Cost and Benefits of Private Equity

12 Pages   |   3,465 Words
Table of Contents
Literature Review.. 2
Emergence of Private Equity Market. 2
Cost-Benefit Analysis. 4
Return Characteristics. 5
Benefits of Private Equity. 5
Risks of Private Equity. 7
References. 10

Literature Review

Private equity is a type of capital market in which an investor can either purchase shares from the stock market or can provide fresh capital to the company in which he is investing. The difference between public and private equity is that in the latter, investing is done in private companies (Moon, 2006). Secondary literature has shown that even though the business offers high return opportunities, it involves greater risks for individual investors. This literature review will explore diverse sources about the private equity market, its development over the course of time, benefits of stock market investment and the drawbacks for individual investors.

Emergence of Private Equity Market

Authors have explained that the present day equity market emerged over several years beginning from 1970s. The process of forming partnerships began, and private equity companies began to provide financing opportunities to other start-up ventures (Neerza, 2014). Two terms are commonly used in private equity literature. First is a general partner (GP) which refers to those partnerships that are raised solely by the private equity companies. Second is the limited partner (LP) which refers to the investors who play an important role in providing capital to these firms. Contrary to other investing options available in the financial markets, the private equity investing offers a particular style that is described and developed by the companies in which the individuals invest their shares (Neerza, 2014).
 

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In the United States, the number of private equity firms grew quickly from the 1980s to 1990s according to the sources of Securities Data Corporation (Neerza, 2014). During this time, most of the companies sold their stocks to private equity firms in the market. Thus, Federal Reserve Bulletin showed that most of the private equity investment firms in the United States were not started purposefully, but they had been turned into this business after running for some other purpose for a short period (Neerza, 2014). This was done by venture capitalists with an aim to increase their returns and also by some banks that diversified their investments to gain better experience, connections and expertise in the financial capital market (Moon, 2006).
According to Roger, Julie and Johns (2003),the private sector emerged as the major source of investment and growth in the 1990s mainly in the growing economies of the world. Various factors contributed to the growth of private equity firms in such economies for example decreasing inflation, low interest rates, high growth opportunities and a positive regulatory system for individuals. The demand for capital by local companies continued to increase, and the environment became highly competitive due to which private equity expanded quickly. Other favourable factors identified by scholarly research are macroeconomic variables in the foreign financial market, shortage of capital in economics, incentive for high returns and government's favourable attitude towards private stock market investments (Roger, Julie and Johns, 2003).
On the other hand, research has also shown that even though circumstances were highly favourable for the growth of private equity market, such emerging economies and equity capitals failed to generate expected returns for private individuals in Europe and United States as compared to elsewhere in the world (Weir and Wright, 2005). One major reason for this lack of development in emerging markets was the fact that the value of dollar increased swiftly around that time whereas there was not much change in the value of other currencies due to which the returns were not that high. The scenario was changed to some extent when in the 1990s, the emerging economies thought of revisiting their capital investment structures and opportunities (Weir and Wright, 2005).
Daniel, Martin and Kathryn (2009) have claimed that the private equity market has changed considerably over a period due to many reasons. For example: due to an enhanced number of investments from individuals as well as professionals, there is a huge amount of capital available. Moreover, financial institutions are willing to provide people with large amounts of debt to deal with their pay-outs. Due to all this, the competition between traditional and new private equity firms has boomed. Burdel (2009) further emphasises that this competition among the PE firms is increased due to the emergence of a secondary market. This is because the duration of investments in portfolios of private equity organisations has increased from 5 to 10, 12 years whereas the secondary market offers better flexibility in terms of opportunity to buy and sell (Burdel, 2009). Thus, individual investors have multiple options available these days. The cost-benefits analysis of public and private equity from the perspective of secondary literature is mentioned below:

