Private equity is an equity instrument usually in the form of preferred stock. Debt capital is a generic term use to describe both bank loans and non bank loans such as unitranche or mezzanine loans. Both private equity and debt capital can be used for the same purposes. Acquisitions, growth, working capital, growth expenses are some of the capital uses. Yet, the real difference between these two is in their pricing and their contractual relationship with their target company. Both forms of capital can work harmoniously in a synergistic way. Additionally, both are used in different ways in different types of scenarios. Private equity is a form of capital that makes majority control investment and minority investments in companies. It’s used mostly for buy-outs wherein a private equity fund is purchasing 100% of the shares for the owner of the business. Its returns are created through increasing the valuation of the company over a 3 to 5 year time frame. Investors like to own companies and call the shots. They usually have a formula they have developed over the years to allow them to add value to a company – be it lowering costs, increasing sales or entering new markets.
In a typical private equity deal, the goal is to increase the value of the company to generate capital appreciation for the private equity owner. To pay for the company, the investors usually use loans to finance up to 80% of price. In this scenario, debt capital fits into the package of capital used to purchase the target company. For a buy-out, the private equity investor usually is keen to change the target companies in many ways including bringing in new management and introducing new strategic ideas. They own the company and have the right to exercise board control as well as day to day operating control. They seek to achieve annual returns in 20% to 25% range. Because, they do not receive current interest payments, there is pressure on them to dramatically increase the growth rate of the company so they can increase the value of the shares over their ownership period.
Debt Capital, when deployed outside of a buy out scenario, operates in a very different way than private equity. It is loan to a borrower, with interest paid monthly. A provider of debt capital has a much lower return requirement than a private equity investor. It has a much different relationship with the borrower than a private equity investor has with its portfolio company. A lender of debt capital is not the owner of the company. They cannot change management or fundamentally alter the way a company conducts its business. They influence and prohibit the company from doing certain things by having covenants, but they do not control the company at the board level or at the day to day operating level. Debt capital providers, especially mezzanine lenders, are usually are happy with returns in the mid teens and receive the majority of that return through interest income. Because they receive a high current return, they are somewhat passive in their view of the long term growth of the company. Both have positives and negatives and the use of each is highly situation dependent. What is clear is that there are differences between private equity and debt capital. So choose wisely when raising capital!