Private vs. Public Equity: An Overview
Companies have a variety of options for raising capital and attracting investors. Generally, the two most common options are debt and equity, each of which can be structured in various ways. Equity enables a company to give investors a portion of the business for which they make a profit as the business grows.
Both public and private capital have advantages and disadvantages for companies and investors. Equities, in general, are not usually a top priority for companies when insolvency occurs, but equity investors are often offset by this additional risk through higher returns. Companies of all types account for capital stock on their balance sheet in the category of capital stock. As such, balance sheet equity is a determining factor of a company’s net worth, which is calculated by subtracting liabilities from assets.
All types of companies use equity capital to raise capital and help their business grow. Both public and private companies can structure share offerings in different ways, giving investors different returns and voting options. Generally, public capital is widely known and highly liquid, making it a viable option for most types of investors. Investing in private equity is generally more geared towards sophisticated investors and often requires investors to be accredited with certain minimum net worth requirements.
- Both public and private capital have advantages and disadvantages for companies and investors.
- One of the biggest differences between private and public equity is that private equity investors are generally paid through distributions rather than stock accumulation.
- An advantage for public capital is its liquidity, as most publicly traded stocks are readily available and traded on a daily basis through public market exchanges.
Most companies start out as private, but a public company can also sell its public shares and become private if it believes that the profits are higher. One of the biggest differences between private and public equity is that private equity investors are generally paid through distributions rather than stock accumulation. Private equity investors typically receive distributions over the life of their investment.
Distribution expectations and other structuring details are discussed in a private placement memorandum (PPM) that is similar to a prospectus for public companies. The PPM provides all the details for an investor. It also explains the requirements for investors. Since private placements are less regulated than a public investment, they generally carry higher risks and are therefore generally geared towards more sophisticated investors. Typically, these investors will be labeled accredited investors. Accredited investors are defined by investment regulations with a specific net worth. Accredited investors can be both individuals and institutions such as banks and pension funds.
From the perspective of a fledgling company, private equity often means having to please a smaller clientele. It also means fewer investment restrictions and guidelines from regulators, including the Securities and Exchange Commission.
The offer of a private placement will generally be very similar to an initial public offering. Private companies often work with investment banks to structure the offering. Investment bankers help structure the value of private equity or paid-in capital as used in the offering. Investment bankers can also help companies test investment demand and set an investment date. Unlike public investments, private companies can also request long-term commitments from investors to help with long-term planning.
All companies need capital to run their businesses and the supply of private equity helps companies grow. Often times, a private equity deal is made with the intention that the company will go public one day. However, starting as a private company gives management the freedom to make distributions and manage capital at its discretion. It also allows them to avoid certain reporting and regulatory requirements, including those included in the Sarbanes-Oxley anti-fraud law.
Sarbanes-Oxley was approved in 2002 following the corporate scandals of Enron, Tyco and Worldcom. It significantly tightened regulations on all publicly traded companies and their management teams, making senior managers more personally responsible for the accuracy of their companies’ financial statements. It also includes lengthy mandates for internal control reporting.
In general, private equity is not subject to the Sarbanes-Oxley requirements, the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, which means less burden on management. When Dell went private in 2013, after a quarter-century as a public company, founder and CEO Michael Dell borrowed money and hired a leveraged acquisitions specialist named Silver Lake Partners to facilitate the deal. Never again will Dell have to please a group of impatient shareholders by offering a dividend, nor will the new private company need to buy back its own shares and thus affect its price on the open market.
Most investors are more aware of public stock offerings. Generally, public equity investments are safer than private equity investments. They are also more available to all types of investors. Another advantage of public capital is its liquidity, as most publicly traded stocks are readily available and traded on a daily basis through public market exchanges.
The transition from a private to a public company or vice versa is complex and involves several steps. A company that would like to offer its shares publicly will generally seek the support of an investment bank.
Most companies usually consider the idea of a public offering when its value reaches a billion dollars, also known as unicorn status.
In an IPO deal, the investment bank acts as the underwriter and is somewhat of a wholesaler. Similar to raising private equity capital, the investment bank helps market the offering and is also the primary entity involved in pricing the offering. Generally, the underwriter sets the share price and then takes most of the responsibility for documenting, filing, and ultimately issuing the offer to investors on a public exchange. The underwriter also usually has some interest in the offering with a specific number of shares purchased in the offering and subsequently when certain thresholds are reached.
In a comprehensive manner, the mechanisms to obtain public equity are easy to understand and to execute. Each of the thousands of publicly traded companies has gone through the IPO process at one point, giving investors the opportunity to participate in these investments. In addition to trading individually in the form of stocks, public equity is also used in mutual funds, exchange-traded funds, 401 (k), IRAs, and a variety of other investment vehicles. Specifically, there are also several funds that focus on IPOs in their portfolios, and IPOs individually can be some of the biggest winners in the market.
Accredited investors exploring a variety of investment options may be interested in tracking the returns of the private equity market versus the public market. Leading US market indicators can provide a starting point through the Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq Composite Index. To understand private equity market returns for comparison, investors will have to dig a little deeper, with monthly or quarterly industry reports from companies like Bain Capital, BCG, and Private Equity Wire. As with all investments, it can be important to understand the tradeoffs between risk and return and to seek the advice of a financial advisor.