Venture capital or private equity refers to investment strategies that invest in the social capital of a private company (which are not publicly traded), such as issues of private shares or issues related to the capital stock of private companies.
Investments in venture capital are usually associated with a greater risk than investment in shares in the stock market, but also (perhaps for that reason) the returns are also usually higher. Another characteristic of this type of investment strategy is that the investment horizon is usually long term, having a fairly high illiquidity component.
Characteristics of venture capital
In summary, we can conclude that venture capital has broadly the following common characteristics:
- It is invested in unlisted companies. In fact, the idea that emerges from venture capital is, on the one hand, to finance small and medium-sized enterprises (through capital injections) and, on the other, to make the investment of those who lend such funds profitable. The intermediation commission (which can be fixed or variable) is the one that takes the venture capital entity. There may be exceptions where you invest in an unlisted company, but it is not usual.
- The investment horizon is between 4 or 10 years, andcan be extended in the event that the state of the economy where the company operates requires it (external factors).
- The return on this type of investment is usually around 20% ( IRR). It comes from the difference between the purchase price and the sale price plus dividends, although normally by investing in companies in an expansion period, they reinvest the benefits.
- Venture capital invests in companies in the growth phase mostly.
- Apart from the funds that are injected and that serve as financing for the company, a professional from the venture capital institutionusually sits on the board of directors.
- The management team is, in most cases, what makes the difference in the companies under investment. Well, it is the only guarantee that venture capital professionals have that companies select. It is not the only thing that is fixed, also the business plan of the company and the future cash flows of the same.
In the process of venture capital, there are three especially important moments that always occur in the same way.
- Fund raising:where the money is collected by the venture capital entity that will be used to invest in portfolio companies.
- Investment:through the venture capital fund .
- Divestment:this is one of the most important points in the whole process. There are several ways in which a venture capital entity has to get out of the company’s capital.
- Sale in the stock market through an IPO (through a public sale offer)
- Shareholders who were initially in the company can repurchase the shares from the venture capital entity.
- The shares can be sold to a third party in a private operation.
- It may be the case that the company is liquidated due to insolvency.
Types of investment
The four different types of investment that fall within the scope of venture capital include:
- Venture capital: capital financing for companies in their first phase of life, startups .
- Leverage buyouts (LBO) or leveraged purchases: in this case they are public companies that are privatized by repurchasing public actions by borrowing money (financing).
- Mezzanine financing: a mix between private debt and capital financing.
- Distressed debt or debt in difficulties: private capital investments in established companies that have financial problems or difficulties.
The risk capital structure
In the structure of venture capital, there are four interrelated parts:
- Venture capital entities.
- Venture capital funds.
- Portfolios of venture capital funds.
This structure may seem confusing, but the term “venture capital investment” appears at all four levels. To clarify some doubts, we have to understand the structure of private equity.
The entities equity have the role of intermediaries in the financial markets . On the one hand, they raise funds (from those investors who wish to obtain a high return) and on the other, they manage the investment of those funds. These firms operate with one or more venture capital funds. The partners, who are limited, usually institutional investors and to a lesser extent people with a lot of money, provide the majority of the capital of the fund. In this way, the partners invest in the venture capital fund instead of directly in the company. Each of the venture capital funds has a portfolio or portfolio of companies in which the funds raised invest.
The Limited Partnership Agreement of the venture capital fund defines the legal framework of the association and describes the terms and conditions for all parties involved in the fund.
The life expectancy of the fund is usually between 4 and 10 years with a possible extension of up to three years. The shares of the fund are not registered with the Securities and Exchange Commission (SEC-), so they cannot be traded in public markets, that is, the Stock Exchange.
A venture capital fund invests in companies that are in a period of expansion, so what it does is sit on the board of directors of one of its professionals in the venture capital entity to take the reins of the company and get Make it more efficient.