Private Equity: Details and Significance of Equity Capital

Inserting a piece of the puzzle

(Image: Stock.adobe.com, Mikael Damkier)

Not only listed companies offer the possibility of participation by third parties. An increasingly important option is private equity or private equity (PE).

It is one of the most important basic rules of the market economy: growth. Without the constant striving for further development, individual companies, industries and entire economies stagnate. This is especially a problem for non-public companies. they provide by far the largest number in Germany’s economy but have only a few options to increase their funds beyond the classic increase in equity capital and external financing through credits and loans. There is also a special problem in the real estate sector: here it is often even more difficult to get fresh money because of the typically large scope of the work involved in the necessary financial resources and the simultaneous limitation of the financial sector by politicians.

This is where private equity comes into play: private equity capital, which, in terms of its chart characteristics, lies between traditional equity and debt capital.

Private Equity: Fresh Money from Alternative Sources

Private equity (PE) has long been an established term in the financial and business world. In the German-speaking area, however, the two formulations, private equity as OTC equity established. This always means the same basic principle:

One or more investors act as donors for a company that is not publicly traded or for a project it supervises. With the payment, the investors acquire stakes in this company and typically also receive voting rights. These are usually much more extensive than is the case with the acquisition of shares in publicly traded companies.

The return of capital typically takes place through profit sharing, but it can also be presented in such a way that PE first buys a company and then sells it, whereby the difference between the investment and purchase amount must of course be higher. It is typically part of the procedure not only to provide financial resources, but also to throw entrepreneurial know-how into the scales via the voting rights acquired – not least important for companies that need PE because they are currently in an economic situation.

This means that PE represents a middle ground between traditional equity capital growth and debt capital, supplemented by an investment of know-how. In some respects, it is similar to the procedure for listed companies, but in no way can be directly compared with this.

Special case of venture capital: private equity for special companies

It is also closely related to the idea or approach of private equity Venture capital (VC). However, with one crucial difference: private equity can be used for countless purposes and companies; in venture capital are already named after (Venture capital, Venture capital) The aim is exclusively for those companies which represent an increased risk of losses for investors, sometimes even of a total nature.

Typically these are start-ups and other young companies; but in some cases this also includes radically new ideas from established companies. In contrast to PE, it is not foreseeable at the time of the investment how the desired income will actually turn out. For this reason, venture capital typically not only includes a pure equity investment, but often also support through know-how. The importance of VC is enormous, especially for the start-up world. In many cases, there are no other ways of obtaining capital. Without venture capital, therefore, countless projects and endeavors would fizzle out before their physical manifestation – with potentially catastrophic consequences for an economy as a whole:

In summary, it can be said that young companies or start-up companies, as carriers of innovations of a rather “disruptive” character, make a decisive contribution to the growth and employment performance of a (highly developed) economy! “

The following difference therefore applies:

  • Private equity is aimed at established companies that have been around for a long time,
  • Venture capital is aimed at start-ups and similar companies in the early stages of their existence.

Private equity: typical modus operandi

Theoretically, it would be possible for private individuals or companies of any kind to buy a private stake in another company. In practice, however, PE usually takes a completely different route. Often behind this are private equity companies.

These are investment companies as well as funds that were founded solely to provide private equity to other companies. They get their funds from a number of sources, typically institutional investors. These can be among others:

  • Banks,
  • Financially potent private individuals,
  • Pension funds,
  • State institutions,
  • Insurance,

to name only the most typical representatives. For such donors, the entry barriers of most PE companies are quite high, as high minimum amounts are required, typically in the millions. In recent times, however, many companies have also been increasingly attracting small investors. For them, previously unconventional investment opportunities became attractive in the course of the key interest rate cut. With funds of funds it is possible for them to invest even with comparatively small amounts (from the point of view of the typical PE level). The entry hurdle here is in the low five-digit range, depending on the fund.

Only a few private equity companies are active in extremely different segments at the same time. Typically, the focus of efforts is on one or only a very few specific industries. One of the most important fields of activity, both in Germany and globally, is the real estate sector. Special companies operate herethat focus, for example, only on certain properties or a property category – such as retirement homes, villas, condominiums and the like. Behind this special form of PE (Real Estate Private Equity, REPE) is primarily a necessity: Not least because of the Basel I – III requirements, it has been and is becoming more and more difficult for banks to allocate funds for real estate projects that are becoming increasingly expensive at the same time. In other words, the need for finance grew and grew, but at the same time decreased and decreased the possibility of traditional capital procurement.

Often, if not always (!), A company’s financial needs are also based on the desire for one Management buy-out (MBO). Here, senior staff of an existing company bundle their knowledge in order to acquire this company practically in-house. If the financial resources of the actors are insufficient, they are directed to PE companies. This means that management is distributed (often for a limited time) to both the new owners and the PE company; whereby the conditions usually favor the former.

Private Equity: Importance for the Modern Market

An important characteristic of private equity is that its importance is constantly increasing. The industry suffered a bitter loss in the second quarter of 2020 when COVID-19 spread, but the industry was able to expand recover within a very short time:

“[…] this crisis was different. While a short-lived opportunity for distressed investors produced deals like the multimillion-dollar recapitalizations of Wayfair and Outfront Media, the value window slammed shut quickly. Both global credit and public equity markets rebounded with blinding speed over the summer, pulling private asset prices (which are highly correlated with public equites) along with them.
Consider that it took nearly seven years for the S&P 500 to get back to its precrisis high after the global financial crisis of 2008-09. This time around, the S&P reclaimed its losses within 150 days and finished the year 16% higher than where it started […].

This investment principle was already established on the US market in the 1980s. On the European and German markets, however, it was only after the turn of the millennium that it was possible to gain a foothold. Then, however, with increasing amounts every year. Since 2009 alone, the investment volume in this country has set new records almost every year:

  • 2009: 3.03 billion euros
  • 2010: 4.98
  • 2011: 7.07
  • 2012: 6.66
  • 2013: 5.43
  • 2014: 7.30
  • 2015: 6.60
  • 2016: 6.78
  • 2017: 11.68
  • 2018: 12.03
  • 2019: 16.59
  • 2020: 12.55

The situation is similar in most other countries. Worldwide, the assets acquired by PE companies exceeded the $ 600 billion threshold for the first time in 2016; 2019 lay the investment volume in Europe at 260 billion euros.

The reason for the sharp drop in volume in 2020 can only be found in the corona pandemic and the resulting increased reluctance in many industries. As soon as the virus is no longer a major threat, all obstacles will probably be removed automatically – especially since many companies will then increasingly need fresh money.

This means that private equity in the post-pandemic era will probably acquire an even greater – global – importance than it is now. Because everywhere the economies were affected by the virus and government defense measures, there is a lot of catching up to do in countless industries and therefore capital is needed, which can often only come from PE companies.

05/04/2021

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