Author: Imarticus Learning

The growing markets for investment, real estate and equity funds have been the talk of the town in recent years. Many people, mainly youngsters, are gaining interest in investments and equity. One of the most popular spheres of the investment business is investment banking. It is a lucrative career option and yields exceptional returns for both the companies and the individuals.

To understand ‘what is private capital’ one must understand the approach of funding it provides to the companies. Private capital is an umbrella term that takes into account various approaches via which funds are provided to various organisations. It only includes sources of funding that do not come from the public forum or public markets. 

Read to gain a detailed understanding of private capital, the various sources of the same, and how it is different from the public market.

What is Private Capital?

Private capital can be described as capital raised from non-public sources. In simple words, capital raised by companies from sources other than public markets or traditional institutions is called private capital. These funds do not include sources like the sale of equities, securities on exchanges, government bonds, public markets and so on. When a company raises capital in the form of private equity and equity investment, that is when it is considered to be private capital.

In the same manner, capital that is extended to companies in the form of loans or debt is referred to as private debt. Hence, private capital is the culmination of both private equity and private debt. 

Private capital generally consists of the various private investment funds and entities that invest their money in privately held companies and real estate businesses. There are firms mainly dealing in private investment and they try to strike a balance between various fund investments as they refrain from investing most of their funds in a single company. Private equity funds invest in diverse and various companies to reduce over-exposure to a single investment and avoid any major loss that may arise. 

The Rise of Private Capital 

One of the major reasons for the advent of private capital is the retreat of various banks. Many banks have been shot or amalgamated, and have also reduced the interest rates. This, however, helps the banks to reduce their regulatory burden and be in a much better shape but has become undesirable for the investors. Investors were not getting good returns on their investments, and hence the shift to private capital happened in the early 2000s. 

Nowadays, investors want to invest in areas that can yield moderate to high returns with considerable risk. The importance of compounding has been realised and people nowadays want to invest their funds in more profitable areas rather than keeping their money with banks. Hence, companies started raising private capital that are from non-governmental sources. 

However, the rules regarding private capital are different from that of commercial banks. Banks are reducing their portfolio as private investment funds are moving into those areas. It has been seen that traditional banks are less suited in areas such as loan flexibility, regulatory restrictions and risk profile. However, private capital investors have extended their lending to start-ups and struggling companies and as a result, the companies are not borrowing funds from banks anymore. Thus, the rise in private capital took place.

Difference Between Private Capital and Public Capital

Private capital vs public capital is an essential concept that everyone in the investment sector must know. They should have a clear understanding of the type of equities they are dealing with. One should know the types of equity that can be used in various situations. 

One may take insightful investment banking courses to learn more about private and public capital and how it proves useful in various investment domains. 

The following table enumerates the details that one should know about private capital vs public capital:

Basis	Public Capital	Private Capital
types of investors	When a company is listed on a stock exchange and the general public can invest in those companies, regardless of their background, this type of capital is known as public capital. Anyone can become an investor in this case.	Private equity involves a diverse range of investors that may be in the form of angel investors, crowdfunding, venture capital, etc. Private equity investors are generally responsible for investing in private companies.
disclosure of information about the company	Public equity investors must disclose the financial information of the company to the general public.	To raise private capital, disclosing financial information is not mandatory. However, it depends upon the preference of the company.
regulations	In order to raise public capital, companies need to follow stringent regulatory rules and regulations. It has greater accountability to its investors.	To raise private capital, regulatory requirements have been relaxed. Private equity firms do not need to disclose their investment information to the government or the public.
trading and investing	In the case of public capital, investors can buy and sell assets without the permission of the company’s management.	In the case of private capital, firms can buy and sell assets only after acquiring the prior permission of the company’s management.
flexibility to buy and sell shares	to buy and sell the shares of public equity, no prior permission is necessary	On the other hand, the consent of the company is mandatory to buy and sell the shares of private equity.
voting rights of investors	Investors in public equity have voting rights to decide the management and also participate in important decisions of the company.	Investors in private equity, do not have the right to participate in the decision-making process or management of the company.
conversion to a public company	A public company is already well established and suitable to raise public equity.	Private companies should possess the necessary qualifications to convert into a public company.

