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Private equity is a type of alternative investment, which means it does not fall into the usual categories of financial assets. It is a separate class of financial instruments not listed on the public exchange.
So how are private equity investments beneficial for you? Can you diversify your portfolio and improve your finances with this type of investing? Keep reading to find out.
Just the Nuggets
- Private equity investing is the next big thing in the world of financial markets.
- It is available only to accredited investors who have a lot of capital or experience to prove their reliability.
- Three types of investors who can indulge in this investment include private equity firms, venture capital firms, and angel investors.
- Private equity includes two types of partners with different benefits to their position: limited partners and general partners.
- The benefits of private equity investing are access to liquidity, rebuilding opportunities, and connections.
- On the other hand, you should watch out for unpredictable costs and lack of transparency.
How Private Equity Works
Private equity can be described as an alternative form of private financing that goes on separately from the public markets. The way it works is, the funds and investors can invest directly into the private companies of their choosing, depending on the features and type of business operations they engage in.
You should keep in mind that not everyone can have access to this advanced and alluring financial activity. Rather, the majority of private equity firms are open to accredited investors, who either have an admirable net worth or have a successful and diverse portfolio plus many years of experience on the market.
In order to invest in private equity, you need to have a significant amount of capital. Namely, this is a direct investment, which can give you access and influence on the company’s internal operations and structure. Some of the private equity companies have a minimum entry requirement of $250,000, while the others require several million.
How is it beneficial for private equity firms?
Well, these types of firms charge different types of fees in return, such as management and performance fees from investors. This way, both sides can gain by entering the process of private equity investing. And if that does not convince you—how about the fact that the private equity market had around $3.9 trillion in assets last year?
Types of Partners
A private equity fund consists of two types of partners. Each of them has its own unique characteristics and advantages that contribute to the success of your private equity investment.
Limited Partners (LP)
Limited partners own 99% of the company shares. They also have limited liability (LLC), which means they are not at risk if the company fails or goes bankrupt due to debt obligations. Limited partners are otherwise known as the silent partners, and they also have limited voting power in the company’s day-to-day operations and strategies.
General Partners (GP)
General partners own 1% of the company shares but receive full liability from day-to-day operations. They have the authority to act and make decisions without the knowledge or permission of other partners.
Since the private equity investments come from either institutional or accredited investors, equities usually take quite a lot of time to generate liquidity and value. This requires a significantly longer time period of holding a certain investment from its purchase to its sale. This is quite relevant in cases of ensuring a turnaround for the distressed companies.
A turnaround is expected for companies with an experience of poor performance during a long period of time, usually because of a recession or stagnation of the economy.
This is the traditional model of generating value through private equity—the companies and individuals making an investment are also gathering a lot of the company’s financial distress due to poor management or other factors. Over time, the value of their investment goes up due to their dedication into the company restructuring, financing, or other changes.
In the early stages of the private equity boom, these firms were able to buy into non-core business units of large public companies. These are usually the sectors significantly neglected by the previous owners. However, in recent years, those same investors have learned that they can generate more value by acquiring an entire company because of the higher investment returns.
Who Can Invest in Private Equity?
As mentioned, you must have thick-lined pockets in order to engage in private equity investing. The main reason for this lies in the fact that the companies would turn to private equity in the first place—to raise a significant amount of capital and allocate it to expansion or new project development.
There are three types of private equity investors, and each one of them has a special set of preferences, skills, and goals they strive to achieve.
1. Private Equity Firms
A private equity firm is an investment management company that provides financial backing and engages in private equity investments. The companies can be both startups and well-established names who are looking to gather additional capital. The private equity firms usually apply some sort of investment strategy to this process:
Leveraged Buyout (LBO)
This is a company’s acquisition of another company with a significant amount of borrowed money. The company’s assets are usually used as collateral for the loan in this case, along with the assets of the acquiring company. This method is useful since it can reduce the costs of financing the acquisition.
Venture Capital (VC)
This is typically used as a form of equity financing for startups, as well as for early-stage and emerging companies with high potential for growth. The venture capital is invested in exchange for equity or an ownership stake.
Growth (Expansion) Capital
This is a minority investment in mature companies looking to expand or restructure their operations or enter new markets. This can also be useful for the restructuring of the balance sheet—reducing leverage or debt of the company.
Private equity firms are able to raise a significant amount of funds for investment over time. They can be charged with a management fee periodically, as well as receive a share in the profits earned called carried interest.
These firms receive a return on their investments in three ways:
- Initial public offering (IPO) – Shares of the company are offered to the general public for the first time.
- Acquisition (Merger) – A company is sold for another company’s shares or cash.
- Recapitalization – Money is distributed to shareholders either from a cash flow generated by the company or from loans raised to fund the distribution.
It should be noted that private equity firms typically make longer-hold investments in the sectors and industries of their expertise. They tend to manage risks and achieve growth by taking operational roles in this process.
