Private equity

What it means

Private equity means investment by funds in companies whose shares or interests are not traded on an exchange. A fund raises money from institutional investors such as pension funds or insurers and invests it in several companies, aiming to increase their value and sell them at a profit a few years later. A typical holding period is three to seven years.

Unlike venture capital, which funds young companies with an uncertain future, private equity focuses mainly on established businesses with stable cash flow. The fund often takes a majority stake and plays an active part in management: it appoints board members, changes strategy, improves processes or finances further acquisitions.

Part of the purchase price is usually financed with debt placed on the acquired company, known as a leveraged buyout. When the buyers are the company's managers backed by a fund, it is a management buyout. The fund makes its return on the sale, or exit, to a strategic buyer, another fund or through a stock market listing.

How it works in practice

For the owner of a family business, private equity can solve succession or allow part of the stake to be cashed out while raising capital for growth. The process starts with preparing the company: audited financial statements, clear contracts, management reporting and a defined strategy. Funds are demanding about data quality.

Next comes thorough due diligence covering finance, tax, legal and commercial matters. The price is often derived from an EBITDA multiple, expressed as an EV/EBITDA multiple, adjusted for net debt and working capital. The deal typically includes an earn-out mechanism based on future results and seller warranties.

If the original owner stays on as a minority shareholder, the shareholders' agreement is key. It covers governance, veto rights, dividend policy, non-compete clauses and exit rules, above all tag-along and drag-along clauses. These decide whether the minority can join the fund's sale or whether the fund can force it to sell.

What to watch out for

A fund has a clear goal: to sell at a profit within a set time. The original owner must expect the company to be run to different priorities and to pass to another owner in a few years. Before signing, it is worth being clear whether that path fits the long-term plans for the company and its staff.

The debt used to finance the purchase burdens the company with interest and repayments and reduces its resilience in hard times. With high leverage even a moderate fall in revenue can threaten compliance with loan covenants. In negotiations it pays to look not only at the price but also at the financial structure the company will carry after the deal.