An equity investment in a business, which is not traded on the capital market, is referred to as private equity. Individuals or private institutions invest in companies with growth potential, without managing the business on a day to day basis through portfolios of private equity projects. They take the private equity route through limited partnerships, which allows them to invest in the portfolio projects while maintaining limited liability. Private equity experts involved in such a portfolio, called general partners, are usually involved with management decisions of the companies that form part of the portfolio. The general partners usually belong to the private equity company or the private equity division of a financial institution.

The limited partnership is referred to as the fund. Sometimes several private equity funds pool their funds together. Investors, private and institutional, can also invest in such ‘fund of funds’.

The most well- known form of private equity investing is venture capital funding. This is also considered the most traditional form of private equity. Venture capital funding has founded several technological successes and failures. In this form of private equity a business is funded from incubation, through set-up, R&amp;D, production and an exit strategy through a buy-out or an initial public offering (IPO). The time frame of such investment is for several years at a time. Venture capitalists usually have several hits and misses in their portfolio. A big success however makes it viable for the investor to invest in further businesses.

Another form of private equity and possibly the largest category in it is the Leveraged Buy Out. Unlike a venture capitalist that has a minority interest in the company of choice, a leverage buyout investor has a majority stake in the company it is buying out. Usually these companies are publicly traded, but once the buy-out happens they usually become privately held. These buyouts see the private equity firm putting 20-40% of its own funds and borrowing the rest, hence the term leveraged buyout. The private equity firm then adds value to the company by involving itself in management and re-engineering it. It then puts up the firm up for sale either privately or through an IPO.

A variant of the leveraged buyout is the management buyout. In this format the managers of the acquired company become large investors in it. Large buyouts usually exceed $10 billion. There are however usually mid-size companies taken into the portfolio. A lot hinges on value addition when the company goes private. Private equity comes from across the globe. An acquired firm usually adds value with the help of its managers, hence management buyouts, to ensure a higher rate of success.

Yet another form of private equity is called distressed investing or vulture investing. Here private equity players zoom in on companies in financial distress. They then buy them out cheaply and restructure them. Any positive accruals made initially first go to debtors.

Additional Resource (Video): Private Equity Model-how private equity firms help businesses.

<iframe width="600" height="335" src="http://www.youtube.com/embed/VPepaKFP52w?rel=0" frameborder="0" allowfullscreen></iframe>

Overview of Private Equity

Venture Capital Funding is a form of private equity wherein the investor has a minority interest in the business. Typically it extends over a few years from ideation to exit.

Let us take a case study of Simply Switch, an online price comparison tool, where a user can switch to the best bargain for electricity, gas, credit card, broadband, etc. In 2002, after assessing Simply Switch’s growth potential, a venture capital firm called Bridges Ventures injected £125,000 pounds at the time when the company had just started. Over a period of three and a half years it totally spent 345,000 pounds. It sold its stake in 2006 for 22 million pounds returning £7.5 million pounds, resulting in an IRR of 165%. Bridges Venture chaired the company initially before placing an industry expert as chair. It undertook new market entry and growth strategies. The venture capitalist provided strategic and financial advice and ascertained the optimum time for exit. (Source: bvca.co.uk).

Clearly there are different stages to venture capital funding of a business. Schilit review offers an understanding into the various stages of venture capital investing. Funding varies from stage to stage. Given below is a table of the stages.
<table class="mytable">
<tbody>
<tr>
<th valign="top" width="239" scope="colspan">Stage</th>
<th valign="top" width="239" scope="colspan">Details</th>
</tr>
<tr>
<td valign="top" width="239">Stage 1: Seed stage</td>
<td valign="top" width="239">A business idea is funded. This initial funding is used for product development and market research.</td>
</tr>
<tr>
<td valign="top" width="239">Stage 2: Early stage financing</td>
<td valign="top" width="239">Funding is provided for initial operation before commercial production ensues and sales begin.</td>
</tr>
<tr>
<td valign="top" width="239">Stage 3: Formative funding</td>
<td valign="top" width="239">This includes seed stage and early stage funding.</td>
</tr>
<tr>
<td valign="top" width="239">Stage 4: Later stage funding</td>
<td valign="top" width="239">Funding provided for commercial operation and sales, but before an initial public offering (IPO).</td>
</tr>
</tbody>
</table>

Early stage funding can be either start-up or first stage funding. In start-up financing capital is provided for initial operations and testing. This would include product development and initial marketing. First stage funding is provided for initial commercial production and sales.

