Private equity: background information on off-market equity capital

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Many investors associate the term private equity with a mysterious investment for multimillionaires and institutional investment professionals. This often raises the question among potential investors: What is private equity?

The interested reader learns from the context and background that private equity is not witchcraft and follows certain logical patterns. It is essential to carefully evaluate a planned investment and acknowledge the opportunities and risks. With this guide, we would like to create a basis so that you can find your way around the Swiss private equity universe.

The most important facts in brief

For your better orientation, we have summarized the contents of the guide on private equity in key points.

• Private equity is capital from private investors
• This capital is invested in companies with the aim of generating long-term profits.
• Behind the capital are investors who invest their assets in companies through holding companies.
• Private equity investments require a lot of skill and experience, the selection of the right investment targets is crucial.

Definition: What is Private Equity?

The term private equity comes from the English language. Literally translated, it is divided into two terms private and equity. It thus describes private equity or off-market equity capital. Private equity companies use the money they collect to invest directly in companies to generate a profit.

In the context of private equity, investments in “start-ups” (young companies) are referred to as “venture capital”, which is naturally exposed to a higher risk.

The difference to other investment opportunities lies in the direct influence of the investor on the operative business of the target company. This includes measures such as:

• Further development of the existing corporate strategy
• Provision of know-how
• Work process optimization
• Expansion into new products and markets

Private equity companies in Switzerland are interested in long-term investment with sustainable corporate success. Achieving short-term speculative profits and a quick return is not the focus. In other investment opportunities, the focus is rather on shareholder returns without a direct influence on the management.

The history of private equity begins immediately after World War II. Through the American Research and Development Corporation (ARDC), the private sector encouraged investments by returning servicemen and women to start-up companies. The first private equity success story was a $70,000 investment in Digital Equipment in 1957, made by ARDC immediately after the company went public.

How does private equity work?

Money is collected from wealthy private investors and pooled to form a fund in the private equity sector. The fund subsequently acquires shares in one or more target companies. Any additional financial resources required are provided by banks or external investors as part of a co-financing arrangement. The investment aims to increase the profitability of the target companies through appropriate measures. After a certain holding period, the investment is sold and liquidated at a profit.

Company investments by private equity funds follow different patterns. The goal is always a significant majority stake to be able to influence the target company. In the first step, a blocking minority is sought in the case of listed companies. This limit is 25.1 percent of the capital stock. This means that no qualified majority resolution can be passed against the new shareholder at the Annual General Meeting.

In the case of the corporate phases in the development of companies, there are further possible uses of private equity. Here a distinction is made between:

• Venture capital in the case of a start-up with a successful business model
• Growth capital when a company expands into new markets or new product lines

In both cases, traditional lending banks are risk-averse and usually only want to provide debt capital after a successful market launch.

The second area of private equity in Switzerland consists of participating in buy-out financings with investments. Here are the best-known forms:

• Leveraged Buy-out (LBO)
• Management-Buy-out (MBO)

Leveraged Buy-out (LBO)

In an LBO, the majority of the purchase price for the target company is debt-financed. The liabilities incurred are charged to the target company. The loans are repaid from the cash flow of the acquired company.

Management-Buy-out (MBO)

In an MBO, the initiator is the management of the company itself. This can be triggered, for example, by a restructuring that is not carried out by the previous shareholders. The capital for financing is provided by the management itself and mostly by private equity firms.

Classification, delimitation, and comparison with other forms of finance

The main objective of private equity is to make equity investments in companies that are not listed on the stock exchange. In connection with private equity, there are two main directions for the targeted investments, as already mentioned in the last chapter:

• Buy-out
• Venture Capital (VC)

In terms of financial instruments, private equity aims to invest equity to gain direct access to the targeted company. A minority shareholding is only very rarely sought.

In terms of investment approach, private equity in Switzerland differs significantly from an investment in shares of companies. When private investors invest money in this asset class, the focus is primarily on achieving the highest possible return. The investor is not interested in making strategic decisions or gaining influence on the management. Whether investment in private equity is ultimately better than a direct investment in shares depends heavily on the timing and holding period of the investment.

Venture capital is mostly used in connection with start-ups with high growth potential. Private equity provides the basis for equity capital here. Because growth financing for young companies is often associated with high risks, the use of debt capital by banks is rare. As an equivalent for the high-risk appetite of private equity funds, a high return on equity is expected during the investment process.

Opportunities & Risks of Private Equity

An investment in private equity is certainly not a basic investment for capital investors. It requires a lot of experience in dealing with financial investments and at the same time a high starting capital for the entry. In connection with the investment in private equity, the investor takes a high financial risk. In exceptional cases, this can also lead to a total loss of the invested funds, because the investor is fully liable. You should keep these risks in mind before making an investment decision:

• Liquidity risks during the term of the investment
• Valuation risks relating to the acquired companies
• Cost risks due to high management fees and distribution costs
• Total loss of the paid-in funds due to insolvency of the target companies cannot be ruled out
• Transparency risks due to lack insight into the transactions carried out
• Lack of own initiative during the investment period, because dependent on the decisions of the investors

Investments in private equity and shares are considered long-term investments intangible assets. Whereas with equity investment you have the option to sell your shares on any trading day, this is not possible with private equity. The private equity fund is an institutional investor that has invested its assets for you on a long-term illiquid basis in unlisted companies. This creates an additional risk for the investor* that he/she cannot freely liquidate his/her investment in the short term.

