What Is Private Equity? A Brief Guide for Investors
Private equity funds often take a controlling stake in the companies in which they invest. As a result, they often play an active managerial role in how the target business operates.
Only certain types of investors can invest in the funds. But for those investors, this alternative class of investment can offer significant returns.
So What Is a Private Equity Fund?
So what is private equity, really? It is money that private equity funds pool together and invest in non-publicly traded companies. Such funds are similar to mutual funds and hedge funds. All three of these types of funds can pool investor money together in order to make investments.
Private equity funds often focus on long term investments. They might invest in companies for a period of up to ten years or even more.
As a result, the funds aren’t going to see a return on their investment immediately. Instead, it takes several years before investors in the fund may begin to get their returns as well.
This in part makes investing in a fund illiquid. Liquidity is a measure of how easily it is to turn an investment into cash.
Popular stocks and bonds, for example, are usually extremely liquid. When an investor wants to sell out of a stock and bond position, it is usually quite easy and immediate.
On the other hand, an investor in a fund may have legal limitations on when and how often they can withdraw funds or sell out of an investment in the fund.
So any investments you need to receive back in a short period of time should usually not be invested in a private equity fund.
Who Can Invest in Private Equity?
Now that you know a little bit about what private equity is, you may have some interest in participating in a fund. And for some investors, it can be a great way to grow your money.
However, not just anyone can invest in private equity. In order to do so, you must be an accredited investor. But how do you become an accredited investor?
There are several types of entities that are allowed to be accredited investors. Examples of these include institutional investors like mutual funds or insurance companies as well as high net worth individuals.
Institutional investors are large financial institutions such as pensions, insurance companies or mutual funds. They are allowed to invest in private equity funds.
But generally, these types of institutional investors are diversified well beyond a private equity fund. This limits their exposure and risk from having too much money concentrated in one place.
Another type of accredited investor is high net worth individuals. As the name implies, these investors are those that have already built a significant amount of wealth.
As a result, people tend to believe that high net worth individuals are rather sophisticated when it comes to growing their money. Therefore, people see them as having the necessary skills to invest in a private equity fund.
Taking a Controlling Stake
Most often, private equity companies follow the strategy of investing long term in a private business or company and taking a controlling stake in that entity. This gives them the ability to have managerial say in the operations of the business. Sometimes they may even buy 100% of the target company and completely takeover.`
As a result, funds have more control over the outcome of their investment. It can increase their likelihood of seeing positive returns for their fund participants.
There are various reasons why a private equity fund may buy a stake in a a particular business. A target company may have a great idea for a product or service, presenting a great investment opportunity. But the target may lack the capital to realize that great product or service without an investment from a fund.
Another reason is that a particular company may be in poor financial shape but have particular assets that could be extremely lucrative. The fund can try to turn the company around or make use of those particular valuable assets in rebuilding the business.
Taking a Minority Stake
Taking a majority stake is not the only strategy that funds use. Sometimes, funds make minority investments in companies. These minority investments do not give them the same kind of control over business activities.
As a result, the funds have less control over the performance of the target company. So why would funds make these minority investments?
It is because they often have other advantages. A common example is when a fund invests in a high growth startup business. These companies can generate outsized returns in a shorter period of time.
These high growth companies may be in the pre-IPO phase. Investing in startups before they go public can deliver big wins if you choose the right ones. For example, think of one-time startups like Google and Amazon.
More on Private Equity
The Profit Motive: How Funds Make Money
Private equity funds make money in a couple of ways. One way is through management fees and the another is through performance fees.
Funds collect management fees just for owning and managing the target company. It is not a question of how well the target company is performing. A poorly performing asset still has to pay this fee. Management fees run from roughly 0 to 3%, averaging about 1.5%.
Performance fees, on the other hand, take the performance of the asset into consideration. When the private equity fund sells its ownership stake in the target company, fees are distributed based on the profits made. These fees can range but are often around 20% of the value of the sale.
Different Types of Partners
Generally there are two kinds of partners in a private equity fund: general partners and limited partners.
General partners are active managers. In addition to investing in the fund, their main function is to choose which target companies they want to acquire a stake in and to manage their stake in those companies.
On the other hand, limited partners do not usually play an active role in the fund. Essentially, they put up some of the money used to invest and later receive returns on their investments.
How to Invest in Private Equity
There are different ways to invest in private equity. Accredited investors can invest as individuals. The Securities and Exchange Commission (SEC) mandates that accredited investors must earn above $200,000 annually or have a net worth exceeding $1 million.
There are other ways to invest, however. A few of these include the following:
- Buying exchange traded funds (ETFs) that invest in private equity
- Buying into funds of funds
- Owning shares of a business development company (BDC)
Generally, these alternative ways of investing in private equity companies are available to any investor. But the returns will likely be a small percentage of what you could possibly make with a direct investment as an accredited investor.
Concluding Thoughts on What Private Equity Is
So now that you know what private equity is, you may determine if you are qualified and interested in investing in a fund. As I have laid out in this article, there are both benefits and drawbacks to investing in private equity.
But, you may determine that a different alternative investment is more appropriate for your money. Or you may want to stick with more traditional investments like stocks and bonds.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.