Just as with public securities, private securities are generally either equity or debt, but that’s the simple part. The most commonly encountered forms of equity are called venture capital and “Private Equity” for private equity (yes…it’s used interchangeably), and senior vs. subordinated debt for private debt. They attract investment because they command higher returns, based solely on their illiquidity and credit risk. But those anticipated returns vary widely.
Here’s a brief description of each basic category of private investment:
Private Equity (“PE” – Equity Investments): While this literally means equity in private companies, Private Equity Funds (“PE Firms”) invest only in companies with positive EBITDA. This is the world of leveraged buyouts, recapitalizations, acquisitions, etc.
Venture Capital (“VC” – Equity Investments): An equity investment in a venture-stage company. “Venture-stage” means a company with negative operating cashflow (or at least one that isn’t consistently generating positive cash-flow). More often than not, it’s an investment in a younger company. It doesn’t have to be young (any fast-growing company could be outrunning its revenues), but usually that’s the case.
A high-risk investment in a company such as this may produce outsized returns. However, high risk means a high failure rate. You should require a high projected return for each VC investment. In that way, despite frequent failures, you hope to have a compelling overall return when your total portfolio is evaluated relative to other investment asset classes.
Senior Debt (Loans & Notes – Debt Investments): The most senior form of security. In case a business fails, senior debt investors are first in line to be repaid either from operating cash flow or from funds raised through asset liquidation.
They are often collateralized by assets — senior secured notes — but not always. Companies with stronger operating histories less frequently collateralize their notes. These are called senior unsecured notes.
Companies which issue senior debt often can’t obtain less expensive bank loans. Nevertheless, if they have adequate cash flow, borrowing represents a lower cost of capital (is cheaper than) than issuing equity.
Subordinated Debt (“Sub Debt” or “Mezzanine Financing” – Debt Investments): Cash-flow lending that is typically unsecured and junior to senior debt in liquidation preference — investors are second in line, or “subordinated,” to senior debt for repayment purposes, but still ahead of equity investors.
It’s easy to see why private investments are confusing — especially in an industry with its own unique language. Once you master the language, it can become much easier to find the investments you are looking for.