Many private equity firms look for additions that can add growth potential and diversity to their investments. This is why venture capitalists create diversified portoflios to showcase the stengths and capabilities of their business.
In this article, we will explain what a portfolio company is, how it is used by investment firms, and what strategies are developed around it.
The definition of a portfolio company is quite straightforward: It is a company or entity in which a buyout firm, holding firm, or venture capital firm invests. The goal of investing in a portfolio is to increase its value and earn returns when the companies are finally sold (via a strategic sale, a secondary buyout, or an Initial Public Offering or IPO).
For example, if a private equity firm has a 30% interest in Company A, a 35% interest in Company B, and a 35% interest in Company C, then A, B, and C are considered portfolio companies. Typically, the companies will be diversified (they inhabit different industries or have different market sizes, they can be private or public, start-ups or settled businesses, etc.
How Do You Create a Private Equity Fund?
As we mentioned, companies in which equity firms hold an interest are considered part of a portfolio. In order to invest in them, two parties are required: The first is a financial sponsor or general partner, and the second is one or more investors. Let’s go through them in a little more detail.
The Financial Sponsor: The financial sponsor or general partner is in charge of managing the private equity fund. In exchange, they receive management fees (that are tied to the capital raised) or carried interest (which is made up of a share of the fund’s eventual profits).
The Investors: The job of investors is to provide the capital that is needed to fund or support the portfolio company. This party usually consists of insurance companies, pension funds, sovereign wealth funds, family offices, foundations, and endowments. These investors will make a return by selling a portfolio company for a higher price than the fund initially paid.
In short, the private equity firm acts as a financial sponsor, and the investors contribute capital to the fund. The combination of the two constitutes a private equity fund that can invest in a portfolio of companies.
Strategies for a Lucrative Portfolio Company
There are many ways in which a private equity fund can invest in a portfolio company. Below are the most common strategies and how they are typically used when looking for new acquisition opportunities.
When using a venture capital approach, private equity can provision capital to start-up companies that are seeking early-stage funding. They typically do this in exchange for an equity stake in the business.
A growth capital strategy uses capital to help businesses expand their operations. For example, by supporting them in developing a new product, expanding to new markets, or restructuring operations.
Leveraged Buyout (LBO)
This type of transaction is pretty standard and involves the use of debt and equity injections to finance the buyout of a company. Hence the name “leveraged“. The way in which the debt is raised tends to be through the use of the company’s assets as security.
Exiting Portfolio Companies
The goal of having a company portfolio is ultimately to generate a return – which happens when the company exits the private equity fund.
This can happen in three ways: Through a strategic sale, secondary buyout, or Initial Public Offering (IPO). It’s common for private equity firms to only hold companies for a specific period of time, typically five to seven years. At the end of this period, the objective is to sell for more than the initial investment.
Strategic Sale: A strategic sale or trade sale means a portfolio company is sold to a strategic buyer who can achieve a fit or realize new synergies. Because the company precedes sentence, strategic buyers typically have to pay a premium.
Secondary Buyout: When a portfolio company is sold to another private equity firm, this is called a secondary buyout. A common reason for selling a company is to get rid of it or find another firm with which to operate.
Initial Public Offering (IPO): Compared to the other two exits, an IPO usually offers the highest valuation. That is if the market conditions are favorable and is a strong demand! However, IPO exits tend to have high transaction costs and can place certain restrictions on investors (for example, a lock-up period for investors).
Why Investing in a Company Portfolio Is a Good Idea
Most investment funds will build company portfolios that represent a broad scope of industries and market positions. As we mentioned above, the goal is to offer their clientele some diversification. They will typically do this by including well-established firms in need of a capital boost and start-ups full of potential that require an early investment to get their feet off the ground.
The main advantage of a diversified portfolio is that it can expose its investors to different levels of risk and, subsequently, different levels of reward. The strategy is also somewhat sound; if one enterprise or company fails, or even if a few do, there will still be many others to mitigate the returns and maintain gains.
There is an additional benefit for private equity firms using a buy-to-sell approach when diversifying a portfolio, and it’s one that tends to attract more investors. Because these businesses will eventually be sold, they stay in the spotlight and feel a certain pressure to perform. And because all investments must eventually be liquidated, it’s easier to create incentives for the executives running the companies.
There is no correct number of companies to hold in a portfolio; however a well-diversified one should reduce exposure to risk, particularly risk associated with a specific industry or company.
An operating agreement is a legal document used by companies to define their organizational structure, roles and duties of owners and other key parties involved in the business, and methods for handling all transactions that occur within the company.
An over-allotment option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It’s also known as a “greenshoe option”.
Participating preferred stock is a type of preferred stock that gives the holder the option to receive dividends equal to or greater than the customarily defined rate at which preferred dividends will be paid to preferred shareholders.