LAW EXPLAINER: What is Private Equity?

Introduction

While the term private equity may not be familiar to you, many of the products and companies funded by it are. Many well-known large companies got their initial funding from private sources instead of through initial public offerings on public exchanges. Private equity financing is considered an alternative asset class, much the same as real estate, venture capital, or others.  Private equity is funded directly through a private equity firm instead of through the open market. Investors work through the firm to raise capital and identify suitable investment opportunities.  

What Are the Advantages of Private Equity?

Private equity can have advantages for both investors and the companies they invest in. For the investor, private equity allows direct investment in private companies, the ability to engage in the acquisition and sale of promising companies, and the possibility for larger returns and greater diversification. For a company, private equity allows easier access to much-needed capital without the stress of quarterly performance required by regulators.  

How Are Private Equity Investments Made?

Private equity investing is part of the private market and cannot be accessed through a public exchange. Private equity is capital that is invested in a company, but unlike some other forms of investment, private equity investors take a majority ownership stake in that company. These investments are made through private equity firms that manage and invest capital through private equity funds. Investment in private equity tends to come from institutional and accredited investors who are more able to dedicate large sums of capital over an extended period of time. These investors are typically more sophisticated, require less oversight and protection, and are willing to take on more risk. They can include large financial institutions, insurance companies, trusts, and individuals with high net worth. Private equity firms form funds, each having a specific fundraising goal. When they have hit their goal, the fund will be closed and they will then invest this money in private companies that they consider particularly promising, make acquisitions in struggling companies, or use the funds as working capital until a company can be publicly funded through an IPO or sold. In most cases, private equity funds invest in companies hoping to increase their value until they can be sold down the road at a profit.  

How Do Private Equity Funds Work?

Private equity firms use capital raised from large institutional and accredited investors called limited partners. The firm invests this capital in companies that look promising from an investment standpoint. These may be companies with large growth potential, or companies that have stagnated or distressed but still show signs of possible growth. Some forms of private equity include:
  • Funding for companies that are underperforming but have good investment potential — The intention for these investments is to make necessary changes to help them turn things around and help them grow and gain value. In some cases, private equity will take a distressed company’s assets and put them up for sale.
  • Leveraged buyouts — Most private equity investment is used to acquire a company to improve it and either sell it or take it public. In the case of a leveraged buyout of a company, the private equity investor often uses a combination of equity funds and debt which the company will then repay. In the meantime, private equity investors work hard to improve the profitability of the company to reduce their repayment burden while increasing value.
  • Real estate private equity — When real estate prices are advantageous, private equity funds often focus investment on commercial properties and real estate investment trusts.
  • Fund of funds — These investments focus primarily on other mutual or hedge funds.
  • Venture capital — A type of private equity investment, investors provide capital typically to entrepreneurs and start-ups for a minority ownership.
Each private equity firm’s investment array of companies is referred to as its portfolio, with each business a designated portfolio company. While limited partners are the main investors and have limited liability, the firm’s general partners are responsible for locating and operating the investments. While general partners may own a small percentage of the shares of these companies, they take on the full liability for the fund and usually make their money in management and performance fees.  

Key Differences Between Private Equity Investment and Venture Capital Investment

Venture capital investment is a type of private investment, but it is different in very fundamental ways. Venture capital firms typically invest in small, emerging, or start-up companies showing promise. While venture capital investors will take ownership interest, usually it is a minority interest in the companies they invest in, making their profit when the company goes public, gets acquired, or by selling shares once the company becomes profitable. While there is a large risk investing in unproven companies, there is also a potential for equally large returns if the company does well. Private equity firms most often invest in traditional industries and companies that have been around for a while that show investment promise. Private equity firms take a majority ownership of those companies, often turning them around and selling them at a profit. Limited partners often see a great return while those who administer the fund make their money in management fees and performance fees intended to incentivize profits.  

The Advantages Aren’t Just For Investors

While private equity has had a bad rap in the business world in the past, newer strategies offer many advantages for private companies making use of this type of capital. Today’s private equity investors are typically much more interested in the acceleration and growth of the company than immediately selling off its assets. Newer private equity firms are holding onto their portfolio companies longer. Private equity investors are also often leaders in their field, offering commitment and added expertise that can help maximize a company’s value and meet new goals. This enables businesses to keep critical employees and offer them incentives and their own role in the company’s growth and future. Most investors want experienced management to stay on and continue in the company’s growth. Infusing the company with financial resources to fuel that growth and purchase new assets makes the company more valuable to all involved, not just the investors. For investors, private equity has outperformed public equities by 4 percent during the past two decades but it has also resulted in over 20 percent growth for the companies that were acquired. This is good for everyone. If you are interested in learning more about private equity and how you may use it to your advantage, contact the Law Office of Ryan Reiffert, PLLC online or call us at (210) 817-4388. We would be happy to answer your questions and may be able to offer some direction.

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