Private equity is an investment modality in companies distinct from those made in the stock market, as it involves investing in privately held companies by a select group of investors. This investment modality is promising because it enables the acquisition of stakes in companies with significant growth potential.
In this post, we aim to cover all the key points of Private Equity: who can invest? What are its modalities? What are its main risks? Among other questions that might be sources of uncertainty for those interested in the investment. Stay tuned!
What is Private Equity?
Private Equity is a private investment made by investment funds into privately held companies with the goal of purchasing ownership stakes in the company’s equity, thereby becoming a business partner. The primary objective of this investment is to acquire companies with growth potential, so that the fund can eventually sell its ownership stake for a profit in the future.
These investment funds are regulated by the Securities and Exchange Commission and are called Private Equity Funds. However, it’s important to highlight that the investment can also be made by corporations, the government, or even individual investors. You yourself can invest in a Private Equity fund, but this is limited to a specific class of investors.
Often, when a fund invests in a privately held company, it is not limited to just receiving returns from its ownership stake; it seeks to leverage the company’s value through active participation in management, utilizing the expertise of executives to aid in the company’s growth. Generally, these investment funds target companies with substantial revenue and existing profitability.
What are the risks of Private Equity?
Due to dealing with privately held companies, there is a high risk associated with this investment type, as the fund’s performance will directly depend on the company’s performance after the injection of capital and whether the company will succeed in a future Initial Public Offering (IPO) on the stock market, where, in most cases, Private Equity funds liquidate their position and exit with the profits. However, this investment has a considerable success rate, given its focus on mature and consistent companies.
Private Equity x Venture Capital: What’s the difference?
Unlike Private Equity, Venture Capital is an investment made in early-stage companies that have significant potential for appreciation. Some examples of companies that have succeeded with injections of money from Venture Capital funds are: ByteDance, SpaceX, SHEIN, etc. – in other words, companies that present an innovative idea and are striving to establish themselves in the market.
Venture Capital funds are considered extremely high-risk due to the uncertainty surrounding the future of the startup, which often does not yet generate profit. The purpose of these funds is precisely to address this point. Believing in the future profitability potential of the company, these funds “cover” the losses by injecting substantial resources that provide financial support to the company to continue its operations.
Common ways to become a shareholder in companies of this size are through Mutual Funds for Emerging Companies Investment (FMIEE) and through Private Equity Investment Funds (FIP), both regulated by the Securities and Exchange Commission.
How does a Private Equity fund work?
Perhaps you’d like to learn more about Private Equity, so let’s outline the key points of this type of investment, its phases, and the qualifications required.
First, it’s important to note that this isn’t an investment that yields overnight returns. Because it involves a value creation process within a company, it’s considered a long-term investment. Typically, the fund’s divestment from the company occurs on average after 5 to 10 years, a timeframe that could be shorter or even longer, depending on the objectives and economic landscape.
The duration of a Private Equity fund can be summarized in three respective phases: fundraising, investment, and divestment. Let’s delve into them:
Phase 1: Fundraising
This is where the fund comes to life! The initial phase involves fundraising, during which investors sign documentation committing to providing financial contributions to raise capital for the fund. If requested, they also commit to investing additional funds. This is a crucial stage, as it provides the manager with an idea of how much capital has been raised to begin building the fund’s portfolio through investments in companies.
This is the initial stage, and now the fund can begin analyzing potential investment opportunities. This stage is characterized by extensive analysis of the targeted companies by experts, aiming to understand the future potential of the company and minimize investment risks.
Phase 2: Investment
After analyzing the company, setting goals, determining its value, and reaching agreements with the company’s stakeholders in which the fund has an interest to invest, financial contributions are made to fuel the company’s activities. This involves implementing planned strategies to foster the company’s growth.
Common strategies for boosting growth include investing in infrastructure and facilities, acquiring competitor companies, expanding the brand to other regions, among others. Another strategy involves enhancing the company’s governance standards, with an eye on the future issuance of company shares on the stock exchange.
Phase 3: Divestment
Following the investment phase comes the divestment stage. At this point, the company may already be providing returns to the fund’s portfolio, either through dividend payments or amortizations. This is when the fund sells its ownership stake and realizes the majority of the investment profit. Divestment typically occurs through:
- Initial Public Offering (IPO) on the stock exchange.
- Sale of the ownership stake to a company interested in the business.
- Sale of the ownership stake to other funds of the same class.
The “J-Curve”
The J curve represents the cash flow of a Private Equity fund in the three phases described above and is so named because it takes the shape of the letter “J.” On the vertical axis, we have the return, and on the horizontal axis, we have time. This graph is characteristic for illustrating the trajectory of this investment: significant initial cash outflows, but in return, a high expectation of future returns.
What are the investment rounds?
Fundamentally, the process of raising money for investment in a company occurs in the following stages:
1st stage: Pre-Seed
This investment round aims to raise resources for the early stages of a small company’s life. At this point, the idea is germinating in the founders’ minds, and activities such as product testing and market analysis are carried out.
2nd stage: Seed Capital
This investment round focuses on team hiring/expansion, marketing investment, and sales execution.
3rd stage: Series A
This round takes place at a slightly more advanced stage of the startup, with a focus on increasing sales, expanding the product offering, and potential product enhancements. This is the stage where investments from Venture Capital funds are concentrated.
4th stage: Series B
At this stage, it’s assumed that the startup has achieved a level of market solidity. Therefore, the goal of this round is to raise funds for activities such as acquiring competitors, opening branches, and more.
5th stage: Series C
This is the final classification for investment rounds. The objective of this stage is to accelerate the company’s growth in the international market, becoming a globally recognized company, often referred to as “unicorns.” Private Equity funds targeting mature companies with market solidity typically make investments in this stage.
Final stage: IPO (Initial Public Offering)
Finally, when the company reaches its “limit” stage, it goes public on the stock market, seeking billions in funding to continue investing in its productive activities. As mentioned, this is the stage where funds exit their positions.
How to Invest in Private Equity?
To invest in Private Equity funds, you need to have an account with a brokerage and search for investments within this asset class. However, unfortunately in Brazil, investing in Private Equity requires you to be classified as a “qualified investor” or “professional investor,” meaning you need to have custody of assets ranging from R$1,000,000 to R$10,000,000. This limitation restricts investment to certain classes of investors.
Conclusion
Private Equity Funds are an excellent way to enhance a company’s growth, with the assistance of experts who become part of the team of partners, thereby facilitating the expansion process. Additionally, we can mention some advantages of receiving investment from this type of fund:
- Enhancement of the company’s market presence and image;
- Boost in cash reserves for investment expansion;
- Company expansion through acquisitions;
- Increased competitiveness and growth;
Therefore, Private Equity presents an option for companies aiming to grow and stand out in the market, potentially evolving into a multinational corporation through business expansion.
