Understanding Alternative Investment Assets in Detail

Under normal circumstances, companies are often perceived merely as faceless monoliths, overshadowed by the products or services they offer. Consider Spotify, for instance. We usually see it as just an app where we get our music fix, maybe chase a free premium deal.

Rarely do we ponder the hive of activity behind the scenes: a cadre of developers sitting in the room, and meticulously coding and creating a technology that makes Spotify run.

But why don’t we think of it that way?

Companies, much like people, have their own life cycles. They grow, mature, and need different kinds of support at various stages. The support is often in the form of equity – the cornerstone of a company’s growth. And not all equity is the same. There are two main types — private and public, each playing a unique role in a company’s life.

Welcome back to our module on the alternative investment space. In this chapter, we’re going to understand the differences between private equity and public equity.

Equity represents ownership in a company: A tangible stake in the company’s fortunes and future. It’s not just a piece of paper or a digital entry; it’s a share in the company’s soul, its assets, and its journey of earnings.

Owning equity means you’re more than just an observer; you’re a part-owner, no matter how minuscule your slice of the pie might be. When the company does well, the value of your equity rises, sharing in its success. But if the company faces tough times, the value of your equity can fall, reflecting those struggles.

Private equity includes investments in businesses that are not publicly traded. This can range from startups and small businesses to more established entities that have either not yet gone public or have chosen to remain private.

Although private equity shares some similarities with equity securities of publicly held companies, they are distinct enough to be considered a separate asset class. Key characteristics of private equity investments include high risk, and illiquidity.

Imagine a group of college grads who’ve cooked up a brilliant idea in renewable energy tech. They’ve got a working gizmo and a handful of customers, but when it comes to growing their business, they’re as green as their product. Their funding tank is running on fumes — friends and family have chipped in, but now, their calls are met with voicemail more often than not.

Now, their founders realise it’s time to knock on the doors of the big-money folks. They can’t let their brainchild just fade into oblivion. So, they hit the private equity trail, pitching their hearts out.

After what feels like an endless marathon of meetings, they strike gold. A private equity firm is willing to invest, but it’s asking for a hefty slice of the pie — 35% of their company. Sounds steep, right? But this isn’t just any investor. This firm steps in as a savvy business mentor, doling out advice on how to scale up and make their mark.

Their mission? To pump up the company’s worth over a few years, then make a grand exit, either by selling off their share or helping the company go public. It’s a big chunk of the company to give up, but for a shot at the big leagues, sometimes that’s the play you’ve got to make.

Private equity funds are often in it for the long run. They’re not just in it for a quick profit; they often stay invested for up to a decade or more, particularly in startups that need time to mature and expand.

A typical private equity fund structure involves several entities:

• General Partner (GP): This is the entity at the helm of the fund. Think of them as the fund’s managers, the ones calling the shots. They’re responsible for scouting out promising investments, managing the money put into the fund, and making sure investors see a return on their investment. General Partners are usually specialized private equity firms with a knack for spotting potential and managing assets efficiently.
• Limited Partners (LP): These are the investors in the fund. They provide the capital but don’t get involved in the day-to-day decision-making. Limited Partners could be anyone from wealthy individuals to institutions like pension funds, all looking to grow their money through the fund’s investments./li>
• Target Companies: These are the private companies that the fund invests in. They’re often businesses that show potential for growth but need financial support and strategic guidance to reach their full potential.

Let’s pick up where we left off with our renewable energy startup. Fast forward a few years, and our once-struggling founders have matured into savvy entrepreneurs. Their company has grown massively in value, thanks to a decade of relentless effort. The private equity firm, still holding its investment, is on the lookout for an exit strategy.

The founders’ ambitions have also grown. They’re eyeing international expansion, a shift to cost-effective offshore manufacturing. But this isn’t a cheap dream. They need a hefty investment, more than what their private equity partners can or want to provide, especially as they’re eyeing the exit door.

Now they need a bigger pool of funds and it’s time for Public Equity.

Public equity is when a company steps into the limelight of the stock market. This is the big leagues, where shares are traded on exchanges like Nasdaq. The company transitions from private to public via an Initial Public Offering (IPO), offering shares to the general public for the first time. Post-IPO, these shares live and breathe in the open market, bought and sold by investors.

The first offering process is called an IPO or Initial Public Offering. After this, the shares are listed on the exchanges and any further transactions take place among different investors, not with the company.

By going public, our founders not only gather the funds needed for their expansion dream but also pave the way for the private equity firm to make a graceful exit. The firm can sell its stake in the open market, often pocketing a tidy profit. It’s a win-win — the company gets its much-needed capital, and the private equity firm gets a successful exit as the duo closes the chapter on a fruitful partnership.

In 2022, Indian stock markets outperform some of the world’s largest exchanges, including Dow Jones, FTSE, and Nikkei. Domestic investors have played a significant role, nearly offsetting the money withdrawn by foreign investors. Indian mutual fund assets under management (AUM) reached INR 39.53 lakh crore in August 2022, a significant increase in just 22 months.

However, it’s not all smooth sailing. The markets can be quite volatile, influenced by factors like Federal Reserve rate hikes and geopolitical events. The India VIX, or the “fear index,” has been trading around 22, indicating high market volatility.

Public equity is often seen as a safe haven for long-term investors but can be a challenging terrain for short-term traders due to market volatility.

While both private and public equity represent ownership in a company, they differ in several key aspects:

1. Who Gets In

   • Private Equity: It’s like an exclusive club. Only the big players get in — think pension funds, endowments, or the deep-pocketed individuals. There’s a velvet rope at the entrance, where only those meeting certain wealth or income criteria can step through.
   • Public Equity: Now, this is more like a community park. Everyone’s welcome, whether you’re tossing in a few dollars or a few thousand. It’s the Hufflepuff of the investment world — inclusive and open.

2. Rules of the Game

   • Private Equity: Private equity is subject to fewer regulations as compared to public equity. Fewer rules, less need to show your hand. Investments are often opaque, with limited disclosure requirements.This is because private companies don’t have to declare their performance very frequently — they’re allowed to maintain their privacy if you will!
   • Public Equity: In contrast, this is the well-lit, highly supervised playground. It’s brimming with regulations to protect the interests of a larger group of investors. Everything’s out in the open, with companies needing to spill the beans on their performance regularly.

3. Playing the Long Game vs. Quick Flips

   • Private Equity: When you go for private equity, you’re in it for the long haul. Once your money’s in, it’s staying there, often for around a decade.
   • Public Equity: Here, you can buy and sell securities on a whim. You can even buy today and sell tomorrow. In short, liquidity reigns supreme here, allowing investors to move in and out with relative ease.