How Private Equity Financing Really Works

What You May Not Know About PE: How Private Equity Financing Really Works

Many people have a high-level understanding of private equity as a source of funding and strategic partnership for businesses, but even among professionals, the conceptual line between venture capital and private equity can be a bit murky due to confusion about how private equity financing really works. How does private equity fit into the broader institutional finance ecosystem? What are some common misconceptions? Understanding basic answers to these three questions can help you to understand a critical part of the world of finance.

What Distinguishes Private Equity from Venture Capital?

One reason that many people are unsure of how private equity financing really works is that there are similarities between private equity and venture capital. Both invest in businesses in exchange for an ownership stake with the goal of accelerated growth and an eventual profitable exit. Both actively manage a portfolio of companies and act as strategic advisors and partners to the leadership of portfolio companies. And both tend to specialize within a niche or niches in which the firm’s partners have special expertise.

However, key differences exist. Whereas venture capital firms focus on start-ups and young businesses, private equity firms tend to serve more established businesses (including public companies) that require larger amounts of capital and/or a realignment of market strategy. Private equity firms may buy enough shares of public companies to re-privatize them, allowing the company to shift strategy without pressure from public shareholders and Wall Street analysts. Private equity can also facilitate M&A activity that may be difficult for a struggling business with strong potential but a weaker balance sheet to execute on its own. Private equity firms favor a timeline 4 and 7 years on average from signing of a new partnership to completion of a successful relationship with a business in their portfolios.

Common Misconceptions About Private Equity

There is a perception that private equity firms target struggling companies with valuable assets in order to acquire those assets at bargain prices, dissolve the companies that hold them, and sell off the assets for a profit. While it is possible that this can happen, this is not how private equity financing really works. Many private equity firms consider themselves to be active and engaged investors in the same way that venture capital firms often are, and therefore consider operational and management support to be a key responsibility. A private equity firm can certainly facilitate M&A activity, but this typically becomes an option only after a period of investment and partnership. More often than not, a private equity firm and a business owner will find that they are aligned on goals and that the relationship leads to a better result that otherwise attainable.

How Private Equity Financing Really Works