The people who start companies aren't always the right people to lead them through every stage of development. Frequently, after a certain amount of growth, the existing management team no longer has the skills to grow the company. The company may also require additional infusions of capital to finance growth and, in some cases, help prepare for a public offering. Private equity helps provide that capital, while providing additional management expertise as the company scales up.
The first function of private equity funds and partnerships is to provide profit to the fund owners. They typically identify promising companies that require additional financing to scale up staffing, nurture a new drug through clinical trials, expand manufacturing or otherwise make significant investments. After providing the capital, private equity firms then seek to profit either from ongoing operations or by selling their stakes to downstream investors or to the investing public through an initial public offering.
A private equity firm frequently purchases a controlling interest in the company. This enables the firm to take control of management and replace managers, as needed, with those with more experience running larger enterprises. Their expertise can range from operations to finance and accounting to technical expertise. The company also benefits from the substantial industry contacts the new management can provide.
The private equity firm can provide financial support for the company in a number of ways. The firm can take direct ownership of a majority or minority interest in the company, for example. If the company's owners want to raise capital but do not want to dilute their ownership interests by issuing stock, they may seek out a private equity firm to provide mezzanine financing, a type of senior debt issue. Occasionally, the lender will include an option to convert the debt into stock at a certain price per share. These debt securities are called "convertibles."
Private Equity's Role in the Capital Markets
Looked at more broadly, private equity firms have a role in helping financial institutions and the wealthy diversify their investment portfolios. Private equity opportunities may have a very low correlation to performance in the stock or bond markets. They also give investors and investment managers access to vehicles with potentially higher returns than conventional investments and publicly-traded securities, albeit at a cost of lower liquidity and higher risk.
- "Exposed to the J Curve: Understanding and Managing Private Equity Fund Investments"; Ulrich Grabenwarter, et al., 2005
- "The New York Times"; The Rising Role of Private Equity; William Epstein; July 2006