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Entrepreneurs

What is private equity

Ronen Menipaz

Ronen Menipaz

02.02.2021

In the modern world of entrepreneurial fundraising, what’s the one option that most typically turn to? If you said venture capital, you’re right on the money (pun intended). It’s routinely the go-to fundraising avenue for numerous entrepreneurs who firmly believe they have high, long-term growth potential on their hands. 

Where does that leave our core topic of conversation today, then – private equity (PE)? 

Well, I’d say close by.

For starters, venture capital is technically a part of private equity, which means the latter has great importance and relevance in the fundraising efforts – some of which you may not know. I’ll explain all the major facts about PE so you can get a clear picture of what is going on here.

So, without further ado:

What is private equity, really?

Private equity is a term typically used to categorize pooled funds that aim at more mature, revenue-generating businesses, whether to take them to the next level due to their growth potential or help them solve certain struggles they may face. At the end of the day, the core idea is to increase the value of a business and offload it in some way. 

PE companies are privately owned by founders (as is the case with myself and the rest of the founding M51 gang), groups of investors (institutional, accredited), or certified managers. As a source of investment capital that is not public or traded on the stock market, PE has no constraints in its investment agenda, meaning it can target both public and private companies. 

They pool money in funds to (typically) buy or invest in companies with the hope to “repackage” these companies and/or speed up their growth (you know, generally make them perform better) to sell them to another company, take them public, or offload them in some other way. That is the fundamental reason behind PE’s fairly recent growth and high rates of return.

Perhaps the most important thing to note here is that PE is more than just injecting a significant cash infusion. It also supplies ideas and resources that provide the much-needed boost. What often characterizes PE is active involvement in the business that goes beyond handing over money in order to help it achieve success.

How private equity works

The strategy of steering a business through a transition of swift performance improvement, then profiting off it is at the core of what private equity does and does it well. This is achieved via a number of scenarios that facilitate PE’s investment plans:

  1. Buying out the company, aka leveraged buyout (LBO) 

This is arguably the most popular type of PE funding that centers on buying out a company completely from the founding shareholders and current investors. The intention is to revitalize the business (particularly its financial standing) and make a profit by reselling it to an interested party or conducting an IPO. 

Usually, PE’s use a mix of debt and equity to finance the transaction. Debt financing typically accounts for the majority of the overall funds and is transferred to the acquired company’s balance sheet for tax benefits.

In this scenario, the founding team may stay on board and continue to manage the business, or the PE can install a management team and board of directors to its liking. Leveraged buyouts are popular because a PE fund typically has enough cash at its disposal to buy the entire company, creating less uncertainty for its owners.

  1. Buying out the founder(s)

Apart from forking out the cash for 100% of the company’s shares, it’s also feasible to buy out only the founder(s), while keeping current investors in place. From the founder and investor friction to retirement to sheer boredom, there’s no shortage of reasons why some entrepreneurs sell their ownership. 

Stan Marsh America GIF by South Park

Founder buyout also occurs via a management buyout (MBO) where employees (e.g. the company’s management team) band together with a PE and purchase the assets and operations of their business. Both cases present an attractive option from the PE’s point of view as there is a controlling stake up for grabs, although the former seems to be more widespread.

  1. Buying out the current investors

It’s possible to cash out the existing investors in the same way. Some investors simply grow weary of having their money tied up in private business for years on end, especially if things don’t go quite as planned. So, they decide to hand over the reins to other fellow investors in search of a payday.

  1. Recapitalization

An owner/founder of a privately-held business usually has a significant amount of their personal net worth tied up in the company they worked hard to build. Partnering with a PE company via a recapitalization allows the owner to diversify some personal risk, while remaining with the company at the same time. As a result, PE can recapitalize or restructure a company for the future with a view towards eliminating overhead redundancies, for example. 

It’s an alternative to a complete sale where the new partner (a private equity firm) embraces the owner’s culture and vision, and brings strategic opportunities and management experience (that were not previously available) to help the company reach its next level of growth. Of course – all of this is possible if the company in question meets the criteria for a near-term turnaround. 

  1. Investing in expansion capital

PE firms also often fund an expansion of the business, particularly in cases where most (or all) personal and business assets have already been pledged as collateral on loans. As you can probably imagine, such a scenario can seriously hamper the company’s growth odds and competitive standing. 

This is where private equity funds come into play. They can help a flourishing business maintain its planned course with funding for acquisitions, new product or service development, local and global expansion, and so on.

Regardless of the scenario, the potent combo of business and investment-portfolio management is what makes private equity an enticing and successful option for entrepreneurs. This hard-earned reputation for considerably increasing the value of their investments has helped fuel the growth of PE investments in the past few years. 

