When you hear the words "private equity," you usually think of opulent homes, elegant suits, private islands, and money. There's lots of it. But if you believe that only characters from "Billions" can work in private equity (PE), think again. While private equity is still primarily reserved for high-net-worth individuals and institutional investors such as pension funds, there are some avenues for people to enter the market. Private equity investments are referred to be "private" because they include the purchase of shares or ownership stakes in private companies or funds rather than publicly listed ones.
The private equity industry has experienced significant growth in recent years, with global assets under management reaching a record $5.3 trillion in 2021, according to data from Preqin. This surge in popularity can be attributed to investors seeking higher returns in a low-interest-rate environment and the increasing number of companies choosing to stay private for longer periods. As a result, private equity firms have become increasingly influential in shaping the business landscape, with their decisions impacting everything from job creation to industry consolidation.
How Private Equity Works
In many circumstances, private equity investments have a larger return potential than governmental investments. This is due in part to the opportunity to invest in startups or growth-stage firms before they become household brands, which can result in a good deal before their prices skyrocket. For example, before going public, companies like Uber and Airbnb raised funding from private equity funds, allowing those investors to cash out for substantially more than their initial investment.
Even if you don't hit a home run, private equity returns typically outperform public equity returns due to factors such as lower competition than public markets, the ability of some private equity firms to contribute to a company's growth, and the leverage used by some private equity investors to amplify returns. However, this possible benefit comes with a cost. Private equity fees are frequently higher, the risk is greater, the investments are often less liquid, and there are generally more restrictions on who can invest in private companies and private equity funds, while there are fewer requirements on what the private equity sector must disclose to the Securities and Exchange Commission (SEC).
One of the key advantages of private equity is its ability to take a long-term view on investments, free from the pressures of quarterly earnings reports that public companies face. This allows private equity firms to implement strategic changes and operational improvements that may not yield immediate results but can significantly enhance a company's value over time. For instance, when Blackstone acquired Hilton Worldwide in 2007, it implemented a series of changes, including expanding the company's international presence and improving its technology infrastructure. These efforts paid off handsomely when Hilton went public again in 2013, with Blackstone's investment reportedly generating a profit of $14 billion – one of the most successful private equity deals in history.
Private equity technically refers to any investment in the ownership of a privately held company, but it is most commonly used to describe the private equity industry. In the private equity business, investors frequently participate in private companies through private equity funds, which are managed by private equity firms with unique investment strategies and areas of specialization. Private equity funds typically spend tens, if not hundreds, of millions of dollars in late-stage startups before they go public, as well as more mature enterprises that will likely remain private but can be acquired by other businesses or investors.
Private equity firms frequently acquire a majority stake in private enterprises and, on occasion, the entire company. This is distinct from venture capital funds, which invest lesser sums for minority stakes in early-stage firms. Essentially, private equity funds raise enormous sums of money from long-term investors. This money is used to reorganize or revitalize a failing business, fund acquisitions and start-ups, or take a company public.
The impact of private equity extends beyond financial returns, often playing a significant role in shaping industries and driving innovation. For example, in the healthcare sector, private equity firms have been instrumental in consolidating fragmented markets, such as dental practices and dermatology clinics. This consolidation can lead to improved efficiencies and economies of scale, potentially resulting in better patient care and more affordable services. However, critics argue that the profit-driven nature of private equity can sometimes conflict with the best interests of patients or employees, highlighting the need for careful consideration of the broader implications of private equity involvement in various sectors.
Long investment holding periods are common in private equity since undertakings such as turning around a struggling firm or conducting an initial public offering (IPO) take time to yield significant returns. Private equity funds often keep their investments for three to five years. Additionally, funds typically have a lifespan of roughly ten years. Unlike mutual funds, which are normally open-ended and can purchase and sell public equities indefinitely, private equity funds frequently stop accepting new capital once their funding goals have been met and then make investments in firms before shutting the fund permanently after around 10 years.
Meanwhile, the private equity company may establish a new fund to begin finding fresh transactions while the investments in the other fund run their course. After the fund closes, investors should ideally receive their money back, plus any profits after costs. In some circumstances, such as a real estate limited partnership, investors may get regular income along the route, but the majority of the return is paid at the conclusion.
The private equity industry has not been without controversy, particularly in the aftermath of high-profile bankruptcies of companies acquired through leveraged buyouts. One notable example is the case of Toys "R" Us, which filed for bankruptcy in 2017 after struggling with the debt burden from its 2005 leveraged buyout by Bain Capital, KKR, and Vornado Realty Trust. The company's collapse led to the loss of thousands of jobs and sparked debates about the responsibilities of private equity firms to the companies they acquire and their employees. This incident, among others, has led to increased scrutiny of private equity practices and calls for greater regulation of the industry.
