What is private equity and how does it work?
Private equity refers to investments in unlisted companies. In a private equity takeover, investment companies, known as private equity firms, acquire shares in a company with the aim of increasing its value and selling the shares at a profit in the medium term. Private equity firms utilise various strategies, such as operational improvements, cost reductions and strategic realignments, to promote the growth of the company. This process can have a significant impact on the management and workforce of the acquired company, as far-reaching changes are often made in order to increase profitability. Ultimately, a private equity acquisition aims to sell the company at a profit after a certain holding period, either through an IPO or a sale to a strategic buyer.
The term private equity is explained in detail in the Munich Business School business lexicon.
Why is private equity attractive for SMEs?
- Raising capital: Private equity offers SMEs quick and relatively uncomplicated access to capital. PE companies are often prepared to invest considerable sums due to the targeted increase in value.
- Expertise and network: PE companies often bring with them an extensive network and specialist knowledge that can significantly increase the growth and efficiency of a company.
- Value enhancement: Private equity takeovers are often aimed at promoting the growth and value enhancement of the target company. SMEs benefit greatly from the increasing profitability of the company.
What are the risks and disadvantages of private equity financing?
- Loss of control: One of the biggest concerns with PE takeovers is the loss of management control. PE companies usually demand significant influence and decision-making powers, which can lead to conflicts and a considerable loss of control.
- Profit-orientation: PE investors often have a clear exit plan and are strongly focused on increasing value. This can increase the pressure on the company, management and employees to perform.
- Cultural adjustments: The takeover by a PE company can lead to cultural tensions, especially if aggressive restructuring measures are introduced.
Private equity financing compared to other forms of financing
- Bank loans: Traditional bank loans are often difficult to obtain and are subject to strict conditions. However, they offer the advantage that the entrepreneur retains control. However, they usually come with fixed repayment schedules and interest rates, which can put a strain on liquidity.
- Initial public offering (IPO): Going public can mobilise considerable amounts of capital and offers the advantage of a broad investor base. However, the process is costly, time-consuming and associated with extensive regulatory requirements. In addition, the company remains public and therefore under constant observation.
- Venture Capital (VC): Similar to PE, VC offers capital and expertise, but is aimed more at young, high-growth start-ups. VC investors are often more willing to take risks, but also demand significant co-determination rights and shares.
- Mezzanine capital: This hybrid form of financing combines elements of equity and debt capital and offers flexible repayment structures. It is less invasive than PE, but often more expensive in terms of interest and return requirements.
Private equity vs. venture capital
While venture capital focuses on young companies in the early stages that are still developing their products and testing them on the market (e.g. start-ups), private equity is aimed at more established companies (e.g. SMEs).
Venture capital investments are typically made in start-ups. These companies are in urgent need of capital as they are often not yet profitable and the initial funding has already been used up. Investors are prepared to take higher risks as there is the potential for a high return if the company becomes successful.
In contrast, private equity invests in companies that are already at an advanced stage of development. These companies have proven that their business model works and require capital for expansion, restructuring or takeovers. These are often medium-sized companies or corporate spin-offs.
For which companies is private equity the right form of financing?
A private equity investor can be a valuable support in certain situations. For example, if a company wants to expand but does not have the necessary funds. Larger purchases such as machinery or commercial property often require investments that go beyond regular income. In such cases, a financial investor can help by providing capital in return for the company giving up shares and some of its decision-making freedom.
Even in the event of financial problems, a PE investor can be useful. If bankruptcy is imminent, financing from an investor can be crucial in order to settle existing debts and avert insolvency. In order to regain financial stability in the long term, comprehensive restructuring is often necessary. This may require measures such as personnel adjustments, the optimisation of business processes and strategic realignment. In all of these steps, the investor not only provides financial support but also expertise. Many private equity firms have decades of experience in corporate reorganisation and can therefore be a valuable resource in difficult times.
Conclusion: Careful consideration and due diligence are crucial
For CFOs in the SME sector, the decision in favour of or against PE financing is one of the most important strategic decisions. The opportunities of fresh capital and expertise must be weighed against the risks of loss of control and increased debt. Private equity can provide an enormous boost to growth, but also harbours the risk of robbing the company of its identity and long-term orientation. Thorough due diligence and a clear strategic plan are therefore essential to ensure the success of a PE acquisition.
