Private equity investor & Venture Capital, introduction.
Today we have to start discovering the fascinating world of private equity, and we have to start with the definition. But we are not lucky as the definition is not simple. The definition of private equity is based on two different aspects we must have in mind every time we deal with this issue. On one end private equity is a source of financing for a company. That means a private equity is an alternative of other sources of financing like an IPO or bond issuing or getting a loan from the banking system. On the other hand, private equity is an investment made by a financial institution, we name private equity investor, in a company which is not listed in the stock exchange. Practitioners sometimes say private equity is not public equity and this is true, because a private equity is an investment in a company which is not listed in the stock exchange. The last aspect we must have in mind when we talk about the definition of private equity is sometimes we also use the label venture capital. Venture capital is a very specific case of private equity. That means we have venture capital when the private equity investor invests in a company staying in a very early phase of development, or in a start up. But now, let’s try to understand something more about the relationship between the private equity investor and the company which is financed by the private equity investor itself. That’s quite important also, to fix the taxonomy of this kind of deal. Let’s start with a company. The company needs money. So, let’s imagine a very simple balance sheet. The company needs money, and for this reason, because the company wants to use private equity investment, is going to issue new shares. These shares are bought by the private equity investor, and for this reason the private equity investor is going to give money to the company. The company receives money and the need of financing is satisfied. But the consequences of this very simple deal which is based on the company and on the private equity investor are very important. The first consequence, the private equity investor is not simply a financier like a bank giving loans, but the private equity investor is also a shareholder. That means the private equity investor can enter in the governance of the company, can support the management of the company itself. The second consequence is that the only way to receive a remuneration for the private equity investor is related to capital gain. Because the only way the private investor can use it to obtain profit is to sell the shares and to put, in its pocket, a capital gain. For this reason, practitioners really love to say private equity investment is a marriage but with an end, because the company and the private equity has to stay together but there is clearly an end because the private equity has to exit to receive the capital gain. So these two stories, to be a financier, and to be a share holder live, always, together when we discuss private equity investment. But now we have to understand something
more, and we have to use the angle and the perspective of the investor to better understand the characteristics, the fundamental mechanism of a private equity investment. Before we said private equity is not public equity, so it’s finer to compare private equity with public equity to better understand the mechanisms I mentioned before, and I want to use three different parameters to compare private equity to public equity. The first parameter is related to liquidity, the second one is related to pricing, and the third one is related to monitoring. Let’s start with liquidity. If you are an investor in a company listed in the stock exchange, liquidity is not a problem. You want to exit, you want to sell your shares, you push the button and you receive liquidity from the market. But if you are a private equity investor, to have liquidity is not easy because you cannot use the stock exchange. You have to identify another investor willing to buy your shares. That means it could very time consuming, very tough, and in some cases, very, very, difficult. The second parameter is related to pricing, that means, the price of your shares. If you are an investor in a company listed in a stock exchange, pricing is driven by the market. Pricing could be fair, could be unfair, could be low, could be high, but pricing is not the issue. It’s given by the stock exchange. On the contrary, if you are a private equity investor, every time you have to negotiate the pricing of the share with the other investor. And as you know, the negotiation in some cases could be very easy, in other cases it could be very tough. The last issue is related to monitoring. If you remember, before I said that the private equity investor is a shareholder of the company. That means the private equity investor has to protect his or her right as to monitor the value generating in investment. So if you invest in a company listed in the stock exchange, your rights are regulated by the laws of the stock exchange. And in different countries we have very relevant laws that are able to protect, also, minority equity investors. On the contrary, if you are a private equity investor, case by case you have to write in a contract the way you protect your investment, the rights you want to use to stay in the company. Three different parameters: pricing, liquidity, and monitoring. Every time we discuss our private equity investment we have to understand what’s the right way to manage these three issues all together.