Why people invest in equity / shares

There are two main types of capital that can be injected into a company – debt and equity (or shares). While both can provide management with relative financial freedom, their features are very different. This mini-article focuses on why investors often prefer lower ranking, riskier equity to other forms of capital investment.

When a business fails, the last people to get paid are typically the equity holders. All other capital providers generally rank ahead of equity, meaning that the risk to equity investors of realising a negative yield or losing their entire investment is greater than for other capital providers. However, one of the most attractive aspects of equity is the fact that the potential uplift in value is unlimited, while losses are restricted to the amount invested. This is different to debt in that ordinarily the maximum return from a debt investment is limited to the interest rate, regardless of how the business performs.

Benefits of equity investments

The return that is possible from an investment in equity is what attracts investors to this type of capital. It is very common for investors to invest in the equity of a portfolio of companies, with the expectation that only a small portion will return a profit. The idea is that the returns of profitable investments will more than outweigh the losses of the failures, and hopefully one or two will generate exceptional returns.

By way of example, imagine that an investor invests £10,000 in the equity of 10 different companies. After five years, eight companies have failed and the investor has lost their entire capital invested i.e. £80,000. One company exits at a valuation that provides a return of five times the original investment i.e. £50,000. This quantum of multiplier is not uncommon in private equity investments. The final company exits at a valuation that provides the investors with a return of 20 times their original investment i.e. £200,000. While relatively less common, this type of return does occur with regularity. After initially investing £100,000 five years ago, the investor has now received £250,000 back, a return of £150,000 or 20.1% per annum. This is despite 80% of the investments failing. This is by no means an ambitious example, and many investors have realised far higher returns from similar scenarios.

The potential for significant returns from equity investments is why many of us are drawn to invest in shares.

If you would like to speak to our team about your investments and the best way to structure them, contact Nick Wallis at nwallis@geraldedelman.com.

For further information regarding equity investments, read: Key risks in private equity investment