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Private equity is a form of alternative investment in which money is pooled to make investments. A typical private equity strategy may involve buying all or part of a company, restructuring and repositioning it, and ultimately selling it for a profit, often back onto the public market. Private equity funds can generate good returns but carry some risk and are generally not regulated by the Securities and Exchange Commission.
Here’s how private equity works, the potential rewards and risks involved, and what types of investors typically participate.
How does private equity work?
Private equity, or PE, refers to investments made by a select group of investors, as opposed to public equity such as publicly traded stocks, where anyone can own a share of the company. Private equity investments are organized by private equity firms, which make deals and solicit capital from accredited, high-net-worth investors and others to participate in the PE fund.
PE firms often buy established or publicly traded companies with the goal of increasing their value over time and then selling them profitably, often back to the public stock market. PE firms typically use substantial debt financing to acquire companies, a factor that often makes companies riskier. They are known for quickly and ruthlessly cutting costs at acquired companies to make them more profitable.
Investments in PE funds are typically not easily accessible to individuals, and potential investors must demonstrate that they are accredited and have significant financial resources to be able to absorb a loss. PE funds typically hold investors’ capital for years before gaining access to it, meaning investors often have to wait until a company is sold to another company or floated on the public market.
PE firms are typically responsible for acquiring deals, executing transactions and raising capital. Although private equity funds are not registered with the SEC, the fund’s advisor may be. For these services, private equity firms receive significant compensation from the fund’s investors.
The types of private equity strategies include:
- Venture Capital: Venture capital involves investing in early-stage companies that may not be profitable and do not have a proven track record. These funds generally take more risk than other forms of private equity.
- Growth capacity: This is when a fund invests in established companies that need financing for expansion.
- Leveraged buyouts: Leveraged buyouts, or LBOs, focus on mature companies that can generate cash flow from day one. LBOs purchase a company using a combination of debt and equity. The debt is used to increase returns for equity investors.
What is a private equity fund?
Private equity funds are investment pools managed by private equity firms. As previously mentioned, private equity firms use money from accredited and institutional investors to create funds that can be used to buy, restructure, and later sell companies to make a profit. Private equity funds are not available on the public market and generally have a long investment horizon, often three to seven years or longer.
While private equity is an important part of endowments or other large institutional portfolios, these funds are not suitable – or often even available – for most individual investors. Information about assets can be opaque and infrequently updated, and money cannot be obtained quickly in the way that publicly traded investments can.
– Greg McBride, CFA | Bankrate’s chief financial analyst
How to evaluate a private equity investment
Potential investors should assess the financial health of the target company, including its historical performance and growth prospects. This may include analyzing the company’s business model, competitive advantage and any relevant industry trends. Additionally, evaluating the expertise and track record of the management team is critical as they can impact the company’s success.
Investors will also want to understand the investment structure, terms and conditions and potential risks. Many PE investments involve significant debt, and many investments end in bankruptcy, partly due to high debt levels. So it is important to carefully analyze the investment, estimate its potential return and consider how it fits your risk tolerance and investment objectives.
Other considerations are the often significant costs and whether you can tie up your money in the fund for years. If ESG investing is important to you, add that to your list as well.
Consider all these factors as you make an informed decision about investing in a PE fund.
Who can invest in private equity?
Because private equity is “private” by definition, it is not regulated by the SEC. Private equity is not publicly traded and therefore does not fall under the purview of the SEC. PE is also considered a sophisticated investment, meaning investors must prove they have enough money to participate.
In general, an investment in a private equity fund is usually limited to institutional and accredited investors. Institutional investors include banks, insurance companies, university endowments and pension funds. Individual investors generally must meet the criteria of accredited investors, which may mean earning an income of more than $200,000, or $300,000 with a spouse, having a net worth of more than $1 million, having certain professional qualifications, or being a skilled worker from a private fund. The SEC outlines the specific requirements for accredited investors. Moreover, in certain cases there is a higher threshold for investing in PE fund structures. In these cases, a qualified purchase would be the minimum requirement, typically involving $5 million or more in assets.
It is important to note that while private investors may be excluded from direct investments in private equity, indirect investments are possible through pension schemes and insurance companies that may have private equity funds in their portfolio.
Disadvantages and risks of private equity
Before making any investment moves, you should consider the disadvantages of investing in private equity, including:
- Lack of liquidity. Private equity investments are illiquid, meaning they cannot easily be converted into cash, and investors may have to wait at least several years before realizing any returns.
- Fees and costs. Private equity firms may charge significant fees for managing the fund, in addition to other costs associated with the fund. Investors should check the contract for such fees and charges to avoid surprises later. Additionally, phantom income, an investment gain that has not yet been realized, can result in an increase in annual tax liability depending on the structure.
- Not SEC registered. Because private equity funds are not registered with the SEC, they are not required to provide public disclosures and other documentation that can aid in the transparency of an investment.
- Conflicts of interest. Conflicts can arise between the private equity firm and the fund. Some of these potential sources of conflict include the power of the fund’s management team to decide when the fund can exit its investments, the fund’s ability to purchase assets that the management company already owns, and the fees and timing of it. Investors should ensure that the private equity firm is transparent about these potential conflicts of interest.
- Debt burden. Many PE firms load massive amounts of debt onto their acquired companies to boost returns for investors. However, this heavy debt burden increases the risk of the investment, and many PE firms go bankrupt when faced with even modestly worse operating conditions. The fund’s investors bear the brunt of this loss, not the PE firm, which has already received a lot of compensation along the way.
In short
Private equity can be a lucrative investment option, but comes with a number of risks and considerations, not least that you will need significant financial resources to participate. That said, with the right research and opportunities, private equity can be a way to diversify your portfolio and potentially increase your returns.
