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Equity Firm

An investment company that uses its own funds or capital from other investors for its expansion and startup operations

What is an Equity Firm?

An equity firm or private equity firm refers to an investment company that utilizes its own funds or capital from other investors for its expansion and startup operations. Equity firms are usually not listed publicly, and their shares are not traded in the stock market. For this reason, equity firms are not subject to a majority of the regulations that public companies need to comply with. Often referred to as a financial sponsor, the firm will raise capital to invest according to specific investment strategies.

 

Equity Firm

 

At a Glance

Equity firm investors are usually high net worth individuals, institutional investors, or venture capital companies with an interest in funding the company operations for business or personal interest. The purpose of private equity firms is to provide the investors with profit, usually within 4-7 years. It comprises of companies or investment managers that acquire capital from wealthy investors to invest in existing or new companies.  For the services offered by the manager or the private equity firm, they will be paid a certain fee and also get a certain percentage of the gross profits.

The equity firm will commonly purchase a company via auction. After buying the company, the equity firm will try to increase its value through various strategies such as implementing a growth plan and process improvement. It introduces new processes, technologies and other processes that will improve the operational efficiency and productivity of the company.

Sometimes, the equity firm may make negative decisions like closing down units that are not profitable or laying off workers to improve the company’s profitability. As soon as the struggling company is up and running, the equity firm can choose to exit the investment by offering it for sale to another equity firm or to a strategic buyer. It can also exit the investment via an initial public offering.

Equity firms and their investors will be given a substantial minority or controlling position in a company and then try to maximize the value of the investment. They normally make investments that are longer-hold in specific investment areas that they are experts in or target industry sectors. Private equity firms are different from hedge funds firms that usually make investments that are shorter-term, including securities and other liquid assets in a particular industry but with little control over the company’s operations.

 

Functions of Private Equity Companies

The following are some of the main functions in which private equity investors are involved in their quest to earn money.

 

1. Raise Capital

Equity firms play the role of raising capital by acquiring capital commitments from limited partners/external financial institutions such as retirement and pension funds, insurance companies, wealthy individuals, and endowments. They may also put part of their own money to make a contribution to the fund. The limited partners are normally expected to commit a huge amount of capital for them to be permitted to be involved in the fund.

 

2. Sourcing, Due Diligence, and Deal Closing

During analysis of potential companies for acquisition, public equity firms will take into account things such as the industry the company operates in, what the company is involved in (their service or product), the company’s management, the recent financial performance of the company, and the company’s possible exit scenarios. The firm may get prospective deals through the reputation of the partners, effort, and networks of investment professionals, or through investment banks.

After sourcing a potential deal, due diligence will be conducted by the investment team to evaluate the company’s industry, market, business model, management team, risk factors, strategy, and exit potential.  The deal’s final terms will then be negotiated with lawyers, the deal will be closed, funds will be released, and trade of equity will be done.

 

3. Management through Improvement of Operations and Cutting Costs

Even though equity firms are not involved in the day to day running of their portfolio companies, they provide a range of support and advice on strategy, financial management, and operations. The degree of their involvement will depend on the size of their stake in that company. If the stake they own is small, then they won’t be much involved. However, if they own a significant percentage of ownership in the stake, they will be more involved in company improvement so that the eventual outcome is profitable.

 

4. Sale/Exit Portfolio Companies at a Profit

Exiting from portfolio companies at a sizeable profit is usually the end goal of private equity firms. The exit often happens three to seven years after the initial investment, though it may take more or less time depending on the strategic situation. Value is captured at exit through cutting costs, paying down debt used in funding the transaction, growing revenue during the holding period, optimizing working capital, and selling the company at a higher price that which it was acquired.

Most exits are as a result of an acquisition by a company or an Initial Public Offering (IPO), with acquisitions being the method that is most popular. The returns will then be measured.

 

Key Takeaways

A private equity firm refers to an investment management company not listed on a public exchange that offers financial backing to private companies. The equity firm invests in the private equity of operating companies or a startup through a number of associated investment strategies such as venture capital, growth capital, and leveraged buyout. The core drive for such commitments is the pursuit of attaining a positive return on investment.

Equity firms will be given management fee periodically and also receive a share in the profits earned from the managed private equity funds. Since direct investment into a company is the main goal of a private equity investment, they need a large capital outlay to acquire a substantial level of control over the operations of the firm. This is why the industry is dominated by large funds with lots of money.

Private equity funds engage in a number of functions to ensure that they get a return on their investment. They need to raise capital from limited partners or from their own money to contribute to the fund. The equity firm will then perform due diligence when analyzing potential companies for acquisition. They will also be involved in the management of the company by providing support and advice on strategy, financial management, and operations to improve the performance of the company. This will ensure that the eventual exit is profitable.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Angel Investor
  • Capital Structure
  • Equity Capital Market (ECM)
  • Fund of Funds (FOF)

Financial Analyst Certification

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