Under the later stage funding there can be second stage, third stage and mezzanine funding.

The second stage funding is provided to the company for expansion even though it is not profitable despite commercial production and sales.

In third stage funding, capital is provided for major expansion, for example, in Simply Switch’s case for aggressive marketing of its service for awareness and adoption.

Mezzanine as the name suggests is a kind of bridge funding that will help the company prepare for its journey between its expansion of capacity and the IPO. Simply switch might have availed this between gathering more adopters and having its stake acquired by Daily Mail and General Trust.

Financing through all stages, seed funding to mezzanine, is referred to as balanced stage financing.

Stages of Venture Capital Funding

Venture Capital Funding can be of different kinds. Early stage funding could be at the stage of ideation, initial production and marketing. Expansion funding is done during commercial production, marketing and growth (For more information refer to the article – <a title="Stages of Venture Capital Funding" href="https://financetrain.com/stages-of-venture-capital-funding/">Stages of Venture Capital Funding</a>). Different funds focus on different types of funding and sectors. There are however some unifying characteristics of venture capital funds.
<ul>
	<li>Illiquidity: Easy liquidity by cashing out in the short-term is not an option for venture capital funding. An IPO or buyout of a venture is how venture capitalists disinvest. A premature IPO could undermine an otherwise successful company. Alternatively an IPO released in a poor IPO market could also stall possibilities of cash out.</li>
	<li>Long-term commitment: Venture capital funds need to be latched in for a period of few years before disinvestment. Investors who do not prefer illiquidity will attach a premium to their funds, also known as liquidity risk premium. Therefore an investor who can wait out the time horizon will benefit from this premium. University endowments who seek VC funds to invest in are an example of such investors.</li>
	<li>Difficulty in determining current market values: It is difficult to evaluate the current market value of the portfolio of a VC.</li>
	<li>Limited historical risk and return data and limited information: Venture capital funds more often than not invest in new and cutting edge industries of a sector, where there is little historical data or continuous trading data. It is also difficult to estimate cash flows or the probability of success.</li>
	<li>Entrepreneurial/management mismatches: Entrepreneurs may face difficulties when there is dilution of ownership and control. Bad management choices may scuttle a good venture. Entrepreneurs sometimes find it difficult to step up as the venture gains size.</li>
	<li>Fund manager incentive mismatches: Investors interested in well performing rather than large sized funds need to find managers who match their investment objectives.</li>
	<li>Knowledge of competition: As we discussed earlier since most business’ that are funded are from nascent industries it is difficult to assess the competition, than say in established industries. A complete competitive analysis is therefore difficult to undertake for a VC fund.</li>
	<li>Vintage Cycles: Economic conditions vary from year to year. During some years venture capital funding is plenty and therefore returns for them low. In poor or stressed market condition, even good firms find it difficult to find VC funding.</li>
	<li>Extensive Operation Analysis and Advice: Venture capital funds that plan to invest in technology companies may not have the required expertise to assess them. Financial investment knowledge alone is not sufficient. Good fund managers therefore require both operating and financial analysis and advising skills. A fund manager who does not understand the business will impede rather than improve it.</li>
</ul>

Characteristics of Venture Capital Funding

An important aspect of venture capital investing is the exit strategies. Venture capital funds primarily invest with an exit in mind after a few years. After successfully funding at seed, pre-production, production and expansion stages, a venture capitalist will start assessing exit strategies. The exit in the form of disinvestment or liquidation is the last and final stage of the venture capital funding. The key types of liquidation/disinvestment are trade sales, sale of quoted equity post initial public offering (IPO), and write-offs. Let’s look at each of these in detail:

Trade Sales: In this type of strategy the private company is sold or merged with an acquirer for stocks, cash, or a combination of both.

