Tuesday's announcement that a group of private equity investors would buy out Sabre Holdings
Private equity has always played a role in assisting companies in need of financing. As more deals involving private equity firms occur, understanding the ways in which private equity investors participate in the development of businesses from their beginnings until they become mature companies is important in order to assess the potential impact of such deals on the stocks in your investment portfolio.
What is private equity?
Put simply, private equity refers to any investment in the stock of a company that does not trade on a public stock exchange. There are a number of reasons why companies may not have publicly traded stock. For companies that have recently come into existence and have no history of revenues or profits, it's usually difficult to build sufficient demand among the general investing public to raise capital through public stock offerings. On the other hand, many mature companies that could easily offer their stock on public markets choose not to do so; possible reasons range from a company not wanting to meet the more strenuous reporting requirements that regulators impose on public companies to a company's owners simply wanting to retain complete ownership of the business.
Private equity divides itself into several categories. Venture capital refers to investments in new businesses that are in the initial stages of operating. Mezzanine financing is often used by small companies that need additional capital to finance growth opportunities but lack the resources to borrow money directly from lenders without adding equity-based incentives. In leveraged buyouts, acquiring investors buy a controlling interest in a company by borrowing money, using either outside assets or the assets of the target company itself as collateral for the loans. In addition, special situations that involve bankrupt companies often present investment opportunities to private equity groups.
Private equity investing
Investing in private equity differs greatly from buying stocks of publicly traded companies. While investors in ordinary stock can buy and sell shares of public companies any time they wish, private equity investors have a much longer time horizon for their investments. Firms that offer subscriptions to raise capital for private equity pools often use structures like limited partnerships that severely restrict the ability of investors to withdraw their invested funds before the end of a specified term, which can be as long as 10 years or more. This allows private equity groups to take advantage of opportunities that offer substantial profit potential but will take longer than a few quarters to develop. Depending on the availability of suitable investments for a given private equity pool, investors may be asked to make an initial investment that represents only part of what the pool will eventually need; such investors also make a commitment to deposit additional funds when other promising opportunities arise.
Because private equity involves investing in companies for a longer period of time, it's necessary for private equity groups to determine not only what they can do to increase the value of their investments but also how they will eventually realize the investment gains they create. In some cases, especially for companies whose intent is to complete a phase of fast growth, private equity funds may wish to sell part or all of their interest through a public offering of shares. This happens even with mature companies, leading to cycles during which a given company may go from public to private and back to public again several times. On the other hand, sales to other private equity groups may represent an alternative to going public. Just as small-cap mutual funds may sell shares of companies to mid-cap mutual funds as company market capitalization levels rise, so too may certain types of private equity pools trade their holdings to other pools with a different investment focus as circumstances with the business change.
The fact that private equity deals have become commonplace shows that private equity provides benefits to investors as well as to companies and their corporate managers. The second part of this article looks more closely at how both sides of a private equity investment gain from using this form of financing over public offerings and other methods of raising cash.
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Fool contributor Dan Caplinger won't be ponying up for private equity deals anytime soon. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is always alluring.