What is a Portfolio Company?

A portfolio company is a term used to describe a company in which investors own equity in a company or buy out a company. The goal of the investor is to increase the value of the portfolio company and earn a return on their initial investment.

The investment could be in the form of private equity in established companies or venture capital in companies just starting out. One portfolio company usually forms part of a group of companies in the investor's full portfolio.

Who Invests in Portfolio Companies?

Portfolio companies are used by venture capital firms, private equity firms, and other financial investment firms. Some firms build a portfolio of companies that specialize in a specific sector, such as science or engineering. Others have a diverse mix of portfolios.

Private Equity Firms: Private equity is a type of finance made up of equity securities and debt in companies that are not publicly traded on a stock exchange. The aim of their investment is to provide working capital to a company to help it expand, develop new products, or to restructure the company's operations or management.

Common investment strategies in private equity include:

  • Leveraged buyout (LBO): The act of taking over a company by buying majority control, using mainly debt to finance the buyout. Debt is most commonly raised by using the company's assets as security.
  • Venture capital: Capital invested into young companies like new startup companiesor small businesses that need early-stage funding.
  • Growth capital : Provides financing to an established business to expand and grow the business into areas such as new product development, restructuring operations, expansion into other markets, or financing an acquisition.
  • Distressed investments: Funding provided to companies that are going through financial or operational distress, or are under or close to bankruptcy.
  • Mezzanine capital: A type of financing that is part debt and part equity financing. It gives the lender the rights to switch to ownership or equity interest in the company in the case of default. Mezzanine debt is often used to finance acquisitions and buyouts.

Venture Capitalists: Venture capital is a type of private equity that funds small, emerging, and early-stage companies. Most venture capital firms look for startups that show the promise of high growth, or which are already demonstrating growth (in the growing number of employees, annual turnover, or both). Venture capitalists take on the risk of financing startups in the hope that they will become successful and provide a big return on investment.

Different Approaches to Investing in Portfolio Companies

There are three routes to take when investing in a portfolio company:

Developing Equity in a Company

When private equity firms scout around for a portfolio company, they look for companies that will add diversity and growth potential to their portfolio. Opting for middle-market firms is usually safer because there's still room for growth and it comes with less of the risk of a startup. These companies often need a heavy investment of funds to expand and continue growing. However, just one lucrative portfolio company can return this capital many times over to a clever investor.

Buying Out a Company

A buyout involves purchasing the majority of a company's shares (at least 51%) to gain a controlling interest in the firm. Buyouts occur because the buyer thinks the company's assets may be undervalued and can be resold at a profit. Other buyouts occur because they will bring higher revenues, easier entry into new markets, or less competition.

Funding a Startup

There are three types of venture capital for startups:

  • Seed capital , for new ideas yet to be launched;
  • Early-stage capital, for companies in their first or second stages of existence; and
  • Expansion-stage financing, for companies ready for further growth.

Getting a startup off the ground is no easy feat. Many hopefuls first look at funding the venture out of their own pockets or turning to family and friends for the initial round of funding. Once they exhaust that funding, or if they simply do not have it upfront, they seek out venture capitalists or angel investors.

Venture capitalists provide this financing in the interest of gaining a return on that investment. They enter into the partnership with a profitable exit strategy in mind: either to sell the company's shares to the public for the first time in an initial public offering (IPO), or do a merger or acquisition in which the smaller portfolio company is merged with or sold to a larger enterprise.

Why is a Portfolio Company Important?

Portfolio companies vary from well-established mid-market firms that need a boost in capital to see them through a rough patch to startups with a short track record but a great idea that needs capital to get it off the ground. Without these companies and without the investors who have faith in these companies, many a good idea will never see the light the day and a promising company may sadly fail. Portfolio companies not only bring new ideas to the business market, they also create jobs and inject a boost into the economy.

Reasons to Consider Investing in a Portfolio Company

Financial Gain

Investors don't plow thousands of dollars into companies out of the goodness of their heart. They do so to make money, and to make big money. It's a gamble, as all investing is, but a well-spotted portfolio company that succeeds pays off in massive profits. The money raised by selling to a larger company or going through an IPO pays back the venture capital investment several times over.

The standard return on investment sought by private equity and venture capital firms is approximately 30 times their investment. That is more of a guideline, though — many are so skilled at this game that they easily cash in on much more than that.