This ability to achieve high returns by making necessary changes is generally attributed to multiple factors, with a few standing out:

  • High incentives and motivation to deliver the projected return on invested dollars;
  • Keen focus on cash flow and margin improvement;
  • Aggressive use of debt as leverage in financing and tax advantages;
  • Lack of regulatory limitations imposed on public companies.

The difference between private equity and venture capital

Before we get into the pros and cons of private equity, let’s address the PE vs VC thing quickly.

I’ve previously noted that I consider venture capital a subset of private equity, and I’m not alone in this thinking. PE and VC have moved closer to each other over the years (more on that later on) so it’s understandable why there is some misunderstanding around these two. Both raise capital from outside investors, invest it in private companies or those that eventually become private, and try to sell them at higher prices in the future.

Traditionally speaking (this is important to note), the most notable differences revolve around the following:

  • Types of companies they invest in: PEs typically invest in companies across all industries, while VCs emphasize various forms of tech companies.
  • Acquisition percentage: PE firms often take a majority stake, where they acquire between 50% and 100% of companies, while VCs provide funding in exchange for a minority stake which is usually less than 50% ownership.
  • Investment size and stage: PE firms tend to do larger deals compared to their VC counterparts as they focus on bigger, more mature companies and acquire higher percentages of ownership. On the other hand, VCs make investments in early/earlier-stage companies that are showing rapid growth or the potential for it.
  • Investment structure: PE uses a mixture of equity and debt to make their investments while VC almost exclusively uses cash raised from investors. 
  • Operational focus: PE firms tend to be more involved with companies’ operations because they have greater ownership, and it’s “on them” if something goes wrong.

I’ll point out once again – there are exceptions to every rule with lines getting blurrier each day, as you’ll see in an example later on. More and more companies on both sides are acting out of the norm in an effort to get in on the action that seems to be hotter than ever, especially with the accelerated digital transformation fueled by the COVID-19 pandemic. 

What’s good about private equity

Besides the obvious – money, one of the biggest advantages of private equity is its wide scope of investments. There’s been a noticeable shift in the past decade or so, where more and more PE companies are opting to invest in growth-oriented, revenue-generating businesses.

This is good news for established owners but PE firms are far from scared of investing in struggling businesses. They have the know-how to reinvent a business and build it back to profitability, which significantly increases the range of their investment radar.

Tech companies, in particular, are growingly present in PE investments. This includes a wide array of tech businesses, everything from unicorns to early- to mid-stage profitable and unprofitable companies. For the latter, securing this type of investment would have been unattainable just a few years ago.

Private equity funding often comes packaged with new thinking and ideas, possibly even new management to give the business a second wind. Some private equity firms prefer a more passive, almost a board-level type of involvement with the existing owner and management. Others choose to form a more collaborative relationship that augments the founding team in a variety of ways. 

In more tangible terms, advantages of private equity are:

  • Easy, alternative access to liquidity compared to conventional financial routes such as high interest bank loans or listing on public markets.
  • More efficiency through internal oversight (e.g. minimized operational expenses) which can lead to increased profits.
  • Access to more resources and skills, as well as connections to perfect and offer its products or service to a larger customer base.
  • Financing of ideas at almost every stage of the company’s life cycle.
  • Room to apply unorthodox growth strategies without the typical stress to reach quarterly performance.

What’s bad about private equity

Naturally, not everything is rosy here as there are some cons to address. Perhaps the biggest one is that the underlying motivation for a PE firm isn’t the long-term health of the companies it invests in or buys. It’s to make money, plain and simple, the faster the better. 

This is particularly evident with some of the larger private equity firms today. They don’t seek to retain their investments in the long run as they focus more on generating short-term returns. The harsh truth is that if there is nothing left of the company at the end, that’s really not something to lose sleep over.

The other big thing is that in order for the company to become worth much more, there may have to be some tough choices to make. After all, you have to remember that we’re talking about financial investors who base their decisions primarily upon their projected return on invested dollars. 

In cases where there’s control over a company’s operations, sentimentality, workforce, the role of the founders in the business, anything related to the business’ long-term success – they all take a backseat. So, it’s best to be prepared for some ruthlessness. Still, the rights of private equity shareholders are generally decided on a case-by-case basis through negotiations so it’s not like you are automatically locked out of getting a fair deal. It’s not ideal but it leaves enough room for you to work out the best possible conditions.

Additional controversy surrounding private equity is that whatever happens to the company acquired, private equity makes money anyway due to the fee structure. Moreover, there have been cases where PE firms have taken out additional loans through their leveraged companies to pay dividends to themselves and their investors, and the companies are on the hook for those loans too.

