U.S. Markets open in 5 hrs 45 mins

Private Equity A Trendsetter For Stocks

Stephanie Loiacono

Fashion mavens will be happy to know that the stock market creates - and reuses - fads too. Like the rise and fall of hemlines, the total available domestic stock in the market expands and contracts in cycles. This typically stems from companies that are public and are being taken private and vice versa, due to inefficiencies in how capital is allocated.

Although the terms "private equity" and "venture capital" are often used interchangeably, venture capital is actually just one category of private equity. In this article, we'll show you how private equity sets the trend for stocks everywhere.

Private Equity Funding for Different Risks
Like each one of us, a company experiences a life cycle - that is, different stages of growth - which requires capital in varying amounts and from different sources. The stages of a company's life can be plotted on a "risk continuum." Typically, a very young company with no revenue and no earnings is highly risky from a funding point of view.

This sort of business usually can't afford to borrow, so capital must be obtained from friends and family, or individual "angel investors." As a company matures and becomes profitable, however, its risk profile diminishes. By the time a company is well established, it can usually fund operations inexpensively with a mix of debt and equity securities.

Private equity comes into play at different points along the risk continuum. Private investors can include institutions (pension funds, university endowments, insurance companies, etc.) or individuals (high net worth families, friends and relatives). Private equity also refers to leveraged buyouts (LBOs), mezzanine debt, private placement loans, distressed debt and funds of funds. These types of financing solutions come in various shapes and sizes; however, most are structured as limited partnerships.

Venture Capital for the Next "Big Thing"
When a company is just being launched and has little more than a great new idea, loans from friends and family or sometimes government grants are the typical funding sources available. Venture capital only enters the picture when the company has finally created its product or service, and is ready to bring it to market. Venture capitalists are sophisticated investors who are always on the look-out for the next "big thing," or the newest product that will be all the rage for consumers. Some of the largest and most successful companies - such as Dell Corp., Intel Corp., Apple Computer Corp. and many others - began as venture-funded operations.

Structured as private partnerships and usually with institutional money, venture capitalists generally provide all equity financing, with a minority stake in a start-up or early expansion company. Sometimes a venture capitalist will take a seat on the board of directors for its portfolio companies, ensuring an active role in guiding the company along. Venture capitalists look to hit big early on, and exit investments within five to seven years. The majority of venture-backed investments will fail; however, the few shining stars will return 10 to 50 times, or more, of the value of the original investment.

LBOs and Mezzanines for Mature Financing
Other private equity strategies like LBOs or mezzanine financing are usually tapped when a company is more mature. These methods of financing usually involve some mix of debt and equity, and deals may be backed by the cash flows and assets of the portfolio company itself, or those of the company being acquired in a transaction. Unlike venture capital, other private equity strategies usually involve taking a majority shareholder position. Because target companies are more established and have achieved profitability, the risk involved is far lower. Consequently, fewer of these investments fail.

Leveraged Buyouts
An LBO is one of the most common types of private equity financing. In an LBO transaction, a company receives a loan from a private equity firm to fund the acquisition of a division or another company. The loan is usually secured by the cash flows or the assets of the company being acquired. After a company is acquired in an LBO, it is sometimes broken up and sold in pieces, and the cash generated is used to pay down the high leverage of the transaction. This breakup strategy was much more popular during the 1980s than it is in the new millennium. Because companies now are more expensive, most LBO deals focus more on buying companies and creating value-added from their assets, rather than busting up the companies to sell off their parts.

Mezzanine Financing
Mezzanine debt is a private loan, usually provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often involve a mix of debt and equity in the form of a subordinated loan or warrants, common stock or preferred stock. By not taking a 100% equity position, a mezzanine debt firm can reduce its risk thanks to the capital preservation and current income features of debt.

Private Equity and the Individual Investor
Private capital is illiquid and usually involves high amounts of leverage, which is a risky combination for the individual investor. There are limited ways, therefore, for a retail investor to play safely in the private equity markets. To participate in private equity or venture capital partnerships, an investor must be "accredited." For example, an accredited investor enjoys net worth, either individually or jointly, in excess of $1 million.

For investors who are less well-off, there is the option of exchange-traded funds (ETFs) - the PowerShares Listed Private Equity ETF, in particular. This ETF is designed to replicate the Red Rocks Capital Listed Private Equity Index, which includes more than 30 publicly traded companies that invest directly in private equity. Unlike straight private equity investments, the PowerShares ETF provides liquidity and transparency. Moreover, proceeds can be reinvested back into the ETF, which is rarely possible in a pure private equity investment.

Even if you can't participate directly, the power of private equity in the market can boost stock prices by reducing the total domestic stock available - which may be good for the overall value of your portfolio.

The Bottom Line
Venture capital is just one form of private equity funding that's available to companies at various stages of their life cycles. Moreover, private equity and public equity take turns in cycles over time as the key engine driving capital market valuations higher. Investors should be able to recognize these cycles and understand the impact on their portfolios.

More From Investopedia