Image: Unsplash
Image: Unsplash

Fundamentals of Finance: What is equity?

The equity of an asset, simply put, is its value minus any associated liabilities.  Assets can range from a single piece of equipment to entire companies – anything capable of producing economic value, be it a product, the tool used to create it, or the design specification to which it was produced.  Liabilities come in different forms.  Often, it is the debt taken out to purchase the asset – for instance, the equity on a house is its market value minus the outstanding value of its mortgage.  Any outgoing costs on a company’s balance sheet are also liabilities, like operating costs or dividends paid to shareholders.  

Companies themselves are a complex network of assets and liabilities, where a company’s value can be determined by its total equity (total assets minus total liabilities). A company’s equity is distributed through the sale of shares to its various shareholders, who are considered to hold equity in the company.  Note that the total value of a company’s shares – its Market Capitalisation, or market cap – is usually different from its total equity, because the price of shares is determined by the market, not just its physical assets.

PE firms search for rapidly growing companies and invest early, purchasing controlling stakes in promising startups, chasing the next unicorn

Rich individuals with lots of money to invest form the basis of the Private Equity (PE) industry.  PE firms have grown significantly over the past decade, from $2.5 trillion assets under management in 2010 to $6.5 trillion in 2020.  They are highly exclusive investment management funds that trade in privately held investments, and restrict their clientele to a small number of trusted investors. PE firms search for rapidly growing companies and invest early, purchasing controlling stakes in promising startups, chasing the next unicorn.  They often engage in venture capital, investing in completely new industries, and use Leveraged Buyouts (investing with borrow money).  These practices are risky, but can result in extremely high returns on investment.  PE firms work with informed investors who are aware of the high risk, high return model.

PE firms can also take an active role in managing the companies in which they invest, offering advice and guidance to the companies as they grow. When a company is large enough, the firm will walk them through an exit strategy like an IPO to go public. Because of this, PE requires – and attracts – incredibly talented individuals who can spot investment opportunities, convince start-up owners to accept their investment, then guide the company to success. PE is important because it constitutes the distillation of the financial industry as an “insiders club”: PE firms are the firms with the best talent and the most connections and they use them to make the greatest profit. The industry’s significant growth can be traced to investors flocking to PE firms over the more traditional investment options simply because the return on investment is that much higher.

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