Private Equity Investors
The great majority of investors in a private equity fund are limited partners (LPs), who simply provide funds in exchange for an ownership position or shares in the firm. In contrast, the fund's general partners (GPs) manage and execute the fund's investments. They also own a lower percentage of the shares. For example, BlackRock, a well-known investment management, serves as the general partner for its private equity funds.
LPs are often people that invest in BlackRock funds (or whoever the asset manager is), but not everyone may be an LP. Typically, access to these funds is limited to larger investors such as pension funds, university endowments, and certain other investing organizations such as hedge funds and mutual funds. Some GPs accept contributions of roughly $250,000, while others want millions. Even if GPs wished to expand access, private equity investments are typically limited to accredited investors, with a few exceptions, such as some crowdfunding efforts.
There are several methods to qualify as an accredited investor, including having a net worth of more than $1 million excluding your principal property, or earning $200,000 as an individual ($300,000 with spouse/partner) in the previous two years with a plausible exception to do so this year.
As the private equity industry continues to evolve, there is a growing trend towards democratization of access to these investments. Some firms are exploring ways to make private equity more accessible to a broader range of investors, including through the creation of registered funds that invest in private equity and have lower minimum investment requirements. For instance, Blackstone's Private Equity Strategies Fund allows qualified investors to access private equity with a minimum investment of $25,000, significantly lower than traditional private equity funds. While this trend is still in its early stages, it could potentially reshape the industry by allowing a wider pool of investors to participate in private equity investments.
Investment Strategies
Private equity investments come in a variety of styles. In many circumstances, however, funds adhere to a certain strategy, such as the following:
Growth equity
Growth equity funds often invest in companies that are still rapidly growing but are no longer considered early-stage startups. These companies frequently have proven business strategies with consistent revenue and maybe profitability, and they are on course for continuous growth, which could lead to an IPO or at least continued private valuation rise.
Financial distress
Distressed finance assists struggling businesses, such as those that have filed for Chapter 11 bankruptcy, by agreeing to modify their business model and create a debt payback plan. In certain circumstances, private equity firms plan to assist distressed enterprises by replacing the management and turning them around. In other circumstances, the focus is on profitably selling the company's assets.
Leverage buyouts
A leveraged buyout (LBO) is one of the most prevalent types of private equity investment, in which a private equity fund borrows money to buy a company. LBOs, like distressed funding, frequently involve purchasing a struggling business, but this time the goal is usually to strengthen the business's model before selling it for a profit or going public.
Venture capital
Venture capital is sometimes regarded a distinct category, but it can alternatively be viewed as a subset of private equity. Venture money is used to invest in early to mid-stage enterprises, allowing them to develop their operations and, ideally, become IPO candidates or be purchased.
Specialized limited partnerships
Some private equity firms form specialized limited partnerships to invest in specific types of assets. Real estate is particularly popular among these ETFs. They typically invest in commercial premises or multifamily projects such as apartment buildings. Other private equity funds participate in infrastructure projects such as bridges and roads.
The Private Equity Investment Cycle
Private equity investments do not usually follow the same pattern as public ones. A typical investment cycle for a private equity fund consists of the following five steps:
Fundraising: Private equity businesses begin by obtaining capital from accredited investors, who become limited partners in new private equity funds.
Deal sourcing and due diligence: While this process may overlap with the fundraising round, private equity funds must hunt for suitable investment opportunities and do extensive due diligence before committing millions of dollars from their investors.
Acquisition: Once the targets have been examined and the finance has been secured, private equity funds make acquisitions, either by purchasing a large interest or companies entirely. In many circumstances, buyouts are funded by a combination of investor cash and borrowed capital from banks and other lenders, and the investment phase often lasts three to five years before the funds are fully spent.
Value creation: Private equity firms frequently play a hands-on role in shaping the businesses they invest in. Private equity fund managers and their staff frequently collaborate with portfolio company management teams to enhance areas like as operations and strategy, with the goal of increasing sales, profitability, and other metrics. Private equity funds may also use resources inside their network of investments, such as determining whether two companies in their portfolio have complementary offerings on which they can collaborate.
Exit: Finally, after three to five years of ownership, most private equity funds attempt to leave an investment in order to generate returns for investors rather than only on paper. An IPO, a strategic acquisition from another company, or selling the ownership position to another private equity fund are all possible exit strategies.
Potential advantages of private equity
Many investors prefer private equity because it provides the opportunity of unique benefits such as:
High returns. While not assured, private equity generally outperforms public equity. According to a CAIA Association report, state pension funds that invested in private equity enjoyed net annual returns of 11% from 2000 to mid-2023, compared to only 6.2% from public stocks over the same period.
