Investments in the PE world can vary by size, type, industry, stage of the business etc. The following captures (at a high level), the various types of investment strategies followed by the PE firms:
Venture Capital
Venture Capital (VC) investment typically involves a minority investment in an early stage company that may require an incubation to start up and has minimal or even no revenue. These investments are made at a very early stage in the company's life cycle and therefore, are characterized as a high-risk/high-return strategy. The investment is made generally in Equity / Shares. And as most early stage ventures do not have access to debt or credit capital markets, pitching to VCs for equity capital is the best option (and possibly the only option for many entrepreneurs) to launch the company.
From an investor point of view, VCs have the possibility of blockbuster returns but VCs will have to make many investments and guide each of its investments through a transformative journey before seeing some successes. For instance, an initial investment from the VC could be used as seed funding for the company to start building its business. Later when the company proves its business model and is seeking more funding through Series A and subsequent series financing rounds, the value of the VCs stake in the company increases and it is not that uncommon for VC investments to return 10x money on invested capital (MOIC). But, for every company that returns 10x MOIC, there is likely to be tens (or even hundreds) of investments that would have fallen by the way side where the VC fund may have lost all of its capital. So, VC is a high risk / high return strategy. Boom or Bust.
Growth Capital
Growth capital investments typically consist of a PE firm taking a majority or minority ownership in a private company. These investment opportunities typically involve companies that are more developed than the early stage investments that VCs make. Therefore, they are less risky than VC but with lower upside potential because of the lower risk.
Growth Capital helps private companies generate significant value by exploring their growth opportunities and becoming market leaders in their respective segments and industries. PE firms also identify such companies as a platform to build on through acquisitions of other similar private companies in the same industry. This can expedite growth of the business in that market segment and push the merged companies towards an exit, enabling the PE firm to realize its return on investment. PE firms often provide strategic guidance, operational support, management expertise and efficient capital allocation to growth companies. They are fairly hands on with the business as they are constantly looking to navigate the company towards a profitable exit.
Mezzanine Financing
Mezzanine Financing involves compensating investors with a periodic interest payment and sharing the upside of increase in company's valuation through issue of equity or options or warrants. This type of PE deal involve a combination of preferred equity, where return expectations are around 15% to 20% per year or subordinated debt (junior to senior debt).
Most private companies do not prefer mezzanine financing as it takes capital out of the company on a periodic basis, and therefore stifling its growth potential. However, this funding type can be used to fill the gap between senior debt and equity investment, bringing down the overall cost of capital.
In many cases, a private company maybe owned by a consortium of private equity investors. Mezzanine Financing can make deals fairly complicated as different investors in the consortium would have made their investments at different points in the life cycle of the company, so attributing the right % of periodic returns on preferred equity to keep all the investors / shareholders happy can be very difficult.
Leveraged Buyout (“LBO”)
A leveraged buyout is the full acquisition of a public or private company using borrowed funds i.e. debt. LBO is the most commonly used PE investment strategy. In an LBO transaction, a PE firm (also referred to as a Financial Sponsor) or a consortium of PE firms will acquire a target company using capital raised mainly from issuing debt instruments. Typically, capital from debt instrument sources supports 60% to 75% of the LBO buy out price.
The big risk with LBO is the reliance on future cash flows of the acquiring business to service the debt commitments used to buyout the business in the first place. As the debt is repaid over time and the debt balance is lowered, the company's value increases with increase in equity as a proportion of the total capital structure. It is this deleveraging process that helps PE firms make substantial gains in a successfully executed LBO investment.
Top PE firms (the ones I mentioned in my previous post) generally get into the biggest LBO transactions as they have the ability to take on the most debt. Due to their heavy reliance on financial leverage, LBO firms have to dynamically manage their capital to maintain an optimal capital structure to create value and grow their investments.
Distressed Buyout
Financially distressed companies are those that are not performing well and are in the brink of bankruptcy or are on a downward spiral due to operational inefficiencies, poor leadership or a plethora of other reasons. These companies are generally trading significantly below market value. Private Equity firms look for distressed companies that have either an excellent potential to rebound or can be successfully merged with their already existing portfolio of investments in a particular segment to create more value by combining the assets.
PE firms typically do a lot of commercial, finance, tax and feasibility due diligence reviews before acquiring a distressed company. Depending on whether the creditors of the distressed company will become equity holders upon acquisition, PE firms will receive full or partial rights to own the business. PE firms will generally prefer to outright own the full business without any previous creditor involvement to avoid controlling issues.
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