IPO: If the company has done well, the venture capital investors will take the IPO route, by issuing shares registered for public offering. An example is the upcoming Facebook IPO, which is expecting to raise about $15 billion through IPO and is valued at approx. 100 billion. The venture capital investors and other private investors will get their portion of shares who can put them in the open marketplace for trading after an initial lock-in period.

Write-offs: These are voluntary liquidations that may or may not result in any proceeds.

Apart from the above three types of disinvestment, there are a few other options:

Bankruptcy: The company may just go bankrupt.

Buy-back: In this method the entrepreneur buys-back the investment share from the venture capitalists and takes it back to being a privately held company.

Investors who invest in a venture capital fund get distributions of public stock or cash from realized venture capital investments. Sometimes the fund may require further investments from limited partners. At other times, they may make cash or share distributions at random times during the lifetime of the fund. Investors can sell their interests to another buyer if they find one.

In a bad case scenario, some funds find themselves with highly illiquid, barely there companies. In a good scenario, they have good investments, which they disinvest from at a stage and find new investments to fund.

Exit Strategies for Venture Capital Funds

Compared to a traditional project or company with an established business model, valuing a venture capital project is quite difficult.

Even though some of the popular valuation methods can be used to value such a project, the difficulty in assessing the future cash flows of these projects make the results of the valuation models unreliable.

Even though investments in venture capital projects pose significant risks, the investors are motivated by huge expected returns from at least some of the projects. The ratio of success to failure is very low, but the companies that succeed cover up their losses in other investments.

Unlike other businesses, venture capital projects also pose other risks such as inexperienced entrepreneurs, innovative ideas, and uncertain time to success.

However, venture capital funds invest in many projects and the risk of the entire portfolio will be lesser compared to individual investments due to diversification.

There are three key factors while valuing a venture capital project:

1. Expected payoff at the time of exit, if venture succeeds

2. Time to exit

3. Probability of failure

Let's take a simplified example to understand the payoff.

<div class="formula1">An investor is considering investing $1 million in a new project. he expected that if the project succeeds it will pat $10 million at the end of five years.

However, the risk is that the project may daily in any of these five years. The investor's cost of equity is 15%, and he has the following estimates for the project failure in the next 5 years:

<table class="mytable" style="width:540px;">
<tr><th scope="colspan">Year</th><th scope="colspan">Prob. of Faulire</th></tr>
<tr><td>Year 1</td><td>30%</td></tr>
<tr><td>Year 2</td><td>25%</td></tr>
<tr><td>Year 3</td><td>20%</td></tr>
<tr><td>Year 4</td><td>20%</td></tr>
<tr><td>Year 5</td><td>20%</td></tr>
</table>

First we need to calculate the project will succeed, i.e., the project will survive to the end of 5 years. This can be calculated as follows:

= (1-0.30)*(1-0.25)*(1-0.20)^3 = 26.88%

The next thing we want to calculate is the NPV if the project is a success and earn $10 million for the investor. The NPV can be calculated as follows:

NPV if the Project Succeeds

= -$1 million +$10 million/(1.15)^5

= $3.97

NPV if the Project Fails: -$1 million

The expected NPV of the project will be:

=0.2688*$3.97 million + 0.7312*(-$1 million)

=$335,936

Since the expected NPV is positive, the recommendation is the aspect the project.
</div>

Valuation and Risks in Venture Capital Investing

Once a venture capital investor invests in a new venture, he will evaluate the performance of his investment at the time of liquidation, and also during the life of the investment.

The performance is generally measured by calculating the <a href="https://financetrain.com/net-present-value-npv-internal-rate-of-return-irr-excel/" title="Calculating Net Present Value (NPV) and Internal Rate of Return (IRR) in Excel">internal rate of return (IRR)</a> on:
<ul>
	<li>Cash flows since the beginning of the investment</li>
	<li>Unliquidated remaining holdings</li>
</ul>
Many associations such as European Private Equity and Venture Capital Association (www.evca.com) have published detailed guidelines for performance evaluation. Another such organization is the British Private Equity and Venture Capital Association (www.bvca.co.uk). The guidelines can be downloaded from their websites.

