A private equity or venture capital firm usually employs a small team of fund managers who use a fund plan to raise money from investors, such as wealthy entrepreneurs, family offices, institutional investors like insurers, banks and pension funds, large corporates and funds of funds. The money raised is put into a fund. Once the fund reaches the desired size, the fund managers search the market for the most interesting companies (often SMEs) to invest in. The private equity firm acquires a majority interest or (large) minority interest in each company and becomes a shareholder or co-owner. The venture capital firm usually acquires a minority interest.
Strategy and growth
After the purchase, the private equity and venture capital firm will contribute ideas and advise on the company's strategy in close consultation with the management team. For example, investments will be made in new branches, new markets will be explored and efficiency improvements will be made. This can be done by investing in new technologies or by cutting costs. Additionally, analysis can be made of where the company really excels and how efforts can be focussed there.. The company can also benefit from the experience and networks of the fund managers of the private equity and venture capital firms. Examples include their experience with expansion abroad or their network of co-financiers. This is how more resilient, more sustainable and more successful companies are built that grow faster in terms of turnover, employment, employee satisfaction and profit.
Return on investment
Once the companies have been made stronger, larger and more profitable, they are sold after an average of five to seven years. The proceeds are paid out to the investors in the fund. This is how at the end of the fund’s life cycle - after about 10 years - they receive their initial investment plus a return on investment.
Only when a large part of the fund has been invested the next fund can be raised.. Investors will only want to reinvest in a new fund if the private equity or venture capital firm has a good reputation. This first and foremost means that a good return on the investment must have been made. Secondly, the portfolio companies must have been properly managed and risks must have been controlled, including those relating to 'ESG' (Environmental, Social & Governance) aspects. The bottom line is that trust in the skills and qualities of a private equity or venture capital firm is very important. Market forces ensure good competition.
A return on investment is never guaranteed. Creating value is not always easy. Plans do not always materialize. A crisis, a virus, changing markets resulting in reduced product sales, changes in government policy causing a business model to fail, management that does not function well or with which a good relationship fails to come into fruition, etc. It could lead to the company's value increasing less than hoped for, taking longer to sell or, in extreme cases, even going bankrupt. The industry has developed a number of checks and balances where investor interests are held paramount. They are ‘specialisation’, ‘risk diversification’, ‘alignment of interests’ and ‘transparency’.
Apart from capital, private equity and venture capital firms offer important added value by providing a network and strategic, financial, fiscal and legal expertise. Because expertise and network differ enormously per sector and per phase of a company, private equity and venture capital firms increasingly limit themselves to one sector, e.g. IT, energy, healthcare, biotechnology or industrial production companies. They also specialise in other areas. They invest internationally or even regionally. And in young fast-growing start-ups (venture capital) or in mature companies (private equity). Private equity and venture capital firms can add value at every stage of a company's life cycle. From early stage capital (seed and start-ups capital), growth capital, buyout/buy-in financing to restructuring (turnaround financing).
One fund usually involves the purchase of 10 to 15 portfolio companies. So risks are diversified. One bad exit can be offset by nine good exits. The chances of an investor losing its total investment is therefore small. An investor can never lose more than the amount invested. On the upside, the returns are high if a private equity or venture capital firm does its job well and sells most of its portfolio companies at a profit.
Alignment of interests
As fund managers invest in their fund with their own money, this aligns the interests of the fund managers and investors. This guarantees investors that the fund managers remain 100% committed to the fund until the very last moment, regardless of any setbacks. These aligned interests are also created between the fund managers and the portfolio company managers. The most widely used method is to make the managers of the company co-owners. This inspires them to do an even better job.
Investors invest in a fund based on extensive fund documentation supplemented by their own research (due diligence). During the life of a fund investors are periodically informed about any investments and divestments made, the performance of the portfolio companies and other matters that may be of interest. There are international reporting standards, but individual investors also often have specific priorities or further questions. That’s how investors in private equity and venture capital firms may know much more about the portfolio companies invested in than investors in listed companies.