Last Updated on June 1, 2021 by John Fischer
Private equity and debt are the two ways of financing a business. Each approach comes with its own set of pros and cons when it comes to funding a business. Let’s dig down deeper and do a comparative analysis of what would work better for you.
Private Equity vs. Private Debt
The primary differentiating factor between private equity and private debt is the source from which the money is attained and how that money is used.
When it comes to private equity, multiple investors are allowed to invest in small, growing firms that can be sold later at a higher price. The main aim is to acquire large-scale profit.
Whereas private debt, on the other hand, is merely a form of a loan. This loan can be both formal and informal. The debt would not enable you to make huge investments in the company, and the profit margins are fairly low. Private debts are mostly provided by individuals or a company, depending on the relationship terms between the debtor and creditor.
Role of Interest
In private equity, companies prefer young firms and undervalued companies for their investment opportunities to develop them later and resell them at a higher profit margin.
On the other hand, private debt is taken using a credit card, corporate bonds, or a small business loan from individuals or private investors.
Incentive for Investors
In private equity, once the company or firm has expanded and grown in size or value, it catches the attention of various potential investors who are willing to make large-scale investments in a promising company. This increases the chances of obtaining large-scale profit for the original equity investors and gets them a good ROI.
For investors providing debt to you or your company, the incentive is fairly low. There is no guarantee or motivation here to make the business grow or yield a high profit for the creditor. When a company liquidates, the debt holders are first in line to receive the funds. Hence the overall return is low.
Liability on Balance Sheet
Equity is not counted as a liability on your balance sheet. However, you are supposed to disclose other equity holders in your financial and corporate documents.
On the other hand, private debt is considered a liability on the company and the balance sheet. Investors tend to avoid investing in companies that have too many liabilities.
Private equity consists of assets that are not listed on a public exchange. Funds are directly invested into a business by an individual or collective group of investors. In some cases, these investors involve themselves in purchasing these companies, which are not listed on the public exchange. Essentially private equity is a form of private financing with the investors having limited liability.
Individuals or businesses obtain debt financing in several ways. It can be a corporate bond, personal loan, business loan, or credit card and can even be obtained from non-banking companies. Debt financing requires the borrower to pay interest consistently and eventually pay off the loan, which is not the case with private equity.
What’s the Difference?
Private equity is sourced by private investors and companies looking to buy smaller firms. On the other hand, Debt can be obtained from a private company, bank, or even your friends and relatives.
Incentives for Investors
As a business starts to gain ground making consistent sales with good margins, nvestors are attracted to getting in on the action. They invest large sums of money, hoping to turn a huge profit if things work out in their favor.
Individuals and companies that offer debt to a business are not too involved in making a business successful. The interest they receive regularly as well capital repayment delivered at the end of the loan term drives them. They are also aware that if the business liquidates, they will obtain their money before others.
Cash requirements for companies that obtain a private equity investment are not so stringent. If the business is struggling, it will most likely not give out dividends. In the case a partner wants to liquidate their investment, the company or individual buying their share must pay them back.
Debt requires regular cash or equivalent asset payments to the person or company who lent the money. This can strain the cash flow of a business. Moreover, debt must be repaid within a specified term, unlike private equity.
Appearance on The Balance Sheet
On a business’s balance sheet, private equity does not appear as a liability. However, it has to be mentioned under other equity in your balance sheet and other documents. Debt, on the other side, shows up as a liability of the business. Companies with too much Debt are a red flag for investors.
When looking at business financing, both private debt and private equity play a significant role in the growth and development of new firms. Both work on a profit basis and come with their own risks if you are looking to choose any of these options. Analyze your business growth carefully and see which approach would work better for you in the longer run.