The domain of institutional investors and very wealthy individuals.
© AmnajKhetsamtipâiStock/Getty Images
Private equity investing sounds like what it means: Investing in companies that are not publicly traded. But behind this straightforward-sounding term is a sometimes opaque investment strategy thatâs limited to certain wealthy individuals and institutions, and requires investors to lock up their money for years at a time.
Private equity investing sometimes gets lumped in with other asset classes and strategies such as venture capital, hedge funds, and other alternative investments. These are all nontraditional investment types and asset classes (that is, theyâre outside the world of stocks and bonds); however, there are many differences among them.
Key Points
- Private equity funds often buy companies with plans to turn around struggling operations by cutting costs or selling off assets; leveraged buyouts add debt.
- These are opaque investments, as managers arenât required to make regular disclosures and investors often canât access their money until a lockup period has passed.
The allure of private equity funds is that they can reward investors with higher returns compared to what they might receive investing in public marketsâbut thatâs not guaranteed. Hereâs what to know about private equity investing.
What is private equity investing?
The first step to becoming a private equity investor is to invest in a fund thatâs managed by a private equity firm. Private equity firms pool money together from several investors to purchase companies both large and small. General partners manage the fundâs money and make the investment decisions. The investors are known as limited partners.
To create a fund, private equity firms set fundraising goals and seek money from limited partners. Once the general partners reach their capital goal, they close the fund and start investing.
There are several well-known private equity firms, including:
- Apollo Global Management (APO), which owns or controls businesses such as Cox Media Group and CareerBuilder through its investment funds.
- Blackstone Group (BX) invests in real estate private equity and health care, including Service King and Crown Resorts.
- The Carlyle Group (CG) owns a wide range of companies in different sectors, including Memsource and Acosta.
As of June 2022, total private market assets under management reached $11.7 trillion, according to a study by McKinsey.
Private equity funds can buy companies that are already private, or they may take a controlling interest in publicly traded companies and take them private by delisting them from the public stock exchange.
Types of private equity deals
Private equity funds often acquire established but underperforming companies. The general partners then develop strategies to improve the companiesâ value, including methods like these:
- Buyouts. According to the Chartered Alternative Investment Analyst Association (CAIA), buyouts are the largest subcategory of private equity; the average size of buyout deals is over $1 billion. Buyouts seek to create value in acquired firms by improving operations, including installing better management and cutting costs, which may include laying off employees. Private equity firms may also financially restructure the company by selling off assets to pay down debt or to pay limited partners. The most common type of buyout is the leveraged buyout, which adds debt to the company. About two-thirds of all buyouts in 2021 were leveraged buyouts.
- Growth. Some private equity investors may buy a small stake in a company with the plan to help the company grow. Growth investors might use no debt to buy a stake, and only receive equity stake in exchange for capital. These deals are much like a combination of private equity and venture capital, but in this case, the companies are growing and have some degree of profitability.
- Mezzanine financing. A type of hybrid debt and equity deal, where the private equity firm either lends the company money or arranges for debt financing. The firm retains the option to exchange that debt for a percentage stake in the company. These deals are sometimes done in conjunction with a leveraged buyout.
Although growth financing appears to be a hybrid of private equity and venture capital, most private equity and venture capital are distinct investment strategies. Venture capital firms typically finance start-up and emerging companies, while private equity targets mature but struggling companies.
How to invest in a private equity fund
Want to be a limited partner in a private equity fund? Prepare to dig deep. These funds are open only to accredited investors and qualified clients. This can include institutional investors such as pension funds, insurance companies, and university endowments, along with high-net-worth individuals. The Securities and Exchange Commission (SEC) sets guidelines for accredited investors based on income or net worth. Investment minimums to join a private equity fund are typically quite high; they usually start at $250,000, but often run into the millions.
You might indirectly own private equity if you receive a pension or own an insurance policy, as these institutions may invest parts of their portfolios in private equity.
In recent years thereâs been a push to âdemocratizeâ private equity by making this asset class available to more investors through closed-end funds and exchange-traded funds (ETFs) without the extremely high minimums. Many of the funds available to retail investors are focused on real estate and credit strategies that pay dividends or regular income streams. They often have high fees compared to other closed-end funds and ETFs, and have limits on what they can include in holdings because of SEC regulations governing public markets.
Thereâs also an emerging secondary market for private equity. Limited partners who need to raise cash may sell their interest in a fund to a new owner, who assumes their rights, obligations, and commitments, according to CAIA.
But even if you might be able to invest in private equity, should you?
Know the risks of private equity
There are reasons why private equity has long been the domain of institutions and very wealthy individuals. These are usually highly diversified investors who have long time horizons and make private equity a small part of their portfolios.
Here are some key risks and considerations to know about private equity:
- Lockups. The legal structure of a private equity fundâs life is typically eight to 10 years. During the first few years of the fundâs life, limited partners are putting in their money. The rest of the time is spent waiting for a return on the investmentâoften aided by strategic decisions made by the general partner. The true success of an investment isnât known until the fund is wound down, CAIA says.
- Illiquidity. Private equity funds may have to own a private company for several years before realizing a return. General partners often limit investorsâ ability to withdraw funds. These funds are designed not to offer redemptions, so limited partners who need to access their cash may be stuck with having to sell their shares on the secondary marketâperhaps at a steep discountâand may not see a full return on their investment. Additionally, the general partner will have to agree to the sale.
- Not SEC regulated. Private equity funds do not have to register with the SEC, so theyâre not subject to regular public disclosure requirements. The dearth of available data makes it hard for investors to do their due diligence research to see if the fund is right for them.
- Fees and expenses. Private equity fund fees can be expensive. Fee structures vary, but a common oneâsimilar to hedge fundsâis a 2% annual management fee and a 20% performance fee (known as a âtwo-and-twentyâ) that is paid above a preset minimum, called a hurdle rate. This payment setup is called carried interest, and itâs paid at the end of the investment, CAIA says.
The bottom line
Institutions and wealthy individuals invest in private equity because it may deliver returns above public markets and they have the patience to lock up their money for 10 years or more. That long lockup means that private equity may be sheltered from public market volatility, and patient investors may be rewarded for their willingness to wait. However, those long lockups also mean investors canât access their liquidity unless they sell their shares on the secondary market.
Specific companies and funds are mentioned in this article for educational purposes only and not as an endorsement.
This article is intended for educational purposes only and not as an endorsement of a particular financial strategy. EncyclopĂŠdia Britannica, Inc., does not provide legal, tax, or investment advice.
This article was most recently revised and updated by Debbie CarlsonThis article was most recently revised and updated by Doug Ashburn