Types of Private Capital 

Private capital is the money invested in true privately held companies that are not publicly traded. Private capital investments offer abroad, a range of opportunities to investors and also for the companies. Private equity funds are treated as alternative investing areas rather than purchasing real estate properties or stocks that have long-term growth potential. 

There are various types of private capital and the major ones are enumerated as follows:

Venture capital

Venture capital is the best form of private capital that funds new companies and start-ups. Venture capitalists study the market and select the companies that have huge growth potential but are in the early stages at the moment. The investors invest their funds in such companies that can expand more and yield high returns on investments.

Generally, venture capital funds take a minority stake in the company and do not take part in any controlling affairs of the company. The company management retains control of the business without any involvement of the venture capitalists. 

Venture capital is a risky approach as the company is new and has no track record of generating business. That is why only rich investors, angel investors, and investment bankers contribute their funds to such companies.

Leverage buoyant

A leverage-buoyant fund is a combination of an investment fund and a borrowed fund. Investors fund companies with huge amounts in order to make them profitable. This strategy combines the borrowed funds with the investors’ money where the fund manager gathers huge money to buy big companies.

With the help of leveraged buoyant private capital, companies are either bought outright or the purchasing company takes a majority share in the intended company to control the management and business decisions. It is purposely called leveraged buoyant because the purchasing entity leverages the creditors’ and investors’ funds for the purpose of buying larger businesses. This is done to gain large returns for the investors.

Growth equity

Growth equity is a type of private capital that is used by companies to boost expansion. It is also called expansion equity and it works similarly to venture capital. The major difference is that growth equity is less speculative than venture capital. The investors perform their due diligence to ensure that the companies in which they are investing, their funds are already profitable, have a good valuation in the market and have little to no debt upon them.

Growth capital invests in already developed and profitable companies rather than investing in new start-ups like that in the case of venture capital. This type of private capital focuses more on the growth potential of the company by providing it with elevation and exposure. This involves medium risk and allows investors to earn high returns.

Infrastructure

In this type of private capital, companies raise capital from private equity investors. Through this capital, companies purchase various assets, maintain and operate them and eventually sell them for profit. Investors invest in infrastructure only when it has essential utilities or services. Such utilities or services may include:

• Utilities such as electricity, power, water, gas, etc.
• Transportation facilities
• Social infrastructure
• Various types of renewable energy, such as wind farms, solar power plants, tidal plants, etc.

These are stable businesses and run for decades. Here, the profits are stable and involve low risk. Some businesses in infrastructure also have a monopoly such as airports or services of incredible value. 

Real estate private equity

Real estate private equity funds, as the name suggests, invest majorly in properties and real estate. This type of private capital invests both in low-risk projects and high-risk projects. The rental properties that offer predictable and stable returns involve relatively low risk, whereas the land properties that are more speculative and offer high returns involve greater risk. 

This type of private capital is managed by real estate private equity firms also known as REPE firms. They raise capital through limited partners who are outside investors. These funds are used to purchase, develop and operate real estate properties. It operates commercial, rental as well as residential real estate.

Funds of funds

This type of private capital raises capital from investors but does not necessarily invest in private entities. Instead, it invests in another portfolio or other private equity funds. This means, a firm dealing in funds of funds, investment, or another type of fund, such as venture, capital, or real estate private equity. The professionals and investors are in charge of managing this fund and are paid a management fee.

This type of private equity allows the investor to have a sense of diversification. This approach also allows investors to earn higher returns by investing in niche funds. 

