Private Equity

A listed company raises equity by offering shares to the public and letting an exchange price them. A private company does not have that option, so it raises equity by negotiating directly with a small number of large investors. That negotiated capital is private equity.

The term is broad. Venture capital is a type of private equity — the kind that goes into early-stage businesses. But in ordinary use "private equity" means investment in companies that already have an established business model and a track record: what the industry calls later-stage companies.

The rationale is simple to state and hard to execute: earn higher than market returns by investing in promising, growing unlisted companies, and exit at a higher valuation later, on the strength of how the business performs in between.

Private equity is not confined to buying ordinary shares of unlisted companies. The workbook is explicit that the word "equity" here has wider import: a private equity transaction may use equity, preference capital, debt or mezzanine-capital, depending on what the deal needs.

Nor is it confined to unlisted companies. Private equity funds also make direct investments in listed companies, and participate in more complex transactions:

• Buyouts — acquiring control of a target company
• Leveraged buyouts (LBOs) — the same, done with significant borrowing

In control transactions, investors typically look to acquire 51% or more of the share capital or voting rights of the target.

That leaves the defining constraint: illiquidity. The workbook treats illiquidity as the essential characteristic separating alternative from traditional investments, and unlisted equity is its clearest case. There is no exchange, no clearing corporation standing as counterparty, and therefore real counterparty risk in every trade; transfers are bilateral and articles of association usually restrict them; and there is no market price, so the holding has to be valued rather than looked up.

In India this activity is regulated through the alternative-investment-fund framework, where it sits mainly in Category I (venture capital, early stage) and Category II (private equity and debt funds).

A Category II AIF invests Rs 80 crore for a 20% stake in an unlisted speciality chemicals company — a Rs 400 crore post-money valuation on EBITDA of Rs 40 crore, so an entry multiple of 10× EBITDA.

Over five years the company grows EBITDA to Rs 95 crore. At exit the buyer pays 11× EBITDA:

Exit enterprise value = 95 × 11        = Rs 1,045 crore
Less net debt at exit                  = Rs   145 crore
Equity value                           = Rs   900 crore
Fund's 20% share                       = Rs   180 crore

Rs 80 crore became Rs 180 crore — 2.25× over five years, an IRR of about 17.6%.

Where did it come from? Decompose it:

The honest version of this is that the return was earned by the business, not by the entry price. That is the pure-play private equity model the workbook describes: growth capital into later-stage unlisted companies, exited on future performance.

And the thing the arithmetic hides: for all five years there was no price. The holding was carried at a valuation, and if the fund had needed to sell in year three there was no exchange to sell it on.

Chapter 2, section 2.3.2, defines private equity and its relationship to venture capital, buyouts and LBOs; Chapter 4 places it inside the SEBI AIF categories; Chapter 12 handles the valuation of unlisted holdings. The recurring examinable points are that venture capital is a subset of private equity, that private equity may also invest in listed companies, that the "equity" in private equity includes preference, debt and mezzanine instruments, and the 51% control threshold in buyout transactions.

• Private equity is not only unlisted equity. PE funds also invest directly in listed companies, and PE structures routinely use preference, debt and mezzanine instruments.
• Venture capital is a type of private equity, not a parallel category. VC is the early-stage end; PE usually denotes later-stage companies with an established model and track record.
• A buyout and a leveraged buyout are not the same thing. An LBO is a buyout done with significant borrowing; the leverage is what the "L" adds.
• Do not rewrite the AIF categories here. Private equity is a strategy; Category I, II and III are the regulatory buckets, and they are defined elsewhere.
• Illiquidity is the defining feature, not high return. Unlisted equity trades bilaterally, carries counterparty risk, and usually has transfer restrictions in the articles of association.
• There is no market price, so there is a valuation. An interim IRR in a private equity fund rests on the manager's marks, not on a quote.