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Investing In Private Equity – All You Need To Know

Funds and investors that invest directly in private companies compose private equity. In this article, you can find basic info on private equities - What exactly is private equity? How can we invest in private equity and what are the pros cons? Investing In Private Equity - All You Need To Know:
Investing In Private Equity - All You Need To Know

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.

 What Is A Private Equity?

Have you wondered what does it mean “private equity”?

The capital of companies that are not traded on the stock exchange generally describes what private equity is. Funds and investors that invest directly in private companies compose private equity.

They sometimes engage in purchases of public companies that result in the delisting of such corporations in the stock exchange.  Institutional and retail investors are mostly the source of funds for these purchases.

What makes this so special?

These private companies use the invested capital for a variety of purposes aside from additional working capital.  They also utilize them to fund new technology, acquire companies or assets, or to simply stabilize the company's finances.

Institutional investors and accredited investors are normally the ones who provide private equity.  It is because they are able to allocate a substantial amount of money for a longer period. In many situations, private equity investments require a long holding period.  This is to provide sufficient time for a distressed company to recover.  Some companies initiate liquidity events such as an initial public offering (IPO) or sale to a public company.

Let’s jump right back to the starting point:

Beginning in the 70's, the private equity market has gained momentum.  Private equity firms pool their funds to be able to privatize mega-corporations.  Many private equity companies resort to a financial strategy called a leveraged buyout (LBO). An LBO entails acquiring the controlling shares of a corporation using borrowed funds.  Investors raise a huge amount of money to finance large purchases in an LBO.

After they buyout, the private equity firms will try to make the acquired company more marketable.  They will work on its financial health, operations, profits and image in the industry.  The eventual result would be the sale of the same company to another buyer or by cashing in through an IPO.

Private Equity Presents A Compelling Argument For Investors

  • Private equity has its almost independent market rules. The factors that affect prices and profitability in the public equity markets do not influence the private equity scene.  Therefore, it further enhances the potentials of private equity.
  • Private ownership requires a long-term focus. Investors in public equity often set their sights on the quarterly earnings, some even sooner.  Investors in private equity need to be patient to get the full benefits of the purchase.  This perspective often results in a more substantial return.
  • Private equity is more profitable. In general, private equity performs better when compared to public equity.  This is true on both the risk-adjusted return on capital and an absolute return of capital.

Invest In All Stages

Private equity investments span the entire life cycle of a company, whether in its early stages to its matured stage. So what’s it all mean?

  • It can provide venture capital as seed money for start-ups and early-stage corporations.
  • It can support a mature company by supplying funds for significant requirements such as new product development or network expansion. They call this a development, expansion or growth capital.
  • It can furnish the needed money to buy an existing company or one of its divisions. They call this a buyout capital.
  • It can go by way of a subordinated debt. It is financing that gives the lender the right to convert it to equity. They call this a mezzanine capital.
  • It can rescue a distressed company by injecting fresh money to help its financial or organizational rehabilitation. They call this a restructuring capital.

3 Phases For Investors

A private equity investor must be mindful of the three major phases in the process.
1. The investor must sign a Capital Commitment and abide by it. An investor must sign a legal agreement binding him to provide a set amount for the capital. This usually covers a long period of time that range from 3 to 5 years.
2. At an appropriate time, the designated fund manager will ‘call' the committed capital from the investor in increments. This happens when the fund manager finds good investment potentials.
3. After some time, the fund manager ‘exits' the investment by selling the company or initiating an IPO. The investor gets his money back by receiving cash or by opting to offset it to future drawdown.  This is the distribution phase of the process.

Private Equity Investments

In the 1970's, capital for private equity came from individual investors or corporations.  Private equity became an asset class due to its popularity.  Institutional investors invested in it in anticipation of risk-adjusted returns that were higher than public equity investments.

In the 1980's, private equity investment drew insurance companies to its doors.  Much later, it was the turn of public pension funds, endowments and universities to shift to private entity.

For many institutional investors, private equity ranked among their broad asset allocation.  It was another portfolio aside from the traditional assets (ex. public equity, bonds) and alternative assets (ex. hedge funds, commodities).

Sectors Of Private Equity

The early 1980's saw the popularity of private equity as an asset class among select group investors. Public and private pension funds from the US, Canada and Europe invested heavily in private equity. Most of them diversified from their core holdings in public equity and fixed income securities.

Today, the biggest investments in private equity come from pension funds. They outdid the traditional investors such as insurance companies, endowments, and government investment funds.

Direct vs Indirect Investment

Institutional investors often shy away from directly investing in privately held companies for a good reason.  Many of them lack the necessary expertise or resources to carry out an effective restructuring program. Instead, these investors make an indirect investment through a private equity fund.

So, for institutional investors with the requisite capability, they can make direct investments to build their own diversified portfolio. For the rest, they can invest via fund of funds to broaden their ability to create a more diversified portfolio.

Fees & Profits

Although the fees vary, two main categories appear standard.  Investors must pay a management fee and a performance fee. Some firms collect a flat 2% of the managed assets as a management fee. They also require around 20% as their share of the profits of the company.

Positions in private equity firms remain a lucrative option for investment professionals.  Imagine the kind of payoff one will get for a company that has $1 billion in assets under management (AUM).  Firms like this one will most likely employ around 24 fund managers.  The 20% gross profits translate to millions of dollars so it naturally lures the players in the industry.

At a conservative estimate of $50 million to $500 million in deal values, associate positions could command a salary in the low six-figures.  A vice president could earn around $500,000 while a principal could haul in more than $1 million in a year.

Transparency Of Private Equity

In 2015, pressure mounted to have more transparency in the private equity industry.  This is largely due to the volume of income, benefits and astronomical salaries at almost every private equity firm.

As of 2016, several states have pushed for bills and regulations for more freedom to scrutinize the industry’s inner workings.  Capitol Hill resisted these moves and asked the Securities And Exchange Commission (SEC) to limit access to information.

Private Equity Minimum Investment

Private equity requires a hefty minimum investment.

Private equity goes into a corporation's capital and this capital is not loose change.  The company needs substantial amounts for its working capital, to develop new products or strengthen its financial condition.

Unless you have $250,000 to part with, it would be difficult to barge into the ritzy world of private equity.  Private equity investing is not for the average investor.  Many high-end private equity firms typically accept only investors who can commit as much as $25 million. Some firms have lowered this to $250,000 to attract more investors.  Realistically, this amount is still beyond the capacity of most people.
The easiest way to get into private equity investing is to buy shares of an appropriate exchange-traded fund (ETF).  Look for an ETF that tracks the index of publicly traded companies that invest in private equity.  You simply buy some of their shares in the stock market. You need not worry about coming up with $250,000 because you can only buy a number of shares you want.

However, you may need to pay a little more in management fees because an ETF will normally have another layer.  Take note too that you have to pay your broker every time you buy or sell shares.