Benefits of Investment Into Business From Private Capital Firms

The investment by private equity firms into a business is generally accompanied by business strategies that help a company to grow and flourish. Some of the major benefits of seeking investment from private capital firms are enumerated as follows:

• Private capital firms help to raise long-term capital investments.
• Businesses can gain the support of their investors by seeking their skills and expertise.
• Sets a foundation for business growth and seeks additional funds as and when required.
• Gain access to the network and alliances of the investors to assist with important business areas like talent management, critical thinking, decision-making, recruitment, and so on.
• Assistance in building a capital structure plan that is best for a particular business keeping in mind long-term investment plans.

What Do Private Capital Firms Do?

After acquiring a business, private equity firms encourage management to make improvements to the company’s operations before selling the company or exiting it. A company can be sold to another investor who is willing to purchase it or the present owners can exit the company by going public.

The main focus of the private capital firms is to grow the revenue of the company. Several other goals of private equity firms include reducing costs, redefining, the depth structure, and multiple arbitrage. 

Some critics, on the other hand, opine that private equity firms destroy the long-term investment value and focus on short-term gains and easy returns. However, this is not a proven fact. Private firms provide funding to businesses which the traditional investors are banks deny to land money. In such cases, the act has been to these businesses.

Some believe that large private equity firms do not create wealth, but extract wealth out of the companies they invest in. Generally, private equity firms tend to sell companies to other private equity firms without properly maintaining transparency. On the other hand, it is said that smaller private equity firms that acquire smaller companies tend to perform better and add value to the existing business. 

Private Capital Jobs 

Private capital firms generally hire individuals who have little experience in the banking industry. Investment bankers generally follow a career in private equity firms while having a bachelor’s degree in finance, economics, or a related field. Learn more about investment banking and its prerequisites by enrolling in solid investment banking courses.

Landing a career in investment banking is quite a task. It is a very competitive profession and having prior experience is highly recommended. Some of the major job opportunities in investment banking are stated as follows: 

• Junior associate/analyst: An entry-level investment banker does not get to independently work on the deals. They work in areas like reviewing data, understanding financial statistics, financial modeling and so on.
• Senior associate: The senior analyst gets to work independently on the financial deals. They also generate new ideas that will work well in the present financial situation. They seal the deal on their own without any interference.
• Vice president: this job position mainly facilitates communication in finalising the deals. They are not responsible for the sorting of data or preparation of data. They conclude and make decisions based on the prepared data.
• Director: a director is responsible for raising funds for the company as well as facilitating the deal. The execution part is delegated to the subordinates and the major business decisions and negotiations are taken care of by the director. 
• Partner: this is the final position for investment bankers. A partner is the face of the company and are the representatives of the same. They are responsible for maintaining client relationships. Here, technical abilities are not required, but one needs to be a master in negotiation skills. Also, partners invest funds in the company.

Criticisms of Private Capital

Entity, world, and private equity are largely used in businesses but there are people who are of a different opinion. Private equity has been criticised for a variety of reasons. The major criticisms of private equity are stated as follows:

• Short-term profit goals: Many specialists think that private equity focuses more on short-term profit orientation, and ignores long-term capital investments. This, in turn, jeopardises the long-term sustainability of the business.
• High debt: Leveraged buoyant and private capital transactions raise high debt levels to finance acquisitions. This debt amount tends to increase the financial burden and financial risk.
• Cost and employee reduction: Private equity firms generally use extreme cost-cutting measures which include staff layoff, deterioration in work quality, etc.
• Short holding periods: private equity firms do not hold companies for a long period of time and often sell them. This undermines the long-term potential of the company.
• Lack of transparency: transactions of private equity firms are often complex and lack transparency. This creates difficulty for investors in assessing the estimated risk.
• Negative impact on the local economy: selling of companies and restructuring the same results in loss of employment in a particular region creating a negative impact on the local economy.
• Significant fees and costs: private equity firms charge high management and performance fees. Hence, it reduces the gains of the investors in the long run.
• Long-term corporate health: private equity firms allegedly neglect the long-term growth and health of a company. The stringent measures to maximise short-term profits generally result in a company’s inability to grow in the long run.
• Tax advantages: it is said that many private equity firms misuse the provision of tax advantages. It is depicted as an unfair practice as maximising tax liabilities by the companies produces public revenue.
• Possible conflict of interests: the private equity managers may make decisions that fulfil their own interests rather than getting to the needs of the company. This creates a negative impact on the long-term sustainability and development of the business.

