What Is Private Equity? What Is A Private Equity Fund?

Companies looking to raise capital can take out loans, issue stock or sell bonds. The private equity market offers an alternative to these more conventional methods of raising capital.

In the past, the private equity market was often considered murky and difficult to access, but today the lure of private equity is attracting qualified businesses and investors alike. In the third quarter of 2021, private equity deal value reached a new record, topping $787 billion for the year.

What Is Private Equity?

Private equity (PE) refers to a constellation of investment funds that invest in or acquire private companies that are not listed on a public stock exchange. So-called PE funds may also buy out public companies, take them private, and then restructure them for potential future growth.

Another way to define private equity is as a form of financing where public or private companies accept investments from a PE fund. Typically, private equity invests in mature businesses in more conventional industries in exchange for an equity stake in the company.

In the past, private equity funds haven’t always been regulated in the same way as other market participants. These days, however, they tend to be scrutinized more rigorously.

How Does Private Equity Work?

PE funds often target a specific type of company based on where that company is in its lifecycle. For example, different private equity funds may specialize in younger firms with promising futures, well-established companies with reliable cash flows, or failing companies that need to be restructured.

In the latter scenario, a PE fund might buy out all the shares in a weak company with the goal of delisting the company, changing the management and improving its financial performance. The goal would be to sell it to another company or take it public again in an initial public offering (IPO).

Who Can Invest in Private Equity?

Private equity is considered to be an alternative investment class or alternative asset. Only institutional investors and accredited investors are eligible to put money into a private equity fund.

Accredited investors are deemed to have the financial know-how needed to evaluate these types of more opaque investments, and the funds available to be able to handle potentially large financial losses. Accredited investors must meet several criteria, including a specific earned income, net worth, and certain professional certifications, among other things.

Because of these strict qualifications, typical investors for private equity funds usually include institutions like pension funds and banks, or individuals like investment managers or people with a high net worth.

What Is a Private Equity Firm?

Private equity firms became popular during the 1970s and 1980s as a way for companies that weren’t doing well to make money in a way that avoided public markets.

They make their money by charging management and performance fees from investors within a private equity fund. PE firms typically include the following individuals:

  • General Partners (GP) handle the management and movements of the fund, and obtain the actual investment commitments
  • Limited Partners (LPs) are institutional or individual third-party investors that provide the bulk of the capital employed by PE firms. They may include pension funds, endowment funds, retirement funds, insurance companies and high-net-worth individuals (HNWIs).

Members of a specific firm usually agree on a set of terms laid out in a Limited Partnership Agreement (LPA), which designates payments and responsibilities for everyone involved.

Like hedge funds, the most common fee structure is two and twenty. Under this compensation structure, the PE firm charges an annual management fee of 2% of total assets under management (AUM)—even when the fund isn’t successful—and 20% of proceeds after break-even are received by GPs.

Something called a “hurdle rate” may also be included as a way of defining a minimum rate of return to achieve before accruing carried interest to GPs. LPs, on the other hand, receive all fund proceeds, minus the GP payment.

Private Equity vs. Venture Capital

Venture capital (VC) and private equity work somewhat similarly—but there are a few key differences between these two approaches to funding.

Venture Capital

  • Typically supports startups and entrepreneurs.
  • Funding usually provided in exchange for company equity at a minority stake of 50% or less.
  • VC investors tend to take a more advisory or hands-off approach.
  • Returns are realized after the company is acquired or goes public.

Private Equity

  • Typically invests in established businesses at various stages.
  • Funding provided in exchange for a majority stake or to back a complete takeover.
  • Investors tend to actively participate in the management and operation of the company.
  • Returns are usually realized when the company sees growth or, in the case of failing companies, when it is sold or goes public again.

Private Equity Leaders

Companies like Apple (AAPL), Toys R Us, RadioShack, and Payless Shoes have all had run-ins with the private equity industry. That’s not surprising, since many of the world’s top private equity firms are based in the U.S. Some popular ones include:

  • The Blackstone Group. Based in New York City, the firm that Stephen Schwarzman originally cofounded as a boutique merger-and-acquisition advisory business has evolved into a buyout firm worth $684 billion in assets.
  • The Carlyle Group. This global private equity business boasts $169 billion in assets under management and more than 270 active portfolio companies.
  • KKR. This leading alternative asset management company had $471 billion in assets under management as of December 31, 2021 and has raised 23 private equity funds since its inception.

Advantages of Private Equity

From a business perspective:

  • Private equity offers companies at every level an alternative way to raise capital without going through the bank loan process or needing to place their companies up for public offer on the stock market.
  • This structure often allows businesses to focus less on quarterly performance and more on the overall growth and big picture.

From the perspective of investors:

  • Private equity funds offer an opportunity to achieve high returns due to the incentives coming from all sides.
  • There are usually financing and tax advantages.
  • There is freedom from certain restrictions that come with trading on the public market.

Disadvantages of Private Equity

From a business perspective:

  • Waiting for private equity to come through can be a lengthy process and often requires the company to prove itself worthy of investment.
  • Private equity investments often come with changes to business management and/or structure.

From the perspective of investors:

  • This is a very limited investment option, open only to institutional and accredited investors.
  • Even when you are qualified to invest, it often takes years to see a return on your investment.

How to Invest in Private Equity

Private equity investing isn’t directly available for average investors who aren’t accredited.

There are options for investors who don’t qualify for direct private equity investing but still want exposure. Several of the largest private equity firms—like the Carlyle Group (CG), Kholberg Kravis Roberts (KKR), and the Blackstone Group (BX)—are publicly traded.

There are also exchange-traded funds (ETFs) and mutual funds that invest in the publicly traded shares of private equity firms. Use your online brokerage account to buy the funds that interest you, or open a new one to get started.

Should You Invest in Private Equity?

Although private equity investments have enjoyed strong historical performances, the best portfolio is a well-rounded one.

Even if you do decide to include some private equity holdings as part of your portfolio, it’s important to understand that these types of investments do come with risk. Not only can it take years for you to realize the full value of your investment, if the company doesn’t increase its value as expected, you could break-even or see a loss on your investment altogether.

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