Private equity is a financial concept, not a legal term. It can only be understood as distinguished from other forms of financing of and participation in companies.
Target companies and type of financing
No listing on the stock exchange
The part of the term “private” indicated that the financed companies are usually not listed on the stock exchange (so-called “public equity”) or are removed from the stock exchange immediately after a private equity investor invests (in financial terms, this is called “taking private”). However, there are exceptions to this, because some private equity funds provide for the possibility of investing a part of their capital in permanently listed companies (so-called PIPE transactions, private investment in public equity).
Investments in non-listed companies differ significantly in their economic character from investments in listed companies. Through regular trading, listed companies have a market price that can be relatively easily assessed, which is determined by a large number of market participants. The market price of a non-listed company is determined only by participants – often very few – in the sale of the company and is fixed only for the effective date of the transaction.
Listed companies are obliged to provide extensive transparency and to treat all market participants equally. This leads to the fact that, in principle, each market participant has access to the same information with regard to the company. Persons who have access to privileged internal information (so-called insider information) may not trade shares in this listed company. Hence, intensive examination of the company and its internal affairs (called due diligence) before an investment is barely possible. In contrast, non-listed companies usually only publicize little information; however, a potential buyer can conduct intensive due diligence.
Shares in listed companies can generally be sold through the stock exchange at any time through a predetermined process, therefore they are liquid. For shares in a non-listed company, they do not have their own market and no determined trading procedure, therefore they are illiquid.
Equity capital participation
The “equity” part of the term describes that the private equity investor participates in the equity of the company and distinguishes it from the financing of the company with debt.
Equity is permanently allocated to the company. Equity investors generally have significant influence on the business of the company. They can appoint and dismiss the management, they can require consent for certain actions on the part of the management and inspect the accounts of the company. In a crisis of the company, equity investors are subordinated to third party creditors, including providers of debt. In case equity investors provided loans to the company they are also subordinated to third party debt providers. (cf. § 39 para. 1, no. 5, para. 4 and 5 Bankruptcy Act).
In particular, bank loans are identified as debt. In general debt is only provided for a certain time period and must then be paid back. Within the scope of a normal business relationship, providers of debt, i.e., especially banks, do not have particular influence on the business of the company, the management’s actions are not subject to the consent of debt providers and they cannot prevent other investors from investing in the company. They only have limited insight into the company, e.g., they cannot readily access the accounts of the company (cf. Hertz-Eichenrode et al., Private-Equity Lexicon, pg. 73 et seq.).
Between equity capital and debt, there lies the so-called mezzanine financing. Institutional investors, such as banks and insurance companies, as well as mezzanine firms, which are structured like private equity firms, grant such financing. Mezzanine financing typically has a limited term, which is however longer than the term of debt financing. Frequently, the reimbursement of mezzanine financing is also connected to the company’s success. In case of a crisis, those providing mezzanine equity capital have lower priority than the providers of debt but greater priority than providers of equity. Often the capital lender has the right to convert his investment into an equity investment (cf. all Hertz-Eichenrode et al., Private Equity Lexicon, pages 121 et seq.). Mezzanine financing is commonly structured so that in terms of commercial law it represents equity capital and thereby improves the relevant company operating numbers, but it is treated as debt according to tax law and thereby decreases the company’s taxable profits.
Purpose of the investment
Private Equity firms can also be differentiated from other equity investors in non-listed companies by the purpose of their investment.
Because private equity funds are investments with a limited term, the private equity firm’s investments must be resold after a certain holding period. Thereby, private equity funds achieve only a small part of yields through ongoing payments from the portfolio companies and primarily through the sale of the portfolio company. Private equity firms use the holding term of the investment to increase the value of the company. Thus, they differ from so-called “strategic investors”, e.g., large, often listed companies that pursue their own business purpose by investing in a non-listed company. They expect either ongoing earnings distributed by the target company or they are looking for synergies between the businesses of both companies.
Banks, insurance companies, pension funds and wealthy individuals participate in non-listed companies merely for investment purposes. They then often expect ongoing dividends from the target company and/or provide no additional capital for the development, expansion or reorganization of the business of the portfolio company, as private equity funds do.
Distinguishing between private equity and venture capital
Distinguishing between the terms private equity and venture capital is not a clear-cut matter, because the term private equity is used with two different meanings (cf. Thum/ Timmreck/ Keul, Private Equity, pg. 11; Feldhaus/ Veith – Feldhaus, Frankfurt Commentary on Private Equity, chapter 1, marginal no. 6 et seq.).
In the broader sense, private equity identifies the branch of equity capital investments in non-listed companies, distinguished from other forms of financing (cf. above section I.). Venture capital constitutes a subset of private equity in the broader sense.
Strictly speaking, private equity refers to the phase of the life cycle of companies in which financing is granted. Thereby, venture capital comprises the financing of the early stage of the company’s development, which is often subdivided into the seed phase and the start-up phase. In contrast, private equity in the narrow sense invests in later stages of the company’s development. The later stage is typically subdivided into the growth phase, bridge phase, buyout and turnaround (cf. with details on the individual phases Thum/ Timmreck/ Keul, Private Equity, l.c.).
from “Lexicon of the Law Private Equity” by Dr. Fabian Euhus, EMBA