What is Private Equity?
Introduction to Private EquityPrivate equity firms are a significant behind-the-scenes force in the worldwide economy, including not only the tech startups and bankruptcy turnarounds you might have heard of, but also a great number of mainstream companies and small businesses. Many well-known large companies got their initial funding from private equity sources instead of through initial public offerings on public exchanges, and/or have funded operations through a loan or a preferred stock deal with a private equity fund at some point in time.
Just because you don’t know the names of the private equity firms
… does not mean they’re not there!Private equity is a form of financing where significant capital is invested into a company, but NOT on the public market regulated by the U.S. Securities And Exchange Commissions – hence, it is private. Private equity financing is generally considered an “alternative asset class,” similar to other illiquid or alternative investments such as real estate, venture capital, cryptocurrency, non-traded REITs, private debt, or others. As a result of that classification, Private Equity (i) is riskier, (ii) has a potentially higher rate of return, and (iii) is unavailable to most investors.
How Does Private Equity Work?Private equity is funded directly through a private equity firm (or a subsidiary fund of a private equity firm… which is sort of the same thing) instead of through the open public markets such as NASDAQ or NYSE. Investors do not invest in portfolio companies directly – they invest indirectly, through the private equity fund. The private equity firm will raise capital and identify suitable investment opportunities. When a suitable investment opportunity is identified, it is up to the firm to negotiate the terms of the investment, typically without the input of individual investors. The returns of the investment will then be distributed to fund investors according to the agreed terms. Typically, once one fund is closed and investments are made, no more investments can be made in that fund, and no distributions are made from the fund until the occurrence of liquidity event(s). Investors who want to invest with that private equity firm will have to wait until the firm opens another fund, and investors who want to withdraw their money will be unable, or unable without a major penalty. Sometimes the investment agreement will set forth strict timetables for such investments; other times it will not. While the public (regulated) markets are generally open to everyone, because Private Equity invests outside of the public markets, it is not open to everyone – only to those who can “bear the risk” in the form of being an Accredited Investor. More about that later.
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 (these investment opportunities are not available to everyone and can allow for potentially higher returns – although that higher return is accompanied by higher risk), the ability to engage in the acquisition and sale of promising companies, and the possibility for larger returns and greater diversification. For an unsophisticated investor, private equity may not be ideal; but for a savvy player who understands the market and has an appetite for more risk, private equity can be a wonderful opportunity. For a company, private equity allows another means of access to much-needed capital without the stress of quarterly reports, annual reports, special reports, audited financials, and many other onerous disclosures and compliance required by regulators such as the SEC – not to mention the expensive law firms, expensive investment banks, and expensive accountants required to comply with such rules. Private equity also (despite its name) provides companies with an alternative to high-interest rate bank loans or, in the worst case, bankruptcy. But “private debt” doesn’t really have the same ring to it, does it?
What Are the Disadvantages of Private Equity?The advantages discussed above sound great. But the picture is not all roses. Private equity can also have disadvantages for both investors and the companies they invest in. For an investor, private equity is an illiquid asset class. As an illiquid asset, investors cannot sell their private equity investment as they please – the investor may be completely locked in, and “getting off the roller coaster early” may be simply not possible; in the cases where it is possible, the investment agreement is likely to provide that before a certain time, they face high losses due to fees and penalties. If the investor has a sudden need for cash – whether due to an unforeseen emergency, another investment opportunity, or anything else – the private equity investment may be unavailable for those needs. So investors should plan carefully. Moreover, private equity is generally a riskier asset class than an investment in a large public company, government bonds, or so forth. A portfolio company may fail and its value go to zero. While all parties hope against this result, it does occasionally happen, and investors should be aware of and ready for that. But wait! There’s more! Most private equity funds are structured as limited partnerships. This means that investors (who will invest as limited partners, with the general partner being controlled by the sponsor or fund manager), despite any level of ownership, will generally not have voting control or rights to appoint board members, managers, etc. or, indeed, any recourse at all, except in limited circumstances (for example, break of fiduciary duty by the general partner). Additionally, there is a risk that, due to the compensation structure typically used for a private equity fund, private equity firms/management could be incentivized to create a short term spike in value, at the expense of long-term value. A private equity firm making a control investment into a company will generally operate with a laser-like focus on generating profits. Once the company is generating profits, it is somewhat common for investors to make an “exit” – i.e., withdraw from the company by selling it to a strategic buyer or taking it public. This can sometimes (certainly not always!) be detrimental to the companies acquired by private equity buyers, as the short-term value the investors created in order to “exit” may not fully coincide with the long-term value that could have been created by a different strategic plan. For example, investors may load up a company with significant amounts of debt as a tool to create these kinds of returns, which could leave a company financially vulnerable once the private equity investor has left the scene.
How Are Private Equity Investments Made?Private equity investing is part of the private market and cannot be accessed through a public exchange (in other words, all private equity operates pursuant to exemptions from registration pursuant to the Securities Act of 1933 and the rules promulgated thereunder by the SEC; frequently, – but not always – this means Section 4(a)(2) and Regulation D). Private equity is capital that is invested in a company, but unlike some other forms of investment, private equity investors may sometimes (but not always) take a majority ownership stake in that company. If the private equity firm takes a minority stake, it is not uncommon for certain protective terms to be added to the company’s governing documents and/or for the private equity firm to receive one or more board seats. Private equity firms typically manage and invest capital through one or more subsidiary funds, typically structured as limited partnerships by the private equity firm, which will control the fund’s general partner and make all decisions for the limited partnership as a result. Investment in private equity tends to come from large institutional investors or ultra-high net worth individuals who are both more able to dedicate large sums of capital over an extended period of time and more able to assess a private investment on its merits and/or request relevant financials without the mandatory disclosures required by the SEC. These investors are typically more sophisticated, require less oversight and protection, and are willing to take on more risk (with the promise of more return that that risk carries). These institutional investors may include large financial institutions, insurance companies, family trusts, college endowment funds, or pension and retirement funds. 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 Firms Make Money?Private equity firms typically charge management and performance fees. Most private equity firms use the two and twenty (2-and-20) fee structure, which is a lucrative arrangement for the private equity fund managers, while also providing strong financial motivation to make money for investors.. The management fee (the 2% in 2-and-20) is charged on an annual basis, regardless of the performance of the company (the fee will be charged even if the fund performs poorly). Private Equity firms utilize the management fee to pay for daily expenses. Investors view management fees as a source of reliable and predictable income. The performance fee (the 20% in 2-and-20) is calculated as a percentage of the profits generated from the investment. The performance fee, often referred to as “carried interest,” is an incentivizing tool that promotes greater returns by rewarding good performance. However, the carried interest is sometimes not paid if the return does not surpass a certain threshold, the hurdle rate. If the fund does not generate a profit that exceeds the hurdle rate, the general partner will not receive its compensation for the carry (the limited partners will still receive their share, and the management fee will still be charged). To further complicate matters, not all funds have a hurdle rate.
How Do Private Equity Funds Actually 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. Through the use of a leveraged buyout, investors acquire a company using significant amounts of debt secured by the company’s assets, without leveraging a large portion of their personal or fund assets.
- 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 — A fund of funds, or a multi-manger investment, is an investment strategy that involves an investment in other types 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. Investing in a start-up is a risky gamble, as the start-up has not proven it can profit; however, if the start-up succeeds, investors can garner astronomically high returns.