Moving away from the horror stories, PE’s tangible disadvantage is the fact that valuations are not set by market forces. This means that pricing of shares for a company in private equity is determined through negotiations between buyers and sellers, which adds a certain limitation. 

A new, hybrid model of private equity

However, most of these “rules” or standards (however you want to call them) aren’t necessarily set in stone. Private equity is evolving and as lines with VC slowly fade, more companies are adjusting their investing approach (and parameters) to evolving needs of the entrepreneurial scene.

On one hand, PE investments in tech are growing, while numerous VC firms are creating massive late-stage growth funds. The change is also evident in the way they behave: some VC firms are taking controlling interests in startups – a strategy normally associated with their private equity peers. On the other hand, PE companies have begun acquiring majority stakes in startups that managed to raise early-stage investments but are grappling with further funding and scaling their business.

There are companies like M51 private equity (which I’m a founder of) that make tech-oriented investments in early-stage companies with a clear business model. You know – almost everything opposite the established VC norms. For example, M51 invests primarily in the fields of gaming, fintech, martech, and edtech, but also good ole real estate. 

We like to think of ourselves as a hybrid model of private equity (not that we insist on classifications) as we help various kinds of entrepreneurs. We prefer a hands-on approach and work hand-in-hand with entrepreneurs and companies to help them exceed their limits and overcome any challenge. We not only provide funding but also our time, energy, brain cells (we’re still working on power cells), and our entire network of resources so they can achieve their full potential and ultimately, goals. 
And we’re not out to offload or buy out the founders. When we join forces with a startup, it’s in order to maximize its potential and sail into the sunset, better, together.

Private equity in Israel

As an Israeli entrepreneur and investor, I primarily speak about the state of private equity in my own backyard. As I’m sure you already know, there’s a reason why Israel is labeled as the Startup Nation. Besides being labeled a land of venture capital investments first and foremost, private equity also plays an important part here for quite a few entrepreneurs.

In fact, many see it as the solution for a business looking to take things to the next level. There may be less glamour and slower growth compared to its VC counterpart, but PE has a firm and more streamlined focus, especially when it comes to the domestic market. Because of the fertile ground entrepreneurship-wise, the majority of investments are made domestically while a smaller percentage is seeking investment opportunities across the borders.

The private equity market in Israel is highly developed and fairly competitive, sustained both by the development of the local PE scene and global recognition. Just take a look at this list of top private equity companies in Israel and their portfolios. Israel’s private equity sector has firmly embraced the country’s tech industry over the course of the past decade or so, and it isn’t letting go. 

The Israeli high-tech industry continues to produce about 1,000 new innovative companies every year, which maintains the high reward potential for interested parties looking for the next best investment. High-quality human and capital resources have enabled numerous cybersecurity, fintech, business productivity, and various other tech-centric startups to grow and compete globally for investments, helping the Israeli ecosystem emerge internationally through high-powered transactions.

As a result, Israeli tech ecosystem continued to grow in a big way in 2020, despite the pandemic-driven global crisis. The total capital raised was more than $10 billion, the most ever, continuing an impressive growth trend with an increase of 27% in capital and 14% in the number of deals. So, it’s safe to say that Israeli founders and entrepreneurs are becoming more receptive to PE’s and VCs value proposition, both domestic and international.

Capital Raised Comparison In Billions $ between 2016 and 2020

Speaking of international affairs, foreign funds also compete for the highly prized combination of Israeli scientific and technological innovation, apart from tens of Israeli funds. For us local players, it helps that PE funds with a permanent domestic establishment often receive tax rulings from the Israeli Tax Authority providing an exemption from capital gains tax on investments in Israeli tech companies. However, there’s no denying that the allure of foreign capital is enticing and growing stronger each year.

All of this helped form Israel into a diverse and globally important capital ecosystem. 

Final thoughts

Speaking from 20+ years of experience, very few founders create companies in order to flip them. Strong entrepreneurs create companies to transform their missions into reality and positively impact the world. That’s where private equity can be of immense help.

Private equity companies consist of savvy business partners who bring more than just capital to the table. They provide industry, operational and organizational expertise that can increase the value of a business. Partnering with a PE firm means shacking up with deep pockets and extensive business connections that allows the entrepreneur to set the stage for strong growth. 

There are plenty of smaller private equity firms out there that specialize in specific fields and make investments in relatively small companies where there is a lot of room for improvement. It could be the solution for a business that is not only in need of an investment, but also a new top executive to turn things around. After all, the idea is to end up with something better – a win-win situation both sides are willing to work for, hard.

Image credits:

https:/giphy.com/gifs/southparkgifs-l0HlDDyxBfSaPpU88

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