Strategic Input

Private equity firms are not directly involved in the day-to-day operations of their portfolio companies. Rather, their role is to add value to the growth and success of the business by providing input into the financial, operational, and strategic aspects of the business. They work together with the management team and typically have a few seats on the company's Board of Directors or Advisory Board.

Choosing a Portfolio Company to Invest In

When choosing portfolio companies, private equity firms, venture capitalists, and other investment firms, look for strong prospects. Some determining factors include:

  1. Lifecycle of the Company

The stage of growth a company is in can be a determining factor. Some investors are interested in providing growth capital to a stable company in need of further capital to expand. Others want to invest a limited amount of money and quickly turn over some profit by doing a leveraged buyout.

  1. The Size of the Company by Taking into Account
  • EBITDA (earnings before interest, taxes, depreciation, and amortization)
  • Revenue
  • Value of assets
  1. Location
  • Regional
  • Multi-regional
  • International
  1. Industry

Some investment firms only invest in specific industries.

  1. Investment Size

Determine whether the investment firm can put a small, medium, or large chunk of change into the company.

  1. Diversification

Sensible investment always means diversifying. It's a risk mitigation technique that ensures you don't "put all your eggs in one basket." Spreading investment across various companies, sectors, and industries brings a balanced portfolio with a lower risk. Should one portfolio company fail but all the others in the portfolio are performing well, the financial loss is not as devastating.

Once the private equity firm has assessed all of the above, they can then take the next important step of due diligence and, should the findings be in order, begin negotiations with the portfolio company.

Choosing a Portfolio Manager

Investors with the expertise can choose to manage their portfolio of companies themselves. However, it is wiser to use a skilled portfolio manager to build and manage a portfolio that will create the most profit with the lowest risk.

Three things to take into account when choosing a portfolio manager:

  1. Ability to Balance the Portfolio

Private equity firms should choose a portfolio manager that aims to build a diverse portfolio of a broad range of industries and varying scope in market positions. A smart portfolio manager knows that by mixing the different levels of risk and potential reward, they can reduce the overall risk of the investment.

  1. Skill Set of the Portfolio Manager

The reason for investing may also influence the choice of a portfolio manager. The investor may target certain companies for a specific reason. This could be to gain equity shares or to buy out a company completely, and different fund managers may specialize in these different aspects of investing.

  1. Role as an Advisor

Portfolio managers also provide valuable input into researching companies in need of capital and advising whether such companies have the potential for growth. They are also capable of assessing the viability of other investors who are interested in taking part in the opportunity.

Planning the Exit

About a third of portfolio companies don't succeed. That's why it's crucial to evaluate an opportunity thoroughly before investing and have a strong exit strategy in place. Private equity firms never plan to remain invested in a business indefinitely. They acquire companies for a specific period, usually between five and seven years, and with the intent to exit at the end of that period with a profit.

Exits are usually conducted in three ways:

  1. Initial Public Offering (IPO)

The main benefit of an IPO exit is the potential for a high valuation, provided that there is investor demand to buy shares in the company and public market conditions are stable. The disadvantage of an IPO is the high transaction costs and restrictions placed on the investor to remain in the company until the "lock-up" period has ended.

  1. Trade (Strategic) Sale

The most desirable option is to sell to a strategic buyer. Strategic buyers usually have a vested interest in buying the company — for market growth, trade secrets, new products, or to create synergies. Therefore, they are willing to pay higher prices to secure the company. For the investor, they have the benefit of their money immediately upon closing of the sale, rather than waiting for the public offering to finish and the lock-up period to end.

  1. Secondary Buyout

When one private equity firm sells a portfolio company to another private equity firm in a leveraged buyout transaction, this is known as a secondary buyout. Reasons for going this exit route includes selling to a larger investor who can add more value to the portfolio company as it moves into the next stage of its development. Alternatively, an investor may decide to sell the company to another investor if they have reached a high rate of return in a short period of time.

Other exit options include refinancing, partial sales, and liquidations.

Knowing When to Jump Ship Early

Despite all the research and evaluation in the world, sometimes things just don't pan out the way you hoped. It's time to cut your losses if red flags are spotted like:

  • Poor governance
  • Milestones are consistently being missed
  • Glaring disparities in the finances
  • Declining revenue
  • Directors and senior management are resigning

Changes in the macroeconomic, legal, tax and regulatory environments can all also heavily influence the investment landscape. A shift in conditions of public capital markets and bank lending could reduce the viability of remaining invested in the portfolio company.

If you need help with acquiring a portfolio company or taking a portfolio company public, post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top five percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.