Private equity is financing from investors to invest in or buy companies that aren’t listed on a public market and then make improvements to those companies. Their goal is to sell the companies for more than they bought them for. Many people aren’t as familiar with this style of investment as they are with the public trading done through the stock market.
If you’ve ever wondered, what is private equity?, read on to learn more about what it is, how it works, and how to invest in private equity.
What Is Private Equity?
Private equity (PE) is a type of investment where qualified investors can purchase shares of companies that are not publicly traded on a stock exchange or regulated by the Securities and Exchange Commission (SEC). They typically do this through investment partnerships or funds managed by private equity firms.
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 combine their assets to invest in private companies that aren’t typically available to the average investor.
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How Do Private Equity Firms Work?
Private equity firms have funds that allow various investors to pool their assets in order to invest in or buy private companies and manage them.
These 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 assets 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 may aim to receive their profits a few 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, 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.
Can Anyone Invest in Private Equity?
When it comes to 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, and may be well into the millions of dollars, an individual must meet strict criteria to qualify as an individual accredited investor. 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.
How to Invest in Private Equity
Many private equity funds require very large investments that are out of reach for many individuals. And directly investing in private equity funds is not possible for investors who are not accredited. However, there are an increasing number of options for average investors seeking to gain exposure to private equity, including:
Exchange-traded funds (ETFs): Investors can invest in ETFs that have shares of private equity firms.
Publicly traded stock: Some private equity firms have publicly traded stock that investors can buy shares of. This includes PE firms like the Carlyle Group, the Blackstone Group, and Apollo Global Management.
Funds of funds: Mutual funds are restricted by the SEC from buying private equity, but they can invest indirectly in publicly traded private equity firms. This is known as funds of funds.
Interval funds: These closed-end funds, which are not traded on the secondary market and are largely illiquid, may give some investors access to private equity. Interval funds may invest directly or indirectly through a third-party managed fund in private companies. Investors may be able to sell a portion of their shares back to the fund at certain intervals at net asset value (NAV). Interval funds typically have high minimum investments.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
Advantages and Disadvantages of Private Equity
While private equity funds provide the opportunity for potentially larger profits, there are some key considerations, costs, and high risks investors should know about.
Advantages
Here are some possible benefits of private equity investments.
Potentially Higher Returns
With private equity, returns may be greater than those from the public stock market. That’s because PE firms tend to invest in companies with significant growth potential. However, the risk is higher as well.
More Control Over the Investment
Private equity investors are typically involved in the management of the companies they are invested in.
Diversification
Private equity investments allow investors to invest in industries they may not be able to invest in through the public stock market. This may help them diversify their holdings.
Disadvantages
The drawbacks of investing in private equity include:
Higher Risk
Private companies are not required to disclose as much information about their finances and operations, so PE investments can be riskier than publicly traded stocks.
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 years, 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.
Contradicting Interests
Because equity firms can invest, advise, and manage multiple private equity funds and portfolios, there may be conflicts. To uphold the fiduciary standard, private equity firms must disclose any conflicts of interest between the funds they manage and the firm itself.
High Fees
Private equity firms typically charge management fees and carry fees. 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.
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.
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 may offer the opportunity for profitability, they also come with some hefty risks. 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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FAQ
What’s the history of private equity?
Pooling money to buy stakes in a private company can be traced back to 1901, when JP Morgan bought Carnegie Steel for $480 million and merged it with two other companies to create U.S. Steel. That is considered one of the earliest corporate buyouts. In 1989, KKR bought RJR Nabisco for $25 billion, which, adjusting for inflation, is still considered the largest leveraged buyout in history.
How does private equity make money?
Private equity firms make money by buying companies they consider to have value and potential for improvement. PE firms then make improvements, which in turn, can increase profits. These firms also benefit when they can sell the company for more than they bought it for.
How much money do you need to invest in private equity?
Private equity funds typically have very high minimum investments that are often tens of millions of dollars. Some firms may have lower requirements around $250,000. In addition to putting up the minimum investment amount, an individual needs to be an accredited investor with a net worth of at least $1 million or an annual income higher than $200,000 for at least the last two years.
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