Equity (finance)

In finance, the word "equity"—from the Latin aequitas meaning "fairness" or "evenness"—refers to the value of an asset after the value of the asset’s liabilities has been subtracted. The financial meaning of "equity" developed because determining an asset’s value this way before dividing that value up among its shareholders is "equitable," or fair. Equity in finance derives from the legal principle of "equitable claim." As an example of how "equity" is used in finance, when a business goes through bankruptcy proceedings and liquidates its assets, after it repays its creditors, any remaining money is called ownership equity—the value of the liquidated business minus the value of the repaid debts.

Background

The modern concept of equity in finance originates with joint-stock companies, the forerunners of modern corporations. These companies were more complex than a simple partnership, allowing large numbers of investors to jointly own stock in a business venture. In common law terms, each investor owned an "equity," an enforceable right to a fair share of the business venture’s value, which existed independently of and was not overwritten by the ownership rights of the company’s trustees or managers. This concept not only protected investors but also was important to the companies. It reassured potential investors that the right to their fair share of profits was protected, making it possible to raise capital to fund such business ventures in the first place. Famous joint stock companies include the East India Company, which explored and colonized East and Southeast Asia and established the spice trade, laying the groundwork for modern capitalism.

The most commonly discussed types of equity in finance are private equity—the value of shares in ownership of a privately held company—and shareholders’ equity of publicly traded companies. Some types of equity have special terms of art that are more commonly used to refer to them: on a piece of mortgaged real estate, the equity represents the difference between the property’s market value and the balance owed on the mortgage. Although it is accurate to use equity to refer to this concept, "real property value" is the term preferred by lenders and the real estate industry. When the term equity is used, it is usually because the property is being used as collateral for a loan, as in a home equity loan or a home equity line of credit. This is a common source of funding for small businesses, which may face difficulty obtaining funding through traditional business loans.

Overview

In the 1990s, private equity became an increasingly important asset class in the finance sector because of the growth of private equity firms and venture capitalists. Some of this growth resulted from the dot-com bubble, as the rapid population growth of Internet start-up firms required an influx of capital from investors. However, not all private equity investment consists of investment in young or growing companies. Some investment strategies involve leveraged buyouts, in which majority control of a mature firm is assumed through the purchase of either private equity securities or debt. Unlike start-up companies, which usually operate at a loss and are not expected to show a profit until later, these mature companies already generate operating cash flows.

Other private-equity-firm investment strategies include the more traditional venture capital (generally, for new companies), growth capital (when companies need capital to fuel growth), mezzanine capital (lent to small companies beyond the levels that would be allowed by bank loans, at a higher rate of interest), and investment in distressed securities (securities issued by companies or governments experiencing financial distress that puts them at risk of default or bankruptcy). Investment in distressed securities is high risk, but such securities are often available for pennies on the dollar. Specialist firms and hedge funds hire risk management specialists and quantitative analysts to protect them.

Although private equity is intended to represent long-term investment compared to the relative liquidity of publicly traded shares, there is a secondary market for private equity assets, usually called private equity secondaries, or just "secondaries." Participants primarily include private equity firms, major investment banks, and other institutional investors. Transactions consist of either sales of an investor’s share in a private equity fund (or portfolio of funds) or sales of direct investments in companies. Within these two categories of transactions, sales can be accomplished through numerous means. For instance, an investment bank’s shares in a private equity fund can be securitized, meaning they are turned into sellable security called a collateralized fund obligation vehicle, from which the seller issues notes, generating liquidity from otherwise illiquid shares.

Equity is sometimes used in a more figurative sense when referring to an asset’s value. For instance, the marketing field has promoted the concept of "brand equity," which is the equity of an intangible asset—specifically, the value of a product’s brand identity relative to a generic product, usually expressed as the difference in price end users are willing to pay. For instance, the difference in price between a can of Coca-Cola and a can of generic cola is Coca-Cola’s brand equity. The assets and liabilities involved with the brand’s value are all intangible and related to consumer attitudes, but they may also be related to tangible factors, such as product recalls and features lacking in competing products. In some product categories, the challenge is in establishing a generic standard against which to measure the brand.

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