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What is private equity?30/10/2001. Source: Danske Private Equity. 
 Investors are now paying increasing attention to the private equity market. This description of the asset class by Danske Private Equity explains why this market is attractive to investors and offers explanations of the various types of private equity investment.
Private equity capital is invested primarily in unlisted companies or in listed companies that intend to become unlisted. The market for unlisted investments arose at the end of the 1960s in the United States and has since spread to the United Kingdom and then the rest of the world. Private equity differs from traditional asset classes in many ways. These are its leading features:
- Long-term investment horizon
- Limited liquidity
- Inefficient market because of scarce information and lack of liquidity
- High risk
- High historical returns
- Low correlation with other asset classes
There are two main categories of private equity: venture capital and buyout capital. But it is not always easy to draw a clear line between the two. The category in which an investment falls depends on both the development stage of the portfolio company and the investor's possible contribution of managerial or professional expertise to the company.
Historical returns on private equity investments
One of the main reasons that investors are paying increasing attention to the private equity market is the historically high returns of top quarter funds compared with those of the public equity markets.
Source: Venture Economics
Source: Venture Economics
Source: Danske Capital
As the tables show, the returns on private equity investments for the ten-year period of the 1990s were 15.7% in Europe and 22.0% in the US. For the same period, the major stock indices report gains of 13%-18%. In addition, the best 25% of the funds have achieved results far above the average: 32.0% against 15.7% in Europe and 45.9% against 22.0% in the US.
The big spread between the returns of the good and bad private equity funds indicates that the private equity market is less efficient than the traditional securities markets, where the range is narrower.
The fact that private equity investments have given good historical returns, however, does not in any way guarantee that this will also be the case in the future.
Venture and buyout capital
Venture capital
Venture capital is invested in companies at an early stage of development that are expected to grow substantially. These companies usually need much capital and active managerial and/or professional support to build up their business activities. Venture capital investments can be broken down more precisely according to the company's development stage:
Seed
Financing provided to research, assess, and develop an initial concept before a business has reached the start-up phase.
Start-up
Financing provided to companies for product development and initial marketing.
Other early-stage
Financing for companies that have completed the product development stage and require further funds to initiate commercial manufacturing and sales. They are not yet generating a profit.
Expansion
Financing provided for the growth and expansion of a company which is breaking even or showing an operating profit. Capital may be used to finance increased production capacity, marketing or product development, or as additional working capital.
Generally, the earlier the company is in its development, the greater the risk and therefore the greater the required return. But there are significant risks in all types of venture investments.
Buyout capital
Buyout capital is used to invest in companies at a later stage in the life cycle. The stake taken in the company is usually larger than in venture investments, so the transaction size is also much larger. Buyouts often involve the following kinds of company: (1) family-owned businesses undergoing a generational shift; (2) companies that need capital and expertise to continue expansion; (3) business segments that are divested because they are not the company's core business; and (4) companies undergoing a crisis. The situation that prompts the investment defines the type of buyout, as in the following main categories:
Management buyout
Financing provided to enable current operating management and investors to acquire an existing product line or business.
Management buy-in
Financing provided to enable a manager or group of managers from outside the company to buy into the company with the support of private equity investors.
Turnaround
Financing made available to existing businesses which have experienced commercial difficulties, with a view to reestablishing profitability. This type of investment usually demands more active participation in the company than do management buyouts.
The risk in buyout investments is generally lower than in venture investments because they usually involve fully developed companies with stable cash flows. On the other hand, buyouts use a large share of debt capital, and that increases the risk. Turnaround investments entail much greater uncertainty about future cash flows than do management buyouts.
Copyright © 2001 Danske Private Equity
Danske Private Equity is one of the leading private equity players in the Nordic region. The company was founded in January 2000 and now has over E800m under management. It is a company in the Danske Bank Group.
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