Conclusion

It becomes very difficult for companies to arrange their own funding, and that is when private equity firms come into play. These firms generate private capital that the companies can use for their operations and in return the investors get their returns on investment. Private equity investment in banking has been very popular in recent years for all the right reasons.

If you want to pursue a career in investment banking and are looking to learn the fundamentals of the same, consider enrolling for the Certified Investment Banking course by Imarticus Learning. Explore this lucrative profession with the best investment banking courses.

Frequently Asked Questions

• What is an example of private capital?

Pension funds, funds of funds, insurance companies, endowments, and foundations are some of the major examples of private capital. 

• What is the meaning of private capital?

What is private capital can be answered as a collection of investment strategies concerning private acids and businesses, excluding public companies and public assets like stocks and bonds.

• Is it risky to invest in private equity?

Private equity involves moderate to high risk. One must have a prepared plan before investing and investing in diversification is advisable.

• Who invests in private equity?

Generally, private equity is open to accredited investors and qualified clients only. These include institutional investors, angel investors, insurance companies, pension funds, etc.

Hedge funds are often considered mysterious, complex entities reserved for the wealthy and financially knowledgeable.

But what exactly is a hedge fund, and how do they work?

In 1949, Australian investor Alfred Winslow Jones started the first hedge fund with his company, A.W. Jones & Co. He raised $100,000 and created a fund to reduce the risks of long-term stock investing by also betting against certain stocks, which is now known as the long/short equities model.

By 1952, Jones changed his fund to a limited partnership, introduced a 20% incentive fee for the managing partner, and became the first to mix short selling, borrowing money to invest (leverage), and performance-based compensation.

If you’re new to investing, this guide will help you unravel the basics and key terms associated with hedge funds. By the end, you’ll clearly understand what is a hedge fund, how it operates, and whether it might be something to consider in your financial future.

What is a Hedge Fund?

This investment fund pools capital from multiple investors and employs various strategies to generate returns. Unlike traditional mutual funds, usually limited to stocks and bonds, hedge funds can invest in various assets, including derivatives, real estate, currencies, and commodities.

The primary aim of a hedge fund is to maximize returns while minimizing risk, often called “hedging.” This approach involves sophisticated strategies that can profit in rising and falling markets. Because of this flexibility, hedge funds have the potential to offer higher returns than traditional investment vehicles, though they also come with higher risks.

Hedge Fund Meaning

The term “hedge fund” comes from “hedging” investments, which means protecting against potential losses by taking offsetting positions. For example, a hedge fund might invest in a stock but take a short position in a related stock to offset the market downturn risk. This strategy aims to “hedge” or protect the fund’s investments from volatility.

While the name suggests focusing on risk management, not all hedge funds employ hedging strategies; some pursue aggressive tactics to achieve high returns, which can lead to significant gains or losses. Therefore, understanding the specific strategy of a hedge fund is crucial for investors.

How Do Hedge Funds Work?

Hedge funds operate by pooling money from investors and using that capital to make various investments. These investments are managed by a professional fund manager or a team of managers who can pursue diverse strategies. The strategies can range from long/short equity (buying undervalued stocks and shorting overvalued ones) to event-driven strategies (capitalizing on corporate events like mergers or bankruptcies).

One of the characteristics of hedge funds is their ability to leverage or borrow additional capital to amplify returns. This can significantly increase the potential for profits and magnify the risk of losses. Hedge fund managers often charge fees based on performance, typically a management fee (around 2% of assets under management) & a performance fee (often 20% of profits).

