Private equity is money from investors that helps grow and expand companies that aren’t listed on a public market. Many people aren’t as familiar with this style of investment as they are with the public trading done through the stock market. However, private equity plays a crucial role in our economy and helps smaller companies flourish.
To better understand what private equity is, how investors invest in it, and why it’s important to the economy, here is a comprehensive look at private equity.
How Does Private Equity Work?
Private equity is a type of investment where investors can purchase shares of companies that are not publicly traded on a stock exchange or regulated by the Securities Exchange Commission (SEC).
With publicly traded companies, investors purchase shares of the company on a public market such as the New York Stock Exchange. With private equity, qualified investors can directly invest in private companies that aren’t typically available to the average investor.
What is a Private Equity Firm?
Private equity firms manage a fund that backs private companies. They pool capital from various investors or financial institutions and their assets to provide capital for the fund.
These individuals or institutional investors are referred to as limited partners. They are often high-net-worth individuals or institutions such as insurance companies. Equity firms usually require a sizable financial commitment from limited partners to qualify for this investment opportunity.
The equity firm uses the funds from investors to help the companies they invest in achieve specific objectives — like raising capital for growth or leveraging operations.
To help further these objectives, equity firms offer a range of services to the companies they invest in, from strategy guidance to operations management. The amount of involvement and support the firm gives depends on the firm’s percentage of equity. The more equity they have, the larger the role they play.
In helping these private companies reach their business objectives, private equity firms are working toward their own goal: to end the relationship with a large return on their investment. Equity firms usually receive their profits three to seven years after the original investment. However, the time horizon for each fund depends on the specifics of the investment objectives.
The more value a firm can add to a company during the time horizon, the greater the profit. Equity firms can add value by repaying debt, increasing revenue streams, lowering production or operation costs, or increasing the company’s previously acquired price tag.
Many private equity firms leave the investment when the company is acquired or undergoes an initial public offering (IPO).
Types of Private Equity Funds
Typically, private equity funds funnel into two categories: Venture Capital (VC) and Leveraged Buyout (LBO) or Buyout.
Venture Capital Funds
Venture capital (VC) funds focus their investment strategy on young businesses that are typically smaller and relatively new with high growth potential, but have limited access to capital. This dynamic creates a reciprocal relationship between VC fund investors and emerging businesses. The start-up depends on VC funds to raise capital otherwise inaccessible, and VC investors can possibly generate large returns.
Leveraged Buyout
In comparison to VC funds, a leveraged buyout (LBO) is typically less risky for investors. LBO or buyouts target mature businesses, which tend to turn out larger rates of return. On top of that, an LBO fund typically holds ownership over a majority of the corporation’s voting stock, otherwise known as controlling interest.
Private Equity Comparisons
Private equity is one type of alternative investment, but there are others. Here’s how a few of them compare.
Private Equity vs IPO Investing
From an investor’s standpoint, private equity investing means you’re putting money into a company, and hopefully making money in the form of distributions as the company becomes profitable.
Investing in an IPO, on the other hand, means you’re buying stocks in a new company that has just gone public. In order to make money, the company’s stock price needs to rise, and then you need to sell your stocks in that company for more than you initially paid.
Private Equity vs Venture Capital
Venture capital funding is a form of private equity. Specifically, venture capital funds typically invest in very young companies, whereas other private equity funds typically focus on more stable companies.
Private Equity vs Investment Banking
The difference between these two forms of investing is of the chicken-and-egg variety: Private equity starts by building high-net-worth funds, then looks for companies to invest in. Investment banking starts with specific businesses, then finds ways to raise money for them.
Advantages and Disadvantages of Private Equity
While private equity funds provide the opportunity for potentially larger profits, there are some key considerations, costs and risks investors should know about.
Lack of Liquidity
Private equity funds tend to lack liquidity due to the extensive time horizon required for the investment. Since investors’ funds are tied up for three to seven years or more, equity firms may not allow limited partners to take out any of their money before the term of the investment expires. This might mean that individual investors are unable to seek other investment opportunities while their capital is held up with the funds.
For institutional investors, the lack of liquidity may not be a significant problem, since the private equity fund investment is likely only a small portion of their diversified portfolio.
Contradicting Interests
Because equity firms can invest, advise, and manage multiple private equity funds and portfolios, the interests in these funds may clash. To uphold the fiduciary standard, private equity firms must disclose any contracting interest between the funds they manage and the firm itself. There have been several instances where the SEC has taken action against firms that have not disclosed contradicting interests.
There are a lot of parties involved in private equity funds, such as affiliates and external investors. This potentially allows the fund managers to capitalize and profit from each moving part instead of maintaining the fund’s best interests.
Undisclosed Costs
Upon investing in a private equity fund, limited partners receive offer documentation that outlines the investment agreement. All documents should state the term of the investment and all fees or expenses involved in the agreement. There have been instances of firms not adequately disclosing the fund’s fees and costs. Essentially, these firms were charging limited partners without their knowledge.
How to Invest in Private Equity
Only qualified or accredited investors are allowed to become limited partners in a private equity fund. Because private equity funds are not registered with the SEC, they don’t require SEC security disclosures. Thus, investors must understand the highest risk of such investments and be willing to lose their entire investment if the fund doesn’t meet performance expectations.
Since the initial investment is typically pretty high, an individual must meet strict criteria to qualify as an individual accredited investor, as outlined by the SEC , a person must meet a particular set of criteria . A person must make over $200,000 per year (for two consecutive years) as an individual investor or $300,000 per year as a married couple. Alternatively, an investor can qualify as accredited if they have a net worth of at least $1 million individually or as a married couple to qualify (excluding the value of their primary residence), or if they hold a Series 7, 65, or 82 license. Other examples of accredited investors include insurance companies, pension funds, and banks.
There is also the possibility of indirectly investing in private equity. One way that might happen is if an investor has an insurance policy or pension that invests its capital in private equity funds.
The Takeaway
Private equity firms manage funds that invest in private companies that might otherwise not be available to investors. Sometimes these companies are small and new with high growth potential; in other cases, the companies are well-established, and may offer a higher rate of return.
Not everyone qualifies to invest in private equity. If you do qualify, it’s important to remember that while private equity funds offer the opportunity for profitability, they also come with some hefty risks: research shows that start-ups fail at a rate of 90%. As with any investment, it’s a good idea to make sure you fully understand the risks of investing in a private equity fund before moving forward.
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