Matthew B. Murphy III Shares an Explanation of Private Equity Firms and Their Function in the Business World

Private equity firms can provide vital financing to companies at any stage of development. Private equity is positioned as an alternative to bank financing and venture capital financing.

Matthew B. Murphy III, a member of a business financial consulting firm in Indianapolis, Indiana, and whom has served in governance roles on behalf of private equity organizations, explains what private equity is and how it can help businesses grow.

What is Private Equity?

Private equity is an alternative form of investment. It consists of money and property that is not listed on any public exchange. Private equity consists of investors and funds that put their money directly into private companies. These investors may also buy out public companies, causing the capital to be removed from public exchanges.

Private equity investments are generally made into mature businesses. They are most often part of traditional industries like retail, manufacturing, distribution and hospitality. The private equity investor provides funding in exchange for an ownership stake in the company.

The capital received from private equity firms can fund acquisitions, support working capital and a healthy balance sheet, and fund expansions into new technology.

Private equity is considered an alternative asset class like venture capital and real estate. Since they are less traditional investments, access to private equity investments is more difficult than putting money into stocks and bonds.

What Does a Private Equity Firm Do?

Investors working in private equity firms are called private equity investors. These investors are involved in identifying targeted investments and raising capital.

When they want to invest in a company, investors need to raise capital from groups of limited partners. This money forms a private equity fund closed and invested when the right target is found.

A private equity firm generally invests in multiple companies at the same time. Companies funded by these firms are known as portfolio companies.

Private Equity Compared with Other Funds

Private equity funds are sometimes compared to hedge funds, but a few key differences separate these investment vehicles. The funds are restricted to accredited investors, but hedge funds usually operate in public companies while private equity funds invest in private companies.

Venture capital is considered a form of private equity, but the investment structure is different.

Venture capital firms invest at earlier stages than private equity firms. Generally, a venture capital investment is made in a startup company or has begun to see revenue and profitability. Venture capital funding is also focused primarily on technology firms. Private equity firms often target later-stage companies in traditional industries.

The major difference between private equity investments and venture capital investments is that venture capital investors generally take a minority stake in the company. In contrast, private equity firms take a 50 percent stake or higher. This means that the firm has a much greater level of control over the company’s activities than a venture capital firm would have.

How Private Equity Firms Make Money

Unlike mutual funds, which can only collect management fees, private equity funds can collect both management and performance fees. These fees vary depending on the fund, but they generally follow the “2- and-20” rule.

The management fee is generally 2 percent of the assets under management. The performance fee is a percentage of the profits that come from investing. It is generally about 20 percent. These fees help to incentivize better returns. Private equity employees receive these returns as a reward for their success.

How Private Equity Funds Choose their Targets

Private equity investors may choose companies that are potentially distressed or going through a period of stagnation. These companies usually show some sign of growth potential in the future.

Most frequently, private equity firms perform leveraged buyouts of their investment targets. Investors purchase controlling stakes in the company using a combination of debt, which the company must repay, and equity. The private equity investor works to help the company become more profitable so that their debt repayment is not as much of a financial burden.

Private equity firms sell their portfolio companies for profit, giving their returns to the partners who invested. It is also possible that some companies backed by private equity could go public.

Why Choose Private Equity Over Other Types of Funding?

Private equity provides relatively easy access to capital for large and established companies. There is less emphasis placed on quarterly performance, so companies do not have the stress of continually meeting “Wall Street” benchmarks.

Not being on the publicly traded markets has its advantages, and private equity funding can allow a company to raise much-needed money without exposing itself to the headaches that could go along with becoming publicly traded.

Understanding Private Equity

Private equity professionals like Matthew B. Murphy III are dedicated to helping companies grow through the balanced application of capital. Private equity firms do make a significant profit from their investments if the company succeeds. Still, they are also exposing themselves to a large amount of risk if the company fails.

Private equity financing can carry significant advantages for companies compared to other types of investment, and companies that may be stagnant or facing some financial difficulties may want to look into receiving it.

This article does not necessarily reflect the opinions of the editors or the management of EconoTimes