Cost-Benefit Analysis

According to Moon (2006), to understand the growth of private and public equity markets in US and elsewhere, it is necessary to explore the cost-benefit paradigm in detail. In the public equity market, efficiency and liquidity are high and due to the existence of large number of public companies, a huge amount of investments can be generated smoothly. Moreover, the options are diversified there is greater financial flexibility (Moon, 2006).
On the other hand, research shows that private equity is structured in such a way that investors add value to the company in which they invest. The investors are classified and categorised on the basis of the general partnership or limited partnership (Douglas, 2010).
Kaplan and Schoar (2005) explain that over a number of years, the private equity firms have given an average number of returns to their investors which are almost similar to the returns generated by investing in public equity companies. They further emphasised that the difference in return becomes prominent through skills and expertise. However, for individual investors, the skills needed to generate high returns in private equity are much greater than those needed by the public equity investors (Kaplan and Schoar, 2005).
Literature has also shown that irrespective of the financial market conditions, individual investors or shareholders in private equity provide cash or investment (Kravis, 2004). Similarly, in stock market investment or private equity, the business of investing is rigorous due to its legal and financial nature. Through investing in private equity companies, individual investors create a wealth plan that provides them with a number of benefits such as a handful of useful contacts in the financial market, smaller boards, better management team, interactive environment, incentives, and high compensation against the invested amount and so on (Kravis, 2004).
However, the secondary research has drawn a link between the two types of investments i.e. the private and public equity are overlapping and interrelated (Aigner et al., 2008). The venture capital companies usually prefer to go public instead of going private because of the fewer costs associated with it. Moreover, to grab investor attention, the public companies have to display better operational performance as well. The two are related because, for the growth and development of high-functioning private equity firms, the growth and reputation of public equity companies must be good enough (Aigner et al., 2008). According to Neerza (2014), the investors who are not satisfied with the returns and operational performance of public companies can always choose to move towards private ventures. Hence, the two types of markets balance each other.

Return Characteristics

In the private equity investment, returns are highly variable, and they mainly depend on the style and stages of venture selected. It can also be said that the return depends on the amount of risk taken by an individual investor. For example, early stage of investment usually consists of high revenues and payoffs (Conroy and Harris, 2007). While conversely, failures are abundant, so access to the most proficient and effective investor is important. In continual stages of pressure on the sector’s revenues, for instance: the past period, early phase and the later phase returns can bring varying results. During continual phases of weak IPO marketplaces, later phase returns can cover those of initial phases by taking benefit of the M&A marketplace for more established entities. In any occurrence, investment returns usually are very irregular and like any barely focused approach, they become quite unpredictable with rewards happening unevenly (Conroy and Harris, 2007).
On the other hand, in buyouts, over extended periods lesser and mid-cap performers outdo great and mega-cap performers. The upper end of the sector uses more liability leverage and outdoing is hence to a certain degree reliant on credit cycles (Mozes and Fiore, 2012). Large performance indicates comparatively short eruptions of outperformance while the lower end of the marketplace is normally more reliant on operational development over intervals, producing rather stable returns (Kravis, 2004). According to Mozes and Fiore (2012), it is risky to make a comparison between venture returns and buyout returns at any stage throughout the cycle because of discrepancy and disparity among the value of returns among various sectors at different market ends.

Benefits of Private Equity

Private equity dealings are an outstanding way for owners willing to continue as private dealers to gain substantial liquidity at a handsome price without having to manage an absolute sale. Most of the private equity companies desire to acquire almost half of the equity in a usual transaction (Mitchell, 2003). It can create extensive liquidity for the firm owners and can be helpful in the diversification of their stocks by maintaining the same level of ownership. Apart from granting excessive liquidity, private equity transactions also grant excessive growth capital because the investors giving in huge sums of money are indirectly providing opportunities for internal as well as external growth and development (Mitchell, 2003).
According to Conroy and Harris (2007), on average, the net returns from public and private equity firms are perceived to be same. But they emphasise that investments done in highly reputed and superior firms give much higher returns as compared to other stock investment options. For example: in National Capital Venture Market, average earning or return from private equity funds was almost 14.3 percent whereas in public equity firms it was 12.6 percent. Thus, value adding strategies along with the opportunity to invest in superior firms are the major reasons behind increased return of PE investments (Conroy and Harris, 2007).
Similarly, another research conducted by Venture Economics indicates that the earnings from private equity investments are much greater than those from public equity firms. This research also shows that private equity is accompanied by lesser risks due to which the efficiency of bonds and stocks in greater than the public firms (Neerza, 2014).
According to Lopez (2008), the number of private equity investments and leveraged buyout in the United States increased excessively after 1990s. The value of leverage buyout in 2001 was $24 whereas it increased to $320 in 2006. However, during 2007-08, a gradual decline was seen due to global financial breakdown (Lopez, 2008). The research further explains that the funds of private equity companies are managed by professionals from private firms. Despite of professional management, the value of LBOs and bank holdings in PE firms declined due to several reasons such as mortgage crisis of US, interest expenses, considerable changes in the capital structure, value additions by individual investors, debt financing, regulatory issues and so on (Lopez, 2008).
Apart from the benefits associated with increased returns, there are other benefits of stock market investment and private equity in the financial markets. Gaughan (2007) explained that the private equity firms play a positive role in the development of mergers and acquisitions in financial markets. In the 1990s, the number of mergers and partnerships increased a lot mainly due to increased number of private equity dealings (Gaughan, 2007). The study explores that high costs associated with public companies force individual investors to tilt towards the private ones. Moreover, the regulatory requirements and audit practices of public companies were also another reason for increased popularity of private equity investments. The research also shows that individual investors can either own majority or minority shares of any private equity company which means that they can buy either 20 percent, 50 percent or even more i.e. 200 percent of the company’s equity (Gaughan, 2007). It allows the private companies to have better opportunities for leveraged buyout deal, venture capital or other financing options. The author also highlights that in 2005, many private equity firms formed joint partnerships with other PE firms to enjoy better investment benefits, enlarge their domains and maintain their stock targets (Gaughan, 2007).
Cumming and Walz (2007) conducted a research to analyse why institutional investors prefer to invest in private equity firms. They described reasons such as favourable legal environment in the US, high disclosure criterions, durable financial markets and better economic circumstances to be the main drivers that helped the PE firms to attract investors and capital at all stages (Douglas, 2010).

