What is Private Equity?

Private equity investments are an important source of capital for new and emerging firms, distressed firms, and both private and public firms in need of capital. One reason is that private investment avoids the cost associated with pursuing a public stock offering; another is that private equity securities are not regulated as stringently as are public securities. In addition, private equity investors, such as professional venture and buyout firms, institutional investors and high net worth individuals, can provide capital in situations where traditional lenders lack the necessary expertise. In these cases, private equity investors can be a valuable resource to these private companies, whether the companies are seeking to develop an initial business idea, expand a business or reconfigure it to become more profitable. The universe of private equity investments comprises a number of distinct strategies, spanning a companys entire life-cycle. Venture capital

Investing in an underdeveloped or developing product or company Venture capital is financing provided by professionals who invest alongside the management of emerging, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies, often providing the seed capital needed for research and development. Venture capital also assists start-up companies as they begin operations and actively market their products and services. At later stages of a companys life-cycle, venture capital can help to finance the expansion of operations, develop new products and access new markets, as well as provide replacement capital when needed. Venture partnerships typically experience a performance cycle that yields negative or flat returns in the early years, modest returns in the middle years, and, in the case of profitable ventures, significant returns in later years.

Buyout

Acquiring a complete or controlling position of another company A buyout fund, sometimes known as a leveraged buyout or LBO, seeks the takeover, controlling interest, or complete ownership of a company. A buyout fund employs leveraged capital a mixture of debt typically secured by the assets of the business, and equity provided either by the funds capital or newly raised funds. Buyout funds may take an active or passive role in managing the acquired company. The return from a buyout fund is usually determined by the amount of leverage used, the success of the buyout group in enhancing the business, and market valuation once the company has a liquidity event. In a management buyout, the current or new management of a company will partner with a private equity investor to perform a buyout of an existing company. In a management buy-in, a new management team takes over management of an existing company. Other strategies include recapitalising privately held firms, buying and expanding publicly traded companies, and buying businesses to divest non-core divisions. Mezzanine

Financing the expansion of an existing company Mezzanine capital is a late-stage investment typically employed just prior to an initial public offering (IPO). Investors entering a private equity fund at this stage typically take on less risk than at earlier stages due to anticipated capital appreciation or liquidity events resulting from the upcoming IPO. Mezzanine financing is a hybrid of lending and equity investing, and broadly refers to unsecured, high-yield, subordinated debt or preferred stock. With higher repayment priority than equity, it can facilitate payment of new management ahead of existing management in the event of bankruptcy, and is often used in acquisitions and buyouts. Mezzanine financing may take the form of a seller note, where the seller lends a portion of cash proceeds to the company. Special situations

Acquiring distressed or equity-linked debt "Special situations" broadly cover distressed debt, equity-linked debt, project finance and other onetime opportunities stemming from changing industry trends or government regulation, that are expected to cause an increase in value in a company.

Private Equity

Private equity, or investing in the capital or equivalent of unlisted companies, is a long-term investment in promising businesses. We select players who give you the opportunity of investing in innovative areas, or sectors that are seeing rapid growth or restructuring, whilst always focusing on projects supported by rigorous management, appropriate financing, the quality of the founders or management team and proven growth prospects. These products are again generally reserved for experienced investors as they are long-term investments with no possibility of early withdrawal.

An overview of private equity What is private equity? Life-cycle of a company

An overview of private equity

As global financial markets become increasingl complex and interconnected, new opportunities continue to emerge for high net worth and institutional investors to grow, manage and preserve their wealth. Traditional investments alone may no longer provide the returns, stability and diversification these sophisticated investors seek, and many have turned to a growing array of alternative investments to provide new solutions. Among the various alternative investments available today, private equity has demonstrated a strong potential to deliver superior investment returns. The industry has drawn the attention of high net worth investors and entrepreneurs alike, growing into a US$2.3 trillion industry today. Indeed, private equity has become a major force in economies around the world. HSBC Private Bank sees private equity as a strategic part of a diversified portfolio, alongside traditional stocks, bonds, cash instruments and other alternative investments. Allocating a portion of a portfolio to private equity investments may contribute to achieving an optimal asset allocation, which is widely accepted to be one of the most important determinants of a successful, long-term diversified investment strategy.

What is private equity?

Private equity is a broad term that refers to capital invested in companies not listed on a public exchange.

Private equity investments are an important source of capital for new and emerging firms, distressed firms, and both private and public firms in need of capital. One reason is that private investment avoids the cost associated with pursuing a public stock offering; another is that private equity securities are not regulated as stringently as are public securities. In addition, private equity investors, such as professional venture and buyout firms, institutional investors and high net worth individuals, can provide capital in situations where traditional lenders lack the necessary expertise. In these cases, private equity investors can be a valuable resource to these private companies, whether the companies are seeking to develop an initial business idea, expand a business or reconfigure it to become more profitable.

Life-cycle of a company

Strategies

Venture capital

Buyout Mezzanine Special situations

Private equity investing

Venture capital

Investing in an underdeveloped or developing product or company Venture capital is financing provided by professionals who invest alongside the management of emerging, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies, often providing the seed capital needed for research and development. Venture capital also assists startup companies as they begin operations and actively market their products and services. At later stages of a companys life-cycle, venture capital can help to finance the expansion of operations, develop new products and access new markets, as well as provide replacement capital when needed. Venture partnerships typically experience a performance cycle that yields negative or flat returns in the early years, modest returns in the middle years, and, in the case of profitable ventures, significant returns in later years.

