PRIVATE EQUITY FUNDS-AN ALTERNATIVE FUND TO FUND BUSINESS.

The concept of “business finance” has been refined to the form it stands today from the bygone “Baniyas’ System”, where investment needs of business were funded through pledge of personal properties. With the increase in the enterprising attitude of the business fraternity this old system was slowly transformed into a group initiative that saw the beginning of the banking system. The banking system that evolved in the form of                      co-operative societies limited to minority interests are today diversified into nationalized corporations opening up to almost every need of business in every corner of the nation.

We have witnessed revolutionary makeover in the financing of business enterprises in this century with the naissance of financial instruments and solutions like the equities, debentures, bonds, venture capital, mutual funds, GDR’s, FII’s, FDI’s and many more.

One among the means to finance business enterprises is the “Private Equity” [P E Fund] that has gained enormous prominence of late. Private equity involves the issue of shares by a company for the investment made by selected investors into the company’s business. “Private equity” refers to any type of non-public ownership equity securities that are not listed on a public exchange.

To comprehend this concept, let us begin with understanding why and how this need of fund came into origin.

Need of private equity: Business requires huge funds for pursuing its objects. The purposes may be numerous and multiple like the improvements of current business processes to achiever higher operational gains or the expansion of business either in terms of capacity or foray into newer markets or globalization or business consolidation or business diversification or restructuring etc. The accomplishment of these objects involves huge capital outlay. The capital required may be a risk capital, involving the element of risk of varying degrees. In this scenario, the money can be funded only by high risk seeking institutions or funds. Banking institutions have a cap on the risk that can be taken due to the regulations and the involvement of public money. In order to bridge the gap of funds requirement and availability, private equities emerged.

Who will provide the private equity?: Business organization requires funds for either of the objectives mentioned above. For the purpose, they require investors. Who will then provide the high-risk funds? Who are the investors? The answer - the investors are the private equity firms.

Next immediate question will be – What are private equity firms and how they function? Private equity firms are the investing firms that pool funds from other interested investors. The private equity firms can therefore be understood to be private equity raising firms in the sense they first raise the funds and then invest into businesses. Private equity firms are commonly referred to as “Private Equity Funds or PE funds”. Typically interested investors will invest in a specific private equity fund, becoming a limited partner in the firm, rather than an investor in the firm itself.  The investors are risk seeking with high return expectation.

Interested investors having surplus and intent to invest in risk capitals put their money into PE funds. The PE funds pools the money from multiple investors and fund the businesses [referred to as “Target Entity”]. The businesses utilize these funds to accomplish the general or specific objectives.

The other large investors in the private equity fund are the fund-of-funds, which means, a private equity fund investing in another private equity fund with the object to mitigate the risk of the investors.

How will PE funds ensure high returns?: Investors invest in risk capitals with the objective of earning high returns. How will PE fund ensure the achievement of this objective of the investors?

The PE funds do not invest and watch for the returns to rise. They participate in the target entity. This is the unique feature of PE funds. One of the reasons why target entity prefers PE fund is not only for money but also for the expertise and assistance the PE funds provide in enhancing the capabilities of the target entity.

The features of PE funds are

Ø      PE funds participate and will have a representation on the board of the target company. In other words, PE fund will have their nominees on the board of the target company.

Ø      PE funds assists in accomplishing objectives and maximizing gains. PE funds a composition of business analyst and experts, assists target company by providing risk management tools.

Ø      PE funds ensures high standard of corporate governance.

PE funds help the target entity in achieving operational performance and good results leading to good returns. The representative of PE fund also provides strategic vision for the growth of the target entity.

In what sort of target entities will the PE funds invest?: The returns to a greater extent are also influenced by the kind of the entity in which the PE funds invest. So, what kind entities do the PE funds invest in? The target entity should have:

Ø      Good management with sound managerial knowledge, abilities, skills and expertise.

Ø      Sound business ethics.

Ø      Transparency in the conduct of business and process.

Ø      High standard of corporate governance.

Ø      Active board participation.

Ø      Ability to achieve higher pace of growth and global competitiveness.

All these features of target entity together with the PE fund participation in the board of the target entity ensure high returns.

Benefits garnered by a target entity through the exercise of this PE fund option includes:

Ø    Enables issue for small amount of funds;

Ø    Economical in terms of funds raising costs;

Ø    Minimum statutory procedural impediments;

Ø    Time saving and swift proceedings;

Ø    Leverage the expertise of the private equity to drive operational performance.

What are the benefits garnered by PE funds and modes of returns?: Benefits garnered by an PE funds includes:

Ø    Wealth creation;

Ø    Comparatively good returns;

The modes of return of PE funds includes:

Ø    IPO of target entity; [PE funded target entities enjoy higher PE multiple at listing than other non-PE funded companies]

Ø    Merger / sale of target entity;

Ø    Re-capitalization.

All said and done, the benefits of the investors are subject to the performance by the company in the long run.

What are the disadvantages and risks associated with PE funds?:  PE funds require huge funds for investment in target companies. Consequently, most private equity funds are offered only to institutional investors and individuals of substantial networth. Private equities are generally illiquid  and thought of as a long-term investment.

The greatest disadvantage of the PE funds is the longer lock-in-period. The lock-in-period may range from minimum 3 years to a maximum of 10-12 years or even more.

The PE funds carry the risk of loss of significant capital in case the target entity fails to perform as per the required yardstick.

If all the above is about PE funds then what is mutual fund or hedge fund or venture capital funds?:  A confusion is sure to arise if all the above is PE fund then what is mutual fund or hedge fund or venture capital fund and why are they in the market?

 At the most fundamental level - PE funds, hedge funds and venture capital funds are like mutual funds. All the funds, be it PE, hedge, mutual or venture, gather cash from investors, pool it and invest the money in business expected to become valuable over time. But they have very different objectives and target different opportunities