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All you should know about Private Equity Firms: Stages, Valuation, Exit Options

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| Updated: Aug 27, 2019 | Category: SEBI Advisory

Private Equity is playing a crucial role in boosting the Indian Economy. According to the Indian Private Equity Report 2019 published by Bain & Company, the private equity investment momentum remained robust in 2018. Hence, Private Equity Firms are performing excellently.

The total investment from VC (Venture Capital) and PE (Private Equity) summed a total value of $26.3 billion from approximately 793 deals during the year.

With this, India has experienced a surge in PE activity in the past few years with the growth of local funds. Generally, a private equity fund is a collective investment scheme that is used for investing in several equity securities based on one of the investment strategies related to Private Equity.

Typically, such funds are managed by a firm or limited liability partnership. The maximum term of such funds is ten years with an option of an annual extension. To understand the private Equity, its registration process, etc. stay on the page and keep reading.

What is Private Equity?

Private Equity refers to the fund or investment collected from the investors and invested in a potentially successful organization but isn’t traded publicly in the stock market.

Private equity funds gather a handsome return from an investment with 7-10 years of capital appreciation. Private Equity is similar to venture capital to a great extent.

Where does private equity fund come from?

Private Equity Funds come from the following sources:

  • Pension Funds
  • Endowments
  • Institutional Investors
  • High Net Worth Individuals
  • Investment Companies

Private equity firms let high net worth individuals and fund managers to modify their portfolio and lessen risk.

Besides, the investors get their capitals back within ten years and with a higher return.

Stages of Private Equity Investment

Generally, there are four stages of Private Equity Investment in India. They are as follows:

  • Seed stage investment: Under the seed stage, the investment is made for the sake of a business idea. Generally, the investment is made for market research and development.
  • Early-stage investment: It’s the second stage of investment. Here, the investment is made to help companies start up their operation activity and prior to the occurrence of commercial sales.
  • Formative stage investment: In this stage, the investor invests their capital to initiate or scale up the company’s operations.
  • Later stage investment: In this stage, the capital is put up for expanding the business. Furthermore, the investment is made to scale up the business before it goes public.

Valuation of companies by Private Equity Firms

We all know that the public company can trade its shares on the stock market. Hence, they are easily valued. However, the same isn’t true for private companies. The shares of these companies can’t be traded, and therefore, PE firms use several methods and techniques for ascertaining the actual value of shares.

Here are some of the valuation methods for Private Equity Funds:

  • Discounted Cash Flow Method: It’s a valuation technique where the value of the company is valued by discounting estimated future cash flows of the company at a discounted rate. Moreover, high risk intends to convert to a higher discount rate, which implies the company’s lower valuation.
  • Relative value method: It’s a method where earnings multiples of similar companies apply to the target company’s earnings. Generally, the earning multiples equal the average of the earnings and value of comparable companies, traded in stock markets.
  • Replacement cost method: In such a method, the value of a business is estimated through the calculation of the estimated cost to recreate the business as per the value stands on the valuation date. Usually, such techniques are used to estimate the value of companies working in the seed or early stage.

Management of Portfolio Companies by Private Equity Firms

Here are some of the following aspects of the private equity investment that aids private equity firm to manage and operate their investment companies:

  • Corporate Board Seats: To protect the interest of a PE firm, a person is nominated from the Private Equity Firms on the Board of Directors of the company. It follows in case of corporate events such as a business takeover, sale of shares, IPO, restructuring, liquidation, or bankruptcy.
  • Non-Compete Clause: Such a clause is levied on the founders. Besides, it prevents them from starting the same activity again during a pre-defined timeframe.
  • Liquidation preference and preferred dividends: Generally, during the distribution, Private Equity Firms are considered first. Moreover, these are guaranteed a minimum return on their original investment prior to receipt of returns by the shareholders.
  • Reserved matters: Some strategic decisions like acquisitions or divestitures, and changes in the business plan are subject to veto or approval by the PE firm. 

Exit options for Private Equity Firms

Most of the Private Equity Firms consider exit options before making any investment. The reason for the same could be that exit options help in unlocking value in private equity investment.

Below we have described some of the exit options for PE investors:

Initial Public Offering (IPO)

IPO is one of the most preferred exit options among the PE firms. It is because IPO offers higher valuation multiples and improves liquidity. Furthermore, it lets the business raise more funds so that it can grow even more.

Secondary Market

The secondary market is held by PE firms where the shares are sold to a financial investor or strategic investors. Secondary Market Exit Options are one of the most common forms of exit.

Management Buyout

Under such exit options, the management group purchases the shares held by the PE firms through debt raising or other kinds of funds.

Liquidation

Such options are one of the worst cases wherein the firms have to liquidate their shareholding at ground prices in case the company isn’t workable anymore.

Reference : Indian Private Equity Report 2019 published by Bain & Company

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Khushboo Priya is an experienced Legal content writer with a prodigious proof-reading and research & development skill.

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