<h2>EVCA's IRR Measure of Performance</h2>

The EVCA advocates that the performance be measured at three levels:

1. The Gross Return on Realized Investments

This return takes account of the cash outflows (investments) and inflows (divestments, including realization values, dividend and interest payments, repayments of the principal of loans, etc.), which take place between the Fund and its realized investments.

2. The Gross Return on all Investments

This return takes account of all of the following:
<ul>
	<li>The cash outflows (investments) and inflows which take place between the Fund and:</li>
<ul>
	<li>Its wholly realized investments</li>
	<li>Its partially realized investments</li>
	<li>Its wholly unrealized investments</li>
	
</ul>
<li>The valuation of the unrealized portfolio (consisting of wholly unrealized investments and the unrealized portions of partially realized investments but excluding cash and other assets held in the portfolio).</li>
</ul>
3. The Net Return to the Funder

This measures the return earned by the Funders in the Fund, and takes account of:
<ul>
	<li>The cash flows which take place between the Fund and the Funders, net, by definition, of all of the following:</li>
<ul>
	<li>The Venture Capital Company’s carried interest;</li>
	<li>The management fees paid to the Private Equity/Venture Capital Company by the Funders;</li>
	<li>All other applicable professional and ancillary charges which are paid out by the Venture Capital Company in the course of investing, managing and divesting from its investment portfolio.</li>
	
</ul>
<li>The valuation of the unrealized portfolio (consisting of the unrealized portions of partially realized investments, wholly unrealized investments and also including cash and other assets), after deducting the implied carried interest.</li>
</ul>
When the portfolio is fully realized/fully distributed, the Net Return is the ‘cash-on-cash’ return to the Funders.

<h2>Challenges</h2>

There are several challenges in measuring the performance of venture capital projects:
<ol>
	<li>It is difficult to arrive at detailed valuations, as they have very limited information.</li>
	<li>There is no meaningful benchmark against which the performance can be measured.</li>
	<li>Any reliable performance feedback is of long-term nature.</li>
</ol>

Measuring the Performance of Venture Capital Investments

In the world of investments, <a href="https://financetrain.com/overview-of-private-equity/">private equity</a> refers to the investments that some investors and private equity firms directly make into a business. Private equity investments are mostly made by institutional investors in the form of venture capital funding or as leveraged buyout. Private equity can be used for many purposes such as to invest in upgrading technology, expansion of the business, to acquire another business, or even to revive a failing business.

Private equity investors usually have an investment horizon of 5-7 years and plan to exit after that after making a substantial profit on their investment. There are many exit strategies that private equity investors can use to offload their investment. The main options are discussed below:

Initial Public Offer (IPO)

One of the common ways is to come out with a public offer of the company, and sell their own shares as a part of the IPO to the public. As the case may be, you may sell your share immediately, or sell the shares allotted to you after the company gets listed and the shares start trading on the exchange. Stock market flotation can be used only for very large companies and it should be viable for the business because of the costs involved.

Strategic Acquisition

Another alternative is strategic acquisition or trade sale, where the company you have invested in is sold to another suitable company, and then you take your share from the sale value. This is one of the most popular exit routes for private equity funds. The buyer will usually have a strategic advantage in acquiring this business as they both may complement each other. For this reason, the buyer will often pay a premium to acquire such a business.

Secondary Sale

In a secondary sale, the private investors will sell their stake in the business to another private equity firm. This can happen for many reasons, for example, the business may require more money which is not in the capacity of the current equity fund. Or, the business may have reached a stage that the existing private equity investors wanted it to reach and other equity investors want to take over from here.

Repurchase by the Promoters

This is also a successfully used exit strategy, where the management or the promoters of the company buy back the equity stake from the private investors. This is an attractive exit option for both the investors and the management.

Liquidation

This is the least favorable option but sometimes will have to be used if the promoters of the company and the investors have not been able to successfully run the business.

Exit Strategies for Private Equity Investors

Private Equity

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Private Equity

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