photo messaging app Snapchat. In 2012, Barry Eggers, a partner at Lightspeed Venture Partners, heard about Snapchat from his teenage daughter. At the time, Snapchat had fewer than 100,000 installs. He mentioned the new app to his colleague, Jeremy Liew, whose interest was piqued. After Liew researched and met with the app’s co-founders, Lightspeed Venture Partners wrote Snap its first VC check for $485,000.

Liew and his colleagues’ predictions panned out in a big way. When Snap went public in 2017, the company was worth $24 billion, and Lightspeed Venture Partners’ shares were worth upwards of $2 billion.

So, did Liew and his colleagues just get lucky with Snap? How can someone predict which business ideas will be exponentially successful? VC investing is both a gamble and a strategic art, and it’s the only private equity strategy with a high level of persistence. This means a venture capitalist who has previously invested in startups that ended up being successful has a greater-than-average chance of seeing success again.

This is due to a combination of entrepreneurs seeking out venture capitalists with a proven track record, and venture capitalists’ honed eyes for founders who have what it takes to be successful.

Related: How to Finance a Business: 4 Options to Consider

2. Growth Equity

The second type of private equity strategy is growth equity, which is capital investment in an established, growing company.

Growth equity comes into play further along in a company’s lifecycle: once it’s established but needs additional funding to grow. As with venture capital, growth equity investments are granted in return for company equity, typically a minority share. Unlike venture capitalists, growth equity investors can research the company’s financial track record, interview clients, and try the product themselves before deciding if the company is a wise investment choice. Any investment presents risk, but in the case of growth equity, the company has the chance to prove it can provide a return before the private equity firm invests.

Many firms involved in growth equity maintain a database of up-and-coming companies and track their financial information over time, sometimes for as long as 10 or 15 years. This allows firms to flag companies earning revenue and growing at a fast clip, and reach out to them when they appear to need funding to continue expanding.

Growth equity investors typically require a growth strategy from the company to reasonably estimate the return on investment. For example, a company seeking growth equity funds may present the need to hire employees, rent office or retail space, or purchase new production technology to meet rising demand.

Successful growth equity investing relies on a keen eye for a strong founder or team, as well as careful, calculated research and financial analysis and projection.

3. Buyouts

The final key private equity strategy—and the one that’s furthest along in the company lifecycle—is buyouts. Buyouts occur when a mature, typically public company is taken private and purchased by either a private equity firm or its existing management team. This type of investment makes up the largest portion of funds in the private equity space.

When a buyout occurs, all of the company’s previous investors cash in on their shares and exit. The private equity firm or management team becomes the sole investor and must hold a controlling share of the company (more than 50 percent).

There are two types of buyouts:

• Management buyouts, in which the existing management team buys the company’s assets and takes the controlling share
• Leveraged buyouts, which are buyouts funded with borrowed money

Management Buyouts

Management buyouts may be a good choice if a public company needs internal restructuring and wants to go private before embarking on organizational changes. This allows all investors and stakeholders to cash in on their shares before company management takes control. The management team may raise the funds necessary for a buyout through a private equity company, which would take a minority share in the company in exchange for funding. It can also be used as an exit strategy for business owners who wish to retire.

A management buyout is not to be confused with a management buy-in, which takes place when the management team of a different company buys the company and takes over both management responsibilities and a controlling share. This is commonly referred to as an acquisition, although the term can be used to describe any type of buyout.

Leveraged Buyouts

Leveraged buyouts make sense for companies that wish to make major acquisitions without spending too much capital. The assets of both the acquiring and acquired companies are used as collateral for the loans to finance the buyout. An example of a leveraged buyout is the purchase of Hospital Corporation of America in 2006 by private equity firms KKR, Bain & Company, and Merrill Lynch.

The goal of any buyout is to shift control of the company for a period of internal improvement and for those improvements to provide a return on the investment it takes to buy out the company. Just like venture capital and growth equity, buyouts come with significant risk but can potentially allow a company to restructure and reset for astronomical growth.

Strengthening Portfolios with Alternative Investments

Private equity investments can help you diversify portfolios and tap into the potential of private companies—from budding startups to mature organizations with proven value.

Private equity, however, is just the tip of the alternative investments iceberg. Other types of alternatives include hedge funds, private debt, commodities, collectibles, and real estate. Each provides value and comes with its own set of challenges. Consider taking an alternative investments course to familiarize yourself with these strategies and learn more about how to build strong, diverse portfolios.

Are you interested in expanding your knowledge of alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses.