When most investors think of equities or stocks, they think of particular single stocks, smallcases, mutual funds, risk & volatility, etc. All these investments involve putting money in shares/stocks of companies that have been listed on exchanges like the NSE or BSE.
But did you know that there is a very large, active, and lucrative market for investing in private companies that are not publicly listed on exchanges? This is called Private Equity (PE) investing, and it’s usually done by Private Equity fund managers employed by large institutional investors.
Private Equity vs. Public Equity
Public equity refers to shares of a company that’s listed on public exchanges. Similarly, Private equity refers to shares held in a private company that’s not listed on exchanges. A private equity investment is usually made by specialized investment companies called (rather unimaginatively) Private Equity firms (PE firms).
These firms raise funds from institutional investors like pension funds, sovereign wealth funds, HNIs, etc. who provide them with the capital in hopes of earning high returns. PE firms have a few key characteristics that distinguish them from other investors & enable them to earn higher returns.
How do PE firms operate?
Over time, a rather standardized operating model has emerged for PE firms:
- Fundraising: They raise money from other investors (usually institutional) who are called Limited Partners (LPs). The PE firm is a General Partner (GP), and together they create a “PE fund” that has the raised money. Often times, the GP is required to invest alongside to align objectives.
- Dealmaking: The GP manages the PE fund, and invests in private companies in exchange for ownership & often control
- Leveraging: Invariably, the dealmaking is accompanied by taking on debt & leveraging the company
- Improving Operations: PE firms are well-known for turning around or accelerating companies by increasing efficiency, cutting costs, exploiting synergies, and ultimately increasing profits
- Exits: The ultimate goal of PE funds is to exit their invested company after extracting most value/returns
Of course, PE firms do all this to make money for their investors – and obviously for themselves.
PE firms are notorious for charging high fees, with 2% of the AuM and 20% of profits being the standard.
Private Equity Investments
Their mantra of PE firms is to invest in companies, create value during a short time (4-5 years preferably), and exit by selling shares at the highest profits. PE firms conduct extensive due diligence on a company’s business model, management team, industry dynamics, etc. before investing. They look for businesses that show clear growth potential in the near future.
Aside from these things, they look at 2 other key things:
- Control: PE firms are usually looking to take controlling stakes in private companies, so that they can improve existing operations of the company they are investing in.
- Return on Investment: Ultimately, this is what it boils down to – how much returns will the investment make, and how quickly.
Returns are only crystallized once the PE firm has exited their investment – this is usually done by either distributing dividends, selling the company to other buyers, or taking the company public via an IPO.
Often times, PE firms remain invested in a company even after the IPO – this is invariably because they expect even higher returns in the future.
Private Equity in India
While fairly small compared to the global market, structured Private Equity investments in India by PE firms have been steadily increasing. A report by EY expects India PE investments to be $48-$50 billion in 2019. The increase is partly fuelled by the attractive returns of PE funds, which have given average returns of 22% over the past 5 years.
Reports also show that not only revenue & profit of the businesses backed by PE firms have grown 27% faster than their peers, even the stocks of companies backed by these firms have done better in volatile markets.
While investing in private equity isn’t generally available to retail investors due to the high minimum investment that these funds have, it’s still possible to free-ride on the due diligence & expertise of PE funds. After all, many of these funds continue to remain invested in their portfolio companies even after taking them public via an IPO.
The PE List smallcase is a readymade portfolio of exactly such stocks, which count PE funds as one of their key backers/investors. It includes a mix of midcap & smallcap companies like V Guard Industries, Dr. Lal PathLabs, and Amara Raja Batteries that have a high shareholding of PE funds.
Note that while all equity investments come with risk, investments made by PE firms are usually even riskier due to their aggressive objectives. If you’re looking for such a high-risk/high-reward portfolio, then the PE list smallcase might be ideal for you.