2. Venture Capital Firms
This should not be confused with the venture capital private equity firms. In this case, the venture capital firms are focused solely on receiving their ROI through investing in emerging companies but for a shorter period of time.
Because of this, the companies have a quite higher risk of failure with investing in private equity compared to other investors. The reason for that is simple—the startups have a much higher risk of financial failure. That risk comes from the fact that these companies are basing their operations and success on a type of innovative technology or a business model not yet researched or proven as beneficial.
A venture capital investment begins with seed funding. Seed money or seed capital is used as an initial investment in a startup company in exchange for an equity stake or a convertible note stake in the company. This is early-stage funding which comes in many forms, including crowdfunding, friends and family funding, as well as seed venture capital funds.
The most selective form of venture capital funding is the government seed funding—which is usually targeted toward youth as a deciding factor, such as young people who are self-employed. One of the most engaged governmental institutions is the European Commission.
3. Angel Investors
Similar to the venture capital firms, angel investors are individuals who direct their investments toward the startup or emerging companies in their early stages of development. They can also become a part of larger angel groups or angel networks, where they share the investment capital. The number of angel investors has significantly increased in the past 50 years due to a number of benefits, such as bigger chances for a return on investment and lower risks.
The angel investors are usually retired entrepreneurs or executives who have years of experience in particular areas of business and finance. Their goals for investing in private equity usually go beyond the monetary dimension, and they include goals such as mentoring and expanding their experience to new generations of companies and businesses.
How Do They Make Money?
The most important source of income for private equity firms is the fees. Their structure can depend on the features of a certain company, but they usually include management fees and performance fees.
Based on the amount of the investors’ commitment to the fund (the fund size), these fees usually go between 1% and 2% annually during the initial commitment period, after which they can be reduced.
Charged to the investment fund by the manager dealing with the assets, these fees depend on factors that come into play—from the expected income to the possible gains and losses.
In the past couple of years, private equity has proven itself as particularly beneficial for startups and emerging companies. This way, they receive the funding and the capital necessary to build their business from the ground up, usually in the emerging industries such as biotechnology or alternative energy. But what are the benefits for the investors?
1. Access to liquidity
A company or an individual investing in private equity has easy access to large amounts of additional capital. This significantly contributes to their overall liquidity as an alternative financial mechanism. This is particularly useful for high-interest bank loans or initial public offerings.
2. Rebuilding opportunities
Certain forms of private equity allow the opportunity for a company to reinvent itself away from the public eye. For example, if a company is delisted, the investors have the right to finance the last-resort ideas aimed at recovering the company structure.
Lastly, private equity investments can introduce you to another group of people on the market who are tightly connected. You can use this to your advantage when it comes to expanding your knowledge, as well as having premium access to the new trends and other market occurrences.
With private equity, the sole use of the term private brings a lot of downsides. One of the biggest ones that come to mind is exclusivity. And there is a lot more to it.
1. Lack of transparency
Considering that the majority of private equity investment steps are happening away from the public eye, this brings up the question of regulation. Namely, a lot of private equity practices came into the spotlight after some alarming operational moves were taken by the participants. Also, the presence of different types and amounts of fees can be off-putting to some investors.
The process of determining the value of a company share goes on a bit differently in the case of private equity. Namely, these shares do not fall under the usual factors and effects that come from the market. Rather, they are a direct result of private negotiations between buyers and sellers.
Private equity investments do not only allow you access to the company’s structural insights and voting rights but also to the debt. Quite often, this feature can contribute to making a final call for the company to be sold due to the inability to turn it around—which makes the entire investment go to waste.
Private Equity Investment Strategies
There are several strategies that have formed over time when it comes to private equity. Some of them are beneficial for the firms, while others work better for individual investors. What suits you best?
Private Debt Strategy
This strategy assesses the possible downside trends and the losses a company could follow. Since the private equity investors are also taking part of the debt, this is one of the rare strategies focusing solely on the debt dimension.
Direct Lending Strategy
With this strategy, the loans are secured and guaranteed by the company’s assets. This works quite similarly to taking a loan from a bank, so you are probably aware of how it works. The direct lending strategy has grown particularly popular since the global financial crisis of 2008.
Mezzanine Funds Strategy
The mezzanine funds strategy has proven itself worthy and useful in many areas of investing, private equity in particular. There are several advantages with this kind of strategy. They include less detail and paperwork, as well as simpler structure which you can keep track of.
Concerns Around Private Equity
The main concern surrounding private equity is revolving around transparency—it is a critical point in the area of private equity investments that can make or break your trading experience. Since there is a clear lack of any insight into the various details surrounding each deal, it is much harder for the regulation to take care of those steps and make sure that they are up to the industry standards.
In the end, private equity is an alluring investment opportunity. It used to be available only to the most wealthy individuals. But now, there are chances for the general public to join in on the action and diversify their portfolio, thanks to a variety of benefits this investing activity has to offer.