Private Equity Explained

Hey Survivors,

I’m Andrew, an Intern at Lindsay Goldberg – a private-equity firm in New York City. I’m a guest blogger today on WSS! There’s a decent chance that if you’re learning about the stock market on WSS, you may also want to work in finance one day. But I don’t want to overgeneralize. Maybe you just want to make a side income and have absolutely no interest in working dangerously long hours for the very institutions that brought down the economy in 2008. To each his own. Regardless, here is the low down on private-equity.

Before working in private-equity, I had no idea what private-equity (or PE) actually was. Finance is finance, and whether it’s PE (private-equity), VC (venture capital) or IB (investment banking), it’s all just about money and no one really knows what the difference is..right?

Well turns out, there is a difference. Shocking, I know. Investment banking is a super broad division of big banks that focuses on analyzing publicly-traded companies.

Private-equity and venture capital are similar to each other in that they’re both in the business of providing money (professionally known as capital). The key difference is that PE provides capital only to established businesses, whereas VC will give money to startups in their early days.

One of the first questions I asked myself was why don’t these companies just get a loan from a bank instead of seeking out a PE or VC firm ?

There’s a very good reason. Firstly, a startup doesn’t have the option of going to a bank simply because most banks won’t give them a loan. Banks only give out loans when the risk is contained.. So when Mark Zuckerberg was looking for money to start Facebook (or at the time, The Facebook), all he had was an idea that he was working on in his dorm room. The risks were high, and there was a lot of uncertainty surrounding the company he was trying to get off the ground.

A bank was out of the question for The Zuck. So what was he to do? Approach a PE firm or a VC firm? Remember, a PE firm will only provide capital to established businesses because they too do not like to take on so much risk. So for Zuck to raise capital, he had to approach a VC firm. Which is exactly what he did. The Founders Fund, led by PayPal founder Peter Thiel, invested $500k in Facebook in 2004.

How about a company like Starbucks?

Let’s say Starbucks wants to build 300 new stores, but doesn’t have the cash to both build the new stores and pay for continuous operations such as weekly employee salaries, delivery costs, electricity, etc.

Starbucks has two options to get the cash they need. They could:

  1. Get a loan from a bank
  2. Receive investment from a PE firm.

What’s the difference? And what factors does Starbucks need to consider in deciding which route to take?

The first thing you must understand is that both a bank and PE firm would gladly do business with Starbucks. Both banks and PE firms are risk averse, meaning they don’t want to take on too much risk, only very calculated risk. PE firms are using money given to them by investors who want a high, but stable return. Similarly, banks are investing money provided by people like you and I. We’re not really open to the possibility of losing our money when we put it in the bank. (At least I’m not).

There’s 1 major difference between a loan from a bank vs. an investment from a PE firm. A bank loan must be paid back, and a PE investment does not. If Starbucks takes money from the bank, they issue debt. That is, they agree to pay the bank interest on their money at say 5% per year until the loan is fully repaid. So if Starbucks borrowed $1 million, they would have to pay the bank $50,000 each year in interest until they repay the $1m principal.

If Starbucks takes money from a PE firm, it’s in the form of an investment, not a loan. The PE firm takes a stake in Starbucks’ business, which it can sell at any point in time. For example, in exchange for $1 million, Starbucks would issue new stocks (equity) to the PE firm with a value of $1 million. Today, Starbucks (SBUX) is trading at $74 per share. So, Starbucks would have to issue 13,514 shares, which amounts to $1 million in equity stock. Starbucks has no obligation to pay back the $1 million dollars. Instead, the PE firm now owns $1 million worth of the company. If and when Starbucks stock rises above $74, the PE firm could sell its shares to book a profit on the deal. Obviously, the PE firm would only agree to this if it believed Starbucks stock would rise in the future. If Starbucks stock falls, the PE firm will end up losing money.

So those are the basics, people!

I hope you enjoyed reading about the differences of Private Equity compared to other forms of raising money. If you’ve got any questions or want to discuss anything in particular, give me a shout in the comment section below.

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