The impact of Private Equity Funds (aka Vulture Funds) and Venture Capital on Finance

Luca Polach October 23, 20195 mins read

When Private Equity Funds enter a market – typically after a financial crisis - there is usually a good amount of misunderstanding and uncertainty surrounding what they are.

You may have even heard the term “Vulture Funds” used to describe them. In reality, this term is a metaphor that does not paint a very pretty picture. But rather than jumping to conclusions, let’s answer some important questions.

What is Private Equity?

We can have a very long and complex discussion on Private Equity. However, there is a general lack of understanding around what causes these funds to appear as well as how they function. For now, let’s save the detailed analysis and case studies for another day, and focus instead building a foundational understanding.

Private Equity can be a hedge fund, a venture capital fund or a distressed debt fund that invests in various asset classes and particularly in distressed securities. This is debt that is weak or in default. In other words, a vulture fund is a pool of investor money which is used to acquire properties or companies that are either very young or are experiencing poor performance. Of course, the term “Vulture Fund” is considered derogatory, because it compares such funds to predatory birds who prey on debtors and strategically profit off their financial distress.

Why do these funds buy young/struggling businesses?

Private Equity aims to buy businesses that are either very young or struggling based on an assessment of their future potential. By doing so, investors in the fund can acquire these businesses at a reduced cost. After the purchase is made, there are a variety of different strategies that are used to generate a profit which is larger than the original purchase price.

When there is a financial crisis, this is when the growth of these funds becomes very noticeable. A result of a financial crisis is that loans and mortgages become drawn out, as businesses and homeowners struggle to make payments to their issuing banks. At this point, banks are usually unwilling to give further loans to borrowers who are already unable to make loan repayments. Public perception of banks is important and having a poor ratio of non-performing loans to good loans is something that all banks typically want to avoid having on their books.
 
It is at this point where vulture funds swoop in to purchase portfolios of non-performing loans at a discounted rate. In fact, for the sake of balancing their books, banks are often happy to sell off these loans at a considerable discount relative to the original loan price.

Positive or Negative Impact?

After acquiring an asset, especially a company, Private Equity funds are well known for asset stripping that company, sometimes dissolving it completely, and then selling it off. This is one of the strategies that are used to generate profit because things like brand equity, production facilities, physical stores, property assets and even brand name among others can all be sold at a price. This happens quite often across various industries. One common example is pharmaceutical firms that are simply purchased by competitors so their drugs can be acquired, while the rest of the company is stripped and sold off. 

Another example is when struggling companies are acquired and the purchaser inserts their own CFO in place while simultaneously gutting the company and streamlining it.
For these reasons among many others, vulture funds have a name and reputation for picking the last meat off the proverbial bone. But as interesting as this image is, it is perhaps not the most appropriate in all situations. Many private equity firms are making an effort to shed this negative perception and are trying to be viewed rather as “partners in growth”.

Private Equity often gives companies a chance to come back to life. With the funds’ willingness to provide cash, it may very well be their last chance for a revival. This, in many ways, more similar to CPR. After all, the more successful revival of the asset, the greater the profit. If this is done in a situation where failure was the only other option, then this is as close to win-win as you can get, and that is certainly better than nothing.
Regardless of the negative image around Private Equity funds, it is unlikely to stop ambitious companies from partnering with them. When there is financial difficulty and economic issues, a business will almost always roll the dice on the chance to escape an almost certain fate.

The Role of Venture Capital in Startups

Venture Capital is a type of Private Equity that works with start-up companies. If you are a startup, consideration should at the minimum be given to working with venture capitalist firms. Investments can be quite large, so as long as you are prepared to use those funds appropriately to grow, your businesses can scale up in size rapidly.

Another big advantage, vis-à-vis taking a loan, is that you don’t technically have to pay back the money from a venture fund if the business goes under like many startups do. However, venture funds still do expect a return on investment. Typically this means equity in a startup. So when a startup decides to bring on venture capital, having a plan for either in IPO or acquisition should be put into place. Ultimately, as a startup you want to avoid a situation where the fund ends up with a majority share in the business. In this case, you lose management control of the company.
 
With all of this in mind, the use of venture capital should always be assessed on a need’s basis. There is no cookie-cutter model for success. But the choice should be made carefully because it will mean the difference between failure, loss of ownership, and a stunning financial turnaround.

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Luca Polach's picture
Consultant | Finance & Accounting Recruitment
lpolach@morganmckinley.com

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