Active Influence
Public corporations often have such diversified ownership stakes that a single investor has little influence over how the company is run. However, under private equity, a fund may be the sole or majority owner of the companies in which it invests, allowing it to actively affect their operations. That might be appealing to innovators not only for the possible reward, but also for individuals who wish to see specific types of enterprises prosper, such as those focused on the environment.
Diversification
Alternative investments, such as private equity, can help investors diversify their portfolios, potentially lowering total risk. This is because private equity and public companies do not necessarily move in lockstep, so having some allocations to both may help you have a smoother ride. For example, public equities may see short-term movements owing to earnings releases from a few significant companies, but because private equity normally operates on a multi-year period, those short-term impacts may have little impact.
Potential dangers of private equity
While private equity provides various potential benefits that entice investors, there are several hazards to be aware of, such as:
Illiquidity
Private equity investments are often illiquid in the sense that investors frequently agree to keeping their capital locked up for the duration of the fund, or at least several years. Even if LPs have the opportunity to sell their interests, the pool of potential bidders is much narrower than in public equities, which can typically be swapped nearly quickly.
High fees
Private equity funds charge a number of costs, including management and performance fees. A classic arrangement is "2 and 20," in which fund managers charge a 2% annual management fee while getting a 20% cut of annual returns after meeting a certain threshold. If all goes well, investors are willing to pay these costs if it means earning more than they might with other investments; but, these fees can reduce returns to the point where investors would be better off with other options, such as low-cost exchange-traded funds (ETFs). Fees can be complicated and unclear at times.
Performance risk
The potential for bigger gains may come at a higher risk, as some private companies lack the same track record and investor support as public corporations. As a result, the probability of bankruptcy may increase. Furthermore, when private equity funds invest in techniques such as LBOs, the additional debt can amplify losses.
Who can invest in private equity?
Because private equity is less regulated and more sophisticated, investment is frequently limited to only a few investors who are seen to have the knowledge and/or financial resources to bear the risk. This includes:
Institutional investors include pension funds, endowments, foundations, and insurance firms, all of which have substantial pools of money, frequently in the millions or billions of dollars.
High-net-worth individuals typically include accredited investors with substantial financial resources. They may not have enough money to participate in huge private equity funds, but some smaller ones may be interested in their investments, which may amount to tens of thousands, if not hundreds of thousands of dollars, at once.
Limited access for retail investors. Individual investors who are not accredited are sometimes referred to as retail investors, and they are typically unable to engage directly in private equity funds or private enterprises that are actively seeking investment. However, there are a few outliers. For example, the SEC's Rule 506(b) permits private sales to up to 35 non-accredited investors in a 90-day period. Additionally, retail investors may be able to invest through crowdfunding campaigns that sell shares in private enterprises. Furthermore, retail investors may be able to gain exposure to private companies through publicly traded funds, such as mutual funds and ETFs, which invest directly in private companies or private equity funds, or by investing in public assets that are correlated to some private assets. Furthermore, certain private equity firms or financing businesses with private equity arms are publicly traded, allowing you to indirectly earn a part in their underlying investments.
What to Know Before Investing in Private Equity
While private equity investment is not for everyone, it can be an appealing alternative for individuals with the necessary cash to seek higher-than-average profits. However, before deciding to go this path, you should conduct research on the fund's investment plan, other investments, fees, lock-up periods, and so on. Unfortunately, this information can be difficult to obtain because private equity funds are not required to release information as readily as public investment funds such as master limited partnerships, mutual funds, and real estate investment trusts (REITs). That is one of the reasons why private equity investments have generally been limited to institutional and sophisticated accredited investors. However, some of the newer private equity investing options, such as equity crowdfunding and private equity ETFs, allow smaller investors to participate — and perhaps get in on a promising business before it goes public.
As the private equity industry continues to mature, it is also facing new challenges and opportunities. Environmental, Social, and Governance (ESG) considerations are becoming increasingly important in investment decisions, with many private equity firms now incorporating ESG criteria into their due diligence processes and value creation strategies. This shift is driven by both investor demand and the recognition that strong ESG practices can contribute to long-term value creation. Additionally, technological advancements are transforming the way private equity firms operate, from deal sourcing and due diligence to portfolio management and value creation. Data analytics, artificial intelligence, and machine learning are being leveraged to identify investment opportunities, assess risks, and drive operational improvements in portfolio companies. These trends are likely to shape the future of private equity, potentially leading to more sustainable and technologically-driven investment strategies.
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