Private Equity and Venture Capital
Episode #7 of the course Introduction to capital markets by Doha Soliman, CFA
Greetings!
In the first few days of our course, we covered equities and bonds, otherwise known as traditional investments. For the next three days, we’ll discuss alternative investments. These include private equity, venture capital, hedge funds, and real estate.
Alternative investments have similarities to traditional stocks and bonds. However, unlike their counterparts, they are privately traded. Remember when we discussed the going-public process? These investments have either never gone public or have gone public and went back to being private, i.e. not traded on an exchange.
As private corporations, they do not have the legal obligation to release their earnings and other financial records. Furthermore, they are under fewer regulations than their public counterparts.
Private Equity
Private equity refers to investors and funds that invest in a private corporation. It can consist of a handful of investors or several funds and owners. The capital private equity raises can be used for solvency (generating cash to pay debt), for expansion, or to buy out a current owner.
Unlike public equity, private equity is a difficult market to enter for most investors. Since corporations are not traded frequently, valuation of a company can be difficult to obtain. In addition, due to the lack of trading, pricing can be less subject to the laws of supply and demand and thus, have a substantial premium for investors. The final major hurdle in investing in private equity is the minimum investment required, which tends to be rather high for such corporations, since shares traded constitute a significant portion of the entire investment.
For example, if Linda is interested in purchasing a share of Facebook, she can create a brokerage account, deposit money, and start trading by simply buying a minimum of one share, which hypothetically trades at $175/share. However, if prior to becoming a public corporation, Linda had expressed interest in Facebook, she would have had to invest thousands, if not millions, of dollars to become part-owner of Facebook. This is not feasible for most investors, as it ties up most of their funds in one investment and may present legal and financial obstacles. Let’s now discuss venture capital and how it differs from private equity.
Venture Capital
Venture capital is similar to private equity in that it relates to investors buying into a private corporation. Venture capital, however, is an investment in an early-stage corporation that has exhibited high growth and has great prospects. The aim of these investors is typically for the corporation to go public or to be sold to another corporation. Venture capitalists, or VCs (the companies that invest in such corporations), typically buy a minority share in the early-stage company and utilize their contacts, their expertise, and their resources to develop the company to pursue their exit strategy, typically an IPO. VCs tend to play a large role in the operations of their investments and may have an overpowering authority in executing their plan. They tend to prefer technological companies, as they can exhibit high growth in a short amount of time—think Facebook.
In summary, private equity and venture capitalists tend to be wealthy investors or funds that seek out successful corporations in order to sell them over a short period of time for a large profit. Their investments tend to be substantial and are not available for the average investor. They may require a large investment of time, expertise, and financial resources.
Tomorrow, we’ll discuss another alternative investment, hedge funds, and explore fundamentals of mutual funds.
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