Risks of Private Equity

Apart from the high returns and other benefits, research shows that there are several risks and challenges associated with private equity. Individual investors have to focus on a lot of things for example: cyclicality, stages involved in investment, conflicts of interest, discrepancy of returns among various private equity firms and so on (Kojima and Murphy, 2011).
In the United States, one of the biggest challenges has been accessing to top-tier funds in the private equity market. In the starting days of this market, venture capital and stock market investment created lots of cash and capital which took years to get absorbed. The result was that new and better funds in the market were downsized thus causing a setback to potential investors (Daniel, Martin and Kathryn, 2009). Similarly, research indicates that during 2004-2007, the private equity market was full of liquidity and excessive fundraising. But the global financial breakdown of 2008 brought these markets to a standstill leaving to the problem of credit adjustment and unused capital. However, the situation in US improved after 2013, and the risks were reduced to some extent (Daniel, Martin and Kathryn, 2009).
Another challenge explained in literature is that for individual investors, private equity is not good in the short term. Therefore, such investment must be undertaken only with a mindset of long-term benefits and incentives. It is due to external and internal market conditions, uncertainty, credit situations, and volume of liquidity, mergers and acquisitions, company valuations and so on (Mitchell, 2003).
Moreover, stock market investments in private equity are considered to be volatile investments. It means that the value or price of any single stock can either go up and down in a matter of hours thus changing the whole market scenario. Such price fluctuations are beyond the control of individual investors, and therefore it becomes difficult for them to remain updated as the market changes all the time (Kaplan and Schoar, 2005). A little ignorance can lead to huge losses in such investments. Another risk is that the benefits a wealthier and a mediocre investor draws from private equity investment are not same. For example: buying a diversified basket of stocks from the stock market can be beneficial for a wealthier individual whereas it cannot give any advantage to an average investor. It leads to increased chances of loss. Hence, individual investors with the not-so-huge amount of money must buy homogenous stocks instead of diversified ones. It would reduce the risk of returns and would also help in understanding the market ups and downs in a better way (Kaplan and Schoar, 2005).
Caselli (2010) explains that when individual investors reach near the age of their retirement, they must decrease reliance on stock market investments and should start reducing the amount of cash or stocks in their portfolio. For those individuals who want to maintain safer retirement funds, the risk-averse behaviour should be adopted well before time, and they should not take chances with the amount they have invested in private equity firms. The author also explains that private equity firms can be challenges in terms of brokerage costs therefore; they must search for alternate options before finally deciding the firm in which they want to invest (Caselli, 2010).
Other disadvantages of private equity explained by Mitchell are described as follows (Mitchell, 2003):
  • Firstly, private equity transactions bring with themselves increased the burden of debt. It causes strain on business earnings and in case the operational performance does not go the way it is expected to go, the risk of default becomes more evident (Mitchell, 2003).
  • No matter whether the equity investors have a major or minor share of investment in any firm, they want the board to observe closely and monitor their investment to avoid losses and with limited seats on board, it become impossible to ensure such strict monitoring (Mitchell, 2003).
  • Moreover, the equity investors are required to pay back their depositors over a period of five to seven years and during this time; they must exit all of their individual investments in the stock portfolio. Accordingly, when holders decide to partner with private equity stockholders, they have to face the risk that the business or firm in which they have invested can go public after a few years (Mitchell, 2003).
Hare and Steelman (2008) have explained the regulatory issues associated with investing in private equity firms. According to their research, the acquisition capability of the private equity firms has increased over a period and now their investments extend to the banking sector too. So, when the private equity organisations look for banking investment, they require approval from the Federal Reserve System due to which the whole process becomes subject to certain restrictions for example regulations, terms, conditions and other limitations (Hare and Steelman, 2008).
Thus, the literature review analysis indicates the emergence of private equity markets over a course of time as well as differences between public and private equity firms. Secondary research has focussed on positive as well as negative aspects of private equity investments, and both types of viewpoints have been analysed (Conroy and Harris, 2007). The benefits include high returns, better opportunities, mergers and acquisitions as well as other factors that have been explained by the authors mentioned above; whereas some risks and challenges have also been analysed such as price fluctuations, the high variability of interest rates, market conditions and so on.
 