Key Terms to Know

To better understand hedge funds, it is important to familiarize yourself with some terms commonly used in the industry:

1. Alpha: This refers to the excess return a hedge fund generates relative to its benchmark index. It measures a fund manager’s ability to outperform the market.
2. Beta: This measures a hedge fund’s sensitivity to market movements. A beta of 1 signifies that the fund moves in line with the market. While a beta greater than 1 also suggests higher volatility.
3. Leverage: Using borrowed money to increase the return on investment. While leverage can amplify gains, it also increases the risk of significant losses.
4. Short Selling: A strategy where a hedge fund borrows a security and sells it in the open market, intending to buy it back later at a lower price. If the price drops, the fund profits; if it rises, it incurs a loss.
5. Derivatives: Financial instruments whose value is derived from an underlying asset, such as stocks, bonds, or commodities. Hedge funds use derivatives to hedge risks or speculate on price movements.
6. Lock-Up Period: When investors cannot withdraw their money from the hedge fund. This allows the fund manager to invest with a long-term horizon without worrying about redemptions.
7. High Water Mark: A clause in the performance fee structure that ensures the fund manager only earns fees on new profits, not on gains that merely recover previous losses.

Hedge Funds vs. Mutual Funds: What’s the Difference?

You might wonder how hedge funds differ if you’re familiar with mutual funds. While both are pooled investment vehicles, there are several key differences:

1. Regulation: Mutual funds are regulated by the Securities and Exchange Commission, while hedge funds operate flexibly and have fewer restrictions.
2. Investment Strategies: Mutual funds typically follow a more conservative approach, investing in a diversified portfolio of stocks and bonds. Hedge funds, on the other hand, can use a wide range of strategies, including short selling, leverage, and derivatives.
3. Accessibility: Mutual funds are open to investors and usually have low minimum investment requirements. Hedge funds, however, are only available to accredited investors and require a substantial minimum investment.
4. Fees: Mutual funds charge an annual management fee, typically around 1%, while hedge funds charge both a management fee & a performance fee, which can significantly increase the cost of investing.
5. Liquidity: Mutual funds offer daily liquidity, meaning investors can buy & sell shares at the end of each trading day. Hedge funds often have lock-up periods and restricted redemption windows, making them less liquid.

Is a Hedge Fund Right for You?

Now that you understand hedge fund meaning and its basics, you might wonder if investing in a hedge fund is right for you. 

Here are a few things to consider:

1. Your Risk Tolerance: Hedge funds can be risky investments, and their returns can be volatile. A hedge fund might be a good fit if you have a high-risk tolerance and are comfortable with losing money.
2. Investment Horizon: Hedge funds often require a long-term commitment due to lock-up periods and redemption restrictions. If you need liquidity or have a short investment horizon, there may be better options than a hedge fund.
3. Accredited Investor Status: Most hedge funds are only available to accredited investors, meaning you must meet a certain income.
4. Diversification Needs: If you’re looking to diversify your portfolio with alternative investments, a hedge fund could provide exposure to assets and strategies not typically available in traditional markets.
5. Fee Structure: Consider whether you’re comfortable with the high fees associated with hedge funds. The “2 and 20” structure can significantly impact your returns, especially if the fund underperforms.

The Final Words

Hedge funds are complex, high-risk, and high-reward investment vehicles that offer unique opportunities for those willing to navigate their intricacies. By understanding the hedge fund’s meaning, key terms, and pros and cons, you can decide if this option aligns well with your financial goals and risk tolerance.

While hedge funds may not be suitable for everyone, they can be an addition to a diversified investment portfolio for those who meet the requirements and are prepared for the risks. As with any investment, it’s crucial to research, understand what you’re getting into, and consult a financial advisor if needed.

Investing in hedge funds is an exciting and potentially lucrative endeavor, but it’s essential to approach it cautiously and understand the basics. Whether starting your investment journey or looking to expand your portfolio, hedge funds offer a world of possibilities for the investor.

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