The opportunities offered by private equity in Switzerland lie in the fact that investments are only made in selected companies with high expected returns. Investment professionals look for young companies with forward-looking business ideas. The second criterion is an undervalued company that can generate high profits in the future. In both of these cases, investors can expect high returns.

At the end of the investment horizon, an investment of the private equity fund is sold or placed on the stock exchange. Similar to an investment in real estate, the resulting increase in value is added to the investment capital. After realization of the sales proceeds, which are not necessarily generated sustainably, repayment is made to the investor.

Private equity: Only for the super-rich?

Investing in private equity is suitable for qualified private investors with expertise in the field of corporate investments. Before making an investment decision, the investor must aim for a long-term investment horizon. The second factor is that the investor considers the entrepreneurial liability risk. In addition, you should not be dependent on the invested capital during the term of the investment.

The financing amount for an investment in private equity in Switzerland is at least 250,000 Swiss francs or even a multiple thereof. For this reason, private equity is primarily suitable for:

• High-net-worth private clients
• Institutional investors
• Family Offices

You can gain access to the private equity market by contacting an institutional provider that sells such funds. When selecting a fund, it is important to carefully examine the fund’s investment focus in terms of sectors and strategy in advance.

For the normal private investor, this does not mean that he/she is completely excluded from investing in private equity. It is possible to invest money in this area via closed-end private equity retail funds or corresponding public funds. However, even in this environment, the customary minimum investment amounts are often more than 10.000 Swiss francs.

These funds are usually funds of funds, which subsequently invest the collected customer money in other private equity funds. However, before potentially investing money in these vehicles, you should consider:

• The dual fund structure creates an even greater lack of transparency of the invested funds
• Double costs, as the fund of funds, also charges its fees and management costs

How do private equity firms differ?

In their investment decisions, private equity funds set strict criteria according to which they invest the money they collect. A distinction is made between:

• Company phase
• Branch
• Financing amount
• Region

This ensures that the invested assets of a fund have homogeneous objectives.

Company phase

Funds that focus on the allocation of venture capital (venture capital) support a young company in a difficult phase. Here, the risks of total failure are greatest until the company with a promising business model has reached market maturity.

Companies wishing to spin off or expand a business unit look to private equity in Switzerland for growth capital. This can also be done in the course of an international expansion into new markets.

In the case of an MBO (management buy-out), private equity supports the management’s new strategy for a turnaround or business transformation.

Branch

When it comes to sectors, private equity funds specifically select segments with future growth. These are, for example, new trends based on innovative technology or topics that are promising for the future. These include, for example, investments in sustainable technology or products with added ecological value.

Funding Level

When it comes to the amount of financing, private equity focuses on the funds required for the planned investment and on the size of the target company. The volume of funds required often also influences the minimum investment amount.

Region

With a view to the region, private equity is focusing on future growth markets. These do not necessarily have to be in Switzerland or Europe. In the Asian region, in particular, economic growth is unabated in many countries.

Reading tip: Private debt: Alternative corporate financing and exciting asset class

Private Equity – Tips for the first investment

Before you, as an investor, consider investing in private equity funds for the first time, you should take your time to draw up a checklist. These questions, for example, are certainly helpful:

• Can you do without the invested money for a longer period of at least 10 years?
• Are you willing to take a risk that, in the worst case, could even mean a total loss?
• Can you correctly assess the risks of the planned investment?
• Have you chosen the right investment company?
• Is the private equity fund’s plan transparent and comprehensible to you?
• Are you aware of all the fees and costs incurred for the investment?
• Were you fully informed about all the questions you asked in discussions with the fund distributor?
• Are you willing to forego distributions during the term of the investment and only receive your capital with accumulated growth at the end of the investment?
• Are you prepared to take on additional risks (transparency and exchange rate risks) for a possible fund investment abroad?

It is crucial for your financial investment that you answer all of these questions with a clear YES. In addition, other questions may arise that are related to your situation. If the slightest doubt arises when assessing your investment, it is a good idea to consult an expert advisor. Under no circumstances should you ignore possible risks, because, in the end, you bear the sole responsibility for the investment.

A vivid example to imagine the total loss of financial investment is the comparison with the purchase of a luxury car. Imagine you buy a luxury car for at least 100,000 Swiss francs and drive the car head-on into the wall with a total loss on the first drive. If you are willing to take this pain, then nothing stands in the way of investing in private equity funds.

Conclusion on private equity

Private equity means off-market equity capital in connection with investments in companies. In this environment, a private equity fund collects investment money from investors. The most common investor groups in the private equity sector include high net worth individuals, family offices, and institutional investors. For small investors, an alternative is to invest in closed-end private equity retail funds. It is important to note that investing in private equity involves a high level of risk.

In the case of private equity funds, a rough distinction is made between venture capital funds and buy-out funds. Venture capital is mostly used to invest in young companies with a promising business model. Buy-out funds focus on expansion strategies for mature companies or transactions triggered by the management of the previous company. Both projects are supported with capital from private equity funds. In addition, banks and institutional investors can act as co-financiers in buy-out transactions.

Investors should define their approach precisely in advance of the investment. It is crucial to know all possible opportunities and risks with the planned investment employing a checklist. With the distribution of a fund of private equity in Switzerland all facts of the investment are to be discussed in the context of the first discussions. Once the right fund and the right investment objective have been found, you can invest. It is always a good idea to seek the advice of an experienced professional before signing the contracts if any doubts arise.

Read on in our journal:

• All about the Swiss vested benefit act
• More about Private Banking
• 3-pillar principle for pension provision
• Types of asset management mandates