References

 
Aigner, P., Albrecht, S., Beyschlag, G., Friederich, T., Kalepky, M. and Zagst, R. (2008) 'What Drives PE? Analyses of Success Factors for Private Equity Funds', The Journal of Private Equity, vol. 11, no. 4, pp. 63-85.
Burdel, S. (2009) 'Private Equity Secondaries: Opening the Liquidity Tap', Thunderbird International Business Review, vol. 51, no. 6, pp. 12-16.
Caselli, S. (2010) Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals, Burlington: Elsevier.
Conroy, R.M. and Harris, R.S. (2007) 'How Good are Private Equity Returns?', Journal of Applied Corporate Finance, vol. 19, no. 3, pp. 96-108.
Daniel, K., Martin, W. and Kathryn, H. (2009) 'The Changing Face of Private Equity: How Modern Private Equity Firms Manage Investment Portfolios', The Journal of Private Equity, vol. 12, no. 4, pp. 7-13.
Douglas, C. (2010) Private Equity: Fund Types, Risks and Returns and Regulation, UK: John Wiley and Sons.
Gaughan, P. (2007) 'How Private Equity and Hedge Funds are Driving M&A', The Journal of Corporate Accounting and Finance, vol. 18, no. 4, pp. 55-63.
Hare, J.L. and Steelman, C.N. (2008) 'When Private Equity Meets Banks: The Impact of Banking Regulations on Private Equity Investment', The Journal of Private Equity, vol. 11, no. 3, pp. 61-68.
Kaplan, S.N. and Schoar, A. (2005) 'Private Equity Performance: Returns Persistence, and Capital Flows', The Journal of Finance, vol. 9, no. 4, pp. 1791-1823.
Kojima, J.C. and Murphy, D.J. (2011) 'Hitting the Curve Ball: Risk Management in Private Equity', The Journal of Private Equity, vol. 14, no. 2, pp. 18-42.
Kravis, H.R. (2004) Private Equity Analyst Conference, New York.
Lopez, J.A. (2008) The Economics of Private Equity Investments: Symposium Summary, San Francisco: FRBSF Economic Letter.
Mitchell, K. (2003) Five Reasons to Consider Private Equity, [Online], Available: http://www.exinfm.com/workshop_files/5ReaonsConsiderPE_Mitchell.pdf [18 Apr 2015].
Moon, J.J. (2006) 'Public vs. Private Equity', Journal of Applied Corporate Finance, vol. 18, no. 3, pp. 76-82.
Mozes, H.A. and Fiore, A. (2012) 'Private Equity Performance: Better Than Commonly Believed', The Journal of Private Equity, vol. 15, no. 3, pp. 19-32.
Neerza (2014) 'Private Equity Investments: A Literature Review', International Research Journal of Management Science & Technology, vol. 5, no. 1, pp. 209-247.
Roger, L., Julie, S. and Johns, H. (2003) 'Private Equity Investing in Emerging Markets', Journal of Applied Corporate Finance, vol. 15, no. 4, pp. 1-10.
Weir, C. and Wright, D. (2005) 'Incentive Effects, Monitoring Mechanisms and the Market for Corporate Control: An Analysis of the Factors Affecting Public to Private Transactions in the U.K.', Journal of Business Finance & Accounting, vol. 32, no. 5, pp. 909-943.

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