Buyout

Acquiring a complete or controlling position of another company A buyout fund, sometimes known as a leveraged buyout or LBO, seeks the takeover, controlling interest, or complete ownership of a company. A buyout fund employs leveraged capital a mixture of debt typically secured by the assets of the business, and equity provided either by the funds capital or newly raised funds. Buyout funds may take an active or passive role in managing the acquired company. The return from a buyout fund is usually determined by the amount of leverage used, the success of the buyout group in enhancing the business, and market valuation once the company has a liquidity event. In a management buyout, the current or new management of a company will partner with a private equity investor to perform a buyout of an existing company. In a management buy-in, a new management team takes over management of an existing company. Other strategies include recapitalising privately held firms, buying and expanding publicly traded companies, and buying businesses to divest non-core divisions.

Mezzanine

Financing the expansion of an existing company Mezzanine capital is a late-stage investment typically employed just prior to an initial public offering (IPO). Investors entering a private equity fund at this stage typically take on less risk than at earlier stages due to anticipated capital appreciation or liquidity events resulting from the upcoming IPO. Mezzanine financing is a hybrid of lending and equity investing, and broadly refers to unsecured, high-yield, subordinated debt or preferred stock. With higher repayment priority than equity, it can facilitate payment of new management ahead of existing management in the event of bankruptcy, and is often used in acquisitions and buyouts. Mezzanine financing may take the form of a seller note, where the seller lends a portion of cash proceeds to the company.

Special situations

Acquiring distressed or equity-linked debt Special situations broadly cover distressed debt, equitylinked debt, project finance and other one-time opportunities stemming from changing industry trends or government regulation, that are expected to cause an increase in value in a company.

Private equity investing

Features of funds

A number of characteristics distinguish private equity funds from other types of investments, both traditional and alternative.

Structure: Private equity funds and funds of funds are generally organised as limited partnerships in which the investors are limited partners and the fund sponsors are general partners. Investment term: The investment term for private equity funds is typically ten years, and may be subject to extensions as the general partner liquidates all the portfolio holdings. Invested assets are therefore highly illiquid. Capital commitment: As investment opportunities are identified, the fund issues capital calls to investors, requesting a portion of their commitment. Each investors commitment is slowly drawn down. As investments are realised, the fund returns capital back to the investors. Fees: Management fees can be rather high in private equity funds, because fees are usually charged on the entire committed capital, rather than the amount of capital invested at any given time. Carried interest: Management fees often are accompanied by a carried interest fee, by

which a portion of profits are retained by the general partner.

Private equity is usually accessed through one of two methods:

Single manager funds Funds of funds Typical structure of a private equity fund of funds

Single manager funds

A single manager private equity fund is a portfolio of investments managed by one private equity manager. The fund may focus on a specific style such as venture capital or buyout strategies, and often may specialise in one or several market sectors.

Funds of funds

A fund of funds is a portfolio in which the underlying investments are funds, rather than individual securities. A private equity fund of funds, then, invests in a variety of private equity funds. Capital is distributed across a variety of fund managers that directly invest according to their strategy in the underlying investments. A fund of funds may employ a variety of investment strategies or take a more focused approach. Either way, a fund of funds may offer investors reduced volatility and risk relative to a single manager structure. In addition, the economies of scale achieved through a fund of funds structure may offer investors access to funds that would otherwise be closed to them.

Typical structure of a private equity fund of funds

Stages of a investment

Unlike public financial instruments, in which capital is invested all at once, private equity fund managers call capital as needed to make their investments, then distribute cash back to investors when appropriate.

Investment stage: In the early years, private equity funds typically do not produce returns, as initial investments are made and capital is drawn down. This is due to several factors, including management fees that are paid out from the initial committed capital, and the long-term nature of private equity investments, which can take many years to realise returns. Development stage: Over time, invested companies are expected to grow and increase in value, accruing returns for investors. Maturity/Liquidation stage: Ultimately, fund investments are liquidated to produce cash flows, and capital is returned to investors.

Returns on private equity investments are realised through one of five methods:

An initial public offering (IPO) A trade sale in which the private equity funds stake in a company is sold to another company or another private equity firm

A merger with another company A joint venture with another company Liquidation of the company.

The early dip in portfolio value followed by a later rise as investments are realised is known as a j-curve, and is typical of private equity investments. Investment returns in the initial years are generally negative as management fees are drawn from committed capital and certain investments are written down, or reduced from the value of the portfolio.

Typical life-cycle of a private equity fund

Benefits and risks of investing

Before investing in a private equity fund, an investor should carefully weigh the benefits against the potential risks involved. As private equity may involve significant investment risks, there are

stringent guidelines determining an investors eligibility to invest in these vehicles. Most private equity funds are offered only to institutional investors and high net worth individuals with substantial assets and who have had experience with sophisticated investments. Investors must be able to commit large amounts of capital for a long period of time, and recognise that their assets will be illiquid, as these ventures are generally long term and/or volatile in nature, and there is no public market for the funds. Finally, investors must be able to bear the risk and potential of losing their entire principal investment. Benefits

Private equity investments provide access to specialised investment managers. Private equity investments typically seek higher absolute and risk-adjusted returns. Since private equity investments typically demonstrate a low correlation with traditional stock and bond investments, they may provide investors with: - Enhanced diversification - The potential to lower overall portfolio volatility, thereby helping manage risk - The potential for downside protection during varying market conditions.

Risks

Risks include:

Limited marketability and transferability Illiquidity (lock-ups of 12 or more years) Complex tax considerations Lack of regulatory oversight and protection Delayed or limited valuation information.