THE BENEFITS OF PRIVATE EQUITY OVER SENIOR DEBT
WHAT IS PRIVATE EQUITY?
Private Equity (PE) is another source of investment capital that invests in the equity capital of privately held companies, I.e. companies that are not publically traded. Private Equity derives from high net worth individuals and institutional investors that acquire equity shares of privately held companies or acquire a controlling stake in publically traded companies to make them private, eventually becoming delisted from public stock exchanges. These companies are not listed or traded on any stock exchanges. The PE capital can be used to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company’s balance sheet. Now private equity has gained a great amount of influence in today’s financial marketplace.
WHAT IS SENIOR DEBT
Senior debt is money borrowed by a company that has first claims on the company’s cash flows and that must be repaid first during bankruptcy. Junior debtholders and shareholders also have a claim on the company’s assets and cash flow, but these claims are a lower priority if the company defaults on its debt. Senior debt is often held by banks and secured by collateral. It means the lender is granted a first lien claim on the company’s property, plant, or equipment if the company fails to fulfil its repayment obligations.
The advantages of private equity over senior debt
A provider of debt (generally a bank) is rewarded by interest and capital repayment of the loan and it is usually secured either on business assets or your personal assets, such as your home. As a last resort, if the company defaults on its repayments, the lender can put your business into receivership, which may lead to the liquidation of any assets. A bank may in extreme circumstances even bankrupt you, if you have given personal guarantees. Debt which is secured in this way and which has a higher priority for repayment than that of general unsecured creditors is referred to as “senior debt”.
By contrast, private equity is not secured on any assets although part of the non-equity funding capital provided by the private equity firm may seek some security. The private equity firm, therefore, often faces the risk of failure just like the other shareholders. A private equity firm is an equity business partner and is rewarded by the company’s success, generally achieving its principal return through realising a capital gain through an “exit” which may include:
- Selling their shares back to the management
- Selling the shares to another investor (such as another private equity firm)
- A trade sale (the sale of a company’s shares to another company)
- The company achieved a stock market listing.
Although private equity is generally provided as part of a financing package, to simplify comparison we compare private equity with senior debt.
Private Equity Vs Senior Debt
Difference between private equity and senior debt.
|Particulars||Private Equity||Senior Debt|
|Commitment||Committed until “exit”.||Not likely to be committed if the safety of the loan is threatened. Overdrafts are payable on demand; loan facilities can be payable on demand if the covenants are not met.|
|Tenure||Medium to long-term.||Short term to long-term|
|Purpose||Provides a solid, flexible, capital base to meet your future growth and development plans.||A useful source of finance if the debt to equity ratio is conservatively balanced and the company has a good cash flow|
|Cash flow||Good for cash flow, as capital repayment, dividend and interest costs (if relevant) are tailored to the company’s needs and to what it can afford.||Requires regular good cash flow to service interest and capital repayments.|
|Returns||The returns to the private equity investor depend on the business’ growth and success. The more successful the company is, the better the returns all investors will receive.||Depends on the company continuing to service its interest costs and maintaining the value of the assets on which the debt is secured.|
|Preference||If the business fails, private equity investors will rank alongside other shareholders, after the banks and other lenders, and stand to lose their investment.||If the business fails, the lender generally has the first call on the company’s assets.|
|Support on difficulties||If the business runs into difficulties, the private equity firm will work hard to ensure that the company is turned around.||If the business appears likely to fail, the lender could put your business into receivership in order to safeguard its loan and could make you personally bankrupt if personal guarantees have been given.|
|Risk sharing||A true business partner, sharing in your risks and rewards, with practical advice and expertise (as required) to assist your business success.||Assistance available varies considerably.|
Courtesy: ‘A guide to Private Equity by BVCA- www.bvca.co.uk
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About the author
Dileep K Nair
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur and business advisor with an overall 19 years of experience in investment banking, retail banking and corporate finance, with relevant experience in handling private equity transactions, private debt, venture capital, angel investing, M&A, and other growth capital and real estate financing transactions.