The Benefits of Private Capital for Businesses and Investors
Some aspects of traditional private equity have a negative connotation. A unique strategy, called private capital, can create value for both companies and individual investors.
Oct. 5, 2021 - Many people hear the words “private equity” and picture distressed companies in need of a turnaround. Or they may think of early-stage venture capital firms willing to absorb losses in hopes of funding a startup that becomes the next Amazon. In reality, there is a unique form of a private equity strategy known as private capital. Defined as the ownership of both the debt and equity of established, growing private companies, private capital may offer potential benefits for both the companies and the investors that put up the capital to fund those investments.
Let’s start with the potential benefits for portfolio companies. Many of these tend to be high-quality, profitable companies with a strong growth trajectory and solid management team, yet they still may need some additional support to get to the next level. Because the company’s executives have been focused on growing its business, it may not have the resources, expertise, or relationships to capitalize on the full range of options available.
In the past, some of these companies may have gone public (IPOs) to access capital, but that avenue is less attractive for many mid-sized organizations. IPOs bring a high compliance burden and require frequent financial disclosures. Over the past 30 years, the number of public companies has declined, and the number of IPOs has decreased (see previous blog post).1 Similarly, bank lending has become more constrained, further limiting access to growth capital.
IPO Companies Vs. Publicly Listed Companies
SOURCE: “Listed Domestic Companies, Total,” The World Federation of Exchanges, 2020. Jay Ritter, "Initial Public Offerings: Updated Statistics," University of Florida, June 2, 2021.
That combination is creating a financing gap, which private capital firms are filling. These firms do not provide just capital—they also offer strategic and technical expertise to help make fast-growing firms more successful. Rather than extracting value from these businesses, they partner with a goal to create value, using several potential tools.
Three Ways to Create Value
One potential means of value-creation is organic growth. Private-capital partners can bring a fresh look to a company’s business units and portfolio of products and services and ask whether there are ways to increase revenue by expanding or improving existing product lines, moving into new geographic markets or sales channels, or developing new products and services.
Pricing is another means of organic growth. Many organizations do not look strategically at the prices they charge, instead relying on “what we charged last year.” A common tool that private capital firms will apply is optimizing pricing, by determining how to increase prices without affecting demand.
A second means of possible value creation is inorganic growth through M&A (merger and acquisition) deals. Firms can create value by making strategic acquisitions—typically of smaller, complementary businesses that they can tuck into the parent company—and generate some cost savings or synergies between both businesses. Smaller deals often have lower multiples, and firms can bundle together several companies in a similar industry to generate scale advantages. Inorganic growth may also give organizations rapid access to fast-growing products, markets, or customer bases—often significantly faster than a company could achieve through organic growth.
A third way that private capital firms may add value is by making operational improvements to portfolio companies. Because these firms tend to have wide-ranging experience in an industry, they can bring best practices to the companies they acquire. This is particularly relevant in terms of integrating technology into the business, in areas such as building out a sales platform or capitalizing on new digital marketing tools such as social media.
Partnering with Management
Another unique aspect of private capital is that it aligns the interest of key stakeholders. Firms typically take a majority stake but retain the existing management team, often with attractive incentive plans that give that team “skin in the game.” In other words, the existing management teams of the acquired businesses may have meaningful ownership alongside the investment managers. For that reason, the company’s minority owners retain the right mindset to roll up their sleeves and continue to grow the business.
Potential Benefits for Investors
Ideally, the company will be worth more over time, which may generate higher returns for investors. Because private capital is the ownership of both the debt and equity, that may create long-term growth from the equity component of the investment. At the same time, income may be generated from both the debt interest and equity dividends. (Traditional private equity includes no debt component, so investors don’t see any returns from those holdings until the portfolio companies are sold and the fund is liquidated.) Because the strategy is the acquisition of private companies, private capital may offer investors a diversification in assets that do not move in tandem with the public markets. Last, private capital gives individual investors access to private companies that had previously been limited exclusively to institutional investors.
Private capital has limited liquidity, is not suitable for all investors, and entails higher risk than traditional investments. As a result, you will need to work with clients to determine whether it is a fit for their portfolio and long-term financial goals. But for those who want to invest to help grow durable companies, private capital may offer diversification.
1 “Listed Domestic Companies, Total,” The World Federation of Exchanges, 2020. Jay Ritter, "Initial Public Offerings: Updated Statistics," University of Florida, June 2, 2021.
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