Private equity strategies: buyouts, venture capital and growth equity

What is private equity, and how does it differ from public equity?

Private capital is funding that does not come from public markets (stock and bond exchanges) or from traditional lenders such as banks. In the form of an ownership stake it is private equity ; in the form of a loan it is private debt, covered in the private debt lesson.

Private and public equity share the basics: shareholders own the company, vote on the board and strategy, and have a proportional claim on dividends. The difference is control. Private equity stakes are large, so the fund can steer decisions directly, and it works actively with management to raise the company’s value. Capital gains, from price growth or from free cash flow, are usually the biggest part of the return. A manager can run many funds, each holding several investments. The companies the funds own are called portfolio companies .

Private capitalfunding that does not come from public markets

• Private equity Memorize ownership stakes, actively managed
  • Leveraged buyout (LBO) Memorize control, heavy debt, mature or declining firms
    • Management buyout (MBO) Memorize current management joins the buyers
    • Management buy-in (MBI) Memorize a new team replaces current management
  • Venture capital Memorize young firms with high growth potential
  • Growth equity Memorize minority stake in a mature firm that wants to expand
  • PIPE Memorize private placement of shares in a listed firm
• Private debt loans outside public bond markets (next lessons)

Which strategy fits which stage of a company’s life?

Private equity is often sorted by where in the company’s life cycle the investor enters. The earlier the stage, the higher the business risk and the higher the return the investor demands.

Stage	Cash flow and risk	Typical private equity
Seed and start-up	none or negative, very high to high risk	venture capital (pre-seed, seed, early stage)
Growth	rising, high risk	later-stage venture capital, growth equity
Maturity	positive and predictable, low risk	leveraged buyouts
Decline	falling, rising risk	buyouts and restructurings

How does a leveraged buyout work?

In a leveraged buyout (LBO) a private equity fund buys a public company or an established private one, funding a large share of the price with debt. The target’s assets are the collateral, and its own cash flows are expected to service the debt. After the deal the debt sits in the target’s capital structure. When a listed company is bought, its shares stop trading, which is why an LBO is also called a going-private deal.

Two variants differ by who runs the company afterward. In a management buyout (MBO) the current management team joins the buyers. In a management buy-in (MBI) the current team is replaced by the acquiring team.

The fund adds value by improving operations and lifting revenue, profit and cash flow. By contribution, cash flow growth comes from organic revenue growth first, then cost cuts and restructuring, then acquisitions, then everything else. The return leans heavily on leverage: when debt is hard to get or costly, buyouts become less attractive and fund managers shift their focus.

The fund’s own money is the price less the debt. At exit, what it gets is the sale price less whatever debt is still owed.

$$M = \dfrac{P_T - D_T}{P_0\,(1 - w)}$$

Here $P_0$ is the purchase price, $w$ the share of it funded by debt, $P_T$ the sale price and $D_T$ the debt still outstanding at exit.

A multiple needs a time frame. With nothing paid out in between, the yearly return is the multiple raised to the power one over the number of years, less one. This is the same step as in the internal rate of return (IRR) and multiple of invested capital (MOIC) lesson.

$$r = M^{1/T} - 1$$

Exam tip For a buyout multiple, take the debt out twice: once from the price paid and once from the price received.

What are the stages of venture capital?

Venture capital is money for private companies with high growth potential, usually start-ups or young firms. Like all private equity managers, venture capitalists are active, hands-on investors. Funds mostly take an equity interest, though they may also lend, commonly through convertible debt.

Venture capital financingthe earlier the stage, the higher the risk and the required return

• Pre-seed Memorize idea stage; business plan; founders, friends and family, angels
• Seed Memorize product development and market research; first stage VC funds usually enter
• Early stage Memorize moving toward operation, before commercial production or sales
• Later stage (expansion) Memorize after sales begin, before an IPO; equity, debt, convertibles
• Mezzanine stage Memorize bridge to an IPO or sale; named for its timing

• Pre-seed capital (angel investing) funds the idea: a business plan and an assessment of market potential. Amounts are small and come mostly from individuals.
• Seed capital supports product development and marketing, including market research. It is the first stage at which VC funds usually invest.
• Early stage financing goes to companies moving toward operation, before commercial production or sales.
• Later stage (expansion) financing comes after production and sales have begun but before an initial public offering (IPO). It funds initial growth, a major expansion or a marketing push, and can use equity, debt, convertible bonds or convertible preferred shares.
• Mezzanine-stage financing is bridge money that carries a private firm to an IPO or a sale. The name describes when the money arrives (between private and public status), not how it is structured. Mezzanine financing, by contrast, refers to equity–debt hybrid instruments such as convertible debt. Mezzanine-stage deals can use mezzanine financing, but at this point the money is usually equity-like or short-term debt.

Start-ups often raise money with convertible preferred shares . These rank ahead of common shares if the company is liquidated, so the investor recovers its investment before common holders receive anything. They also carry an option to convert into a fixed number of common shares after a set date, which aligns the founders’ and the investor’s interests. The value on conversion depends on the start-up’s valuation, which is highly subjective for a business with no track record.

What are growth equity and PIPEs?

An established company that wants to expand, restructure, enter new markets or finance acquisitions may sell a minority stake. This is growth equity , also called growth capital or minority equity investing. The fund takes a less-than-controlling interest. Often the company’s management asks for it, because it lets them sell some shares before an IPO and still keep control.

Listed companies can raise private equity capital too, through a PIPE (private investment in public equity) . New or existing shares (or convertibles) are sold privately to selected investors, usually institutions, at a fixed price. It involves fewer disclosures and lower costs than a public offering, so it is quicker. PIPEs are common in rescues, where the market price and the company’s value differ widely. They dilute existing shareholders, and the new investors typically require a discount to the market price, which can set the interests of old and new holders against each other.

Go deeper Why buyouts falter when debt is expensive or scarce

In the multiple formula, a smaller $w$ means a bigger equity check for the same price. If the company still earns the same profit, the return on that larger check is lower. Costly debt has a second effect: interest eats the cash flow that was meant to pay the debt down, so $D_T$ at exit is higher than planned. Both effects pull the multiple down, which is why buyout activity slows when credit tightens and managers turn to other strategies.

Go deeper How round sizes and investors change by stage

Amounts rise with each stage: pre-seed rounds are small, seed rounds larger, and early-stage and later-stage rounds usually run into the millions. The investors change too: mostly individuals at pre-seed, funds from seed onward, and institutional investors, family offices and strategic investors in the larger rounds. You do not need size ranges for the exam; know the order of the stages and who typically supplies each one.