Private Equity: What It Is, How It Works & Investments
Private equity is an alternative investment where investors buy shares in private companies to enhance their value over time before ultimately selling for a profit. This type of investment often involves active management strategies, restructuring, operational improvements, and mergers to enhance the performance and value of the company.
What is Private Equity?
Private equity (PE) involves investment partnerships that acquire and manage companies before selling them. These firms handle investment funds for institutional and accredited investors, with the capacity to take over private or public companies entirely or participate in buyouts. Generally, PE firms avoid maintaining stakes in publicly listed companies.
Considered an alternative investment alongside venture capital and hedge funds, private equity requires significant capital commitments over extended periods, limiting access mainly to high-net-worth individuals and institutional entities.
However, equity crowdfunding has emerged as a new avenue, allowing retail investors to participate in the private equity world with minimal capital. Via equity crowdfunding, individuals can engage in investments previously reserved for high-net-worth and institutional players. The democratization of access to private equity provides opportunities for a broader audience to diversify their investment portfolios beyond the traditional stock and bond markets.
Key Takeaways
- Private equity mainly invests in private companies. Once exclusive to high-net-worth individuals and institutions, it is now open to retail investors through equity crowdfunding.
- Private equity includes buyout funds, venture capital, real estate, mezzanine capital, and distressed private equity, each with unique focuses and investment strategies.
- Investors can access private equity via direct investment, ETFs, or equity crowdfunding, each with distinct risk-reward profiles and accessibility.
Understanding Private Equity
Private equity firms and wealthy individuals or entities typically invest in private businesses or privatize public companies. Private equity often delivers superior returns, typically over a time horizon of ten years.[1] PE firms are mostly financed by institutional investors such as pension funds and accredited investors. While historically requiring a minimum investment of $25 million, some PE firms now accept investments as low as $25,000. Investors are usually required to meet SEC-accredited investor guidelines to participate in private equity investments.[2]
In 2012, the legalization of crowdfunding investments with the JOBS Act in the U.S. allowed companies to raise capital from non-accredited investors, thereby opening access to private equity for retail investors as well. In Europe, equity crowdfunding is governed by the European Crowdfunding Service Providers for Business (ECSP) Regulation (EU) 2020/1503, which entered into force on November 10, 2021.[3]
Types of Private Equity
There are different forms of private equity, among which the most common ones include venture capital (VC), buyout funds, real estate private equity, mezzanine Capital and distressed private equity.
- Venture Capital (VC): A private equity firm that actively invests in growth-stage companies or startups.
- Buyout Funds: A common form of private equity, which aims to acquire controlling stakes in established businesses to implement operational, strategic, or financial changes to foster growth and enhance value.
- Real Estate Private Equity: A form of private equity specializing in real estate assets, aiming for property development, acquisitions, and the management of income-producing rental properties.
- Mezzanine Capital: A type of private equity that offers funding via junior debt or preferred equity, filling the space between debt and equity for purposes like acquisitions, expansions, or recapitalizations.
- Distressed Private Equity: A private equity strategy that invests in financially troubled companies to improve operations, restructure finances, and enact strategic changes.
How to invest in Private Equity
To understand the world of private equity, investors must explore different investment options, each presenting its own risk-reward profile. There are three primary pathways to gaining exposure to private equity; direct investment, exchange traded funds (ETFs) and equity crowdfunding.
| Investment Type | Description | Risks | Acceessibility |
|---|---|---|---|
| Direct Investment | For accredited investors who pool their money into PE firms, this model requires substantial initial investments but offers the potential for high returns. | Significant risks | Limited to accredited investors |
| Exchange Traded Funds | ETFs bypass accreditation and high initial investments, offering diversified exposure without the need to engage directly with individual firms. | Potentially lower returns, but mitigated risks | Accessible to a broader investor base |
| Equity Crowdfunding | Requires no significant minimum investment amount. Individuals typically fund new ventures via online platforms, which involve high risks but also offer the potential for substantial rewards. | High risks, high potential rewards | Open to retail investors |
Private Equity Funds
Private equity funds are investment partnerships that purchase and oversee companies to make a profit by selling them later. These funds usually focus on privately owned businesses. Managed by private equity firms, they are funded by institutional and accredited investors. The firms, acting as general partners, manage the funds, earning fees and a portion of the profits. The funds operate for a set period, with profits distributed to investors when the term ends.
Private equity funds generally fall into two categories:
- Buyout Funds
- Venture Capital
Venture capital funds specialize in financing startups and early-stage companies with high growth potential, while buyout funds focus on acquiring established businesses, often implementing operational improvements or strategic changes to increase value.
Private Equity Firms
Private equity firms manage and invest in various types of ventures, including startups, established companies, and real estate assets. They employ diverse strategies, such as borrowing money to acquire stakes in businesses, investing in new companies, or actively assisting existing ones in their growth. These firms acquire capital from wealthy individuals, pension funds, insurance companies, and other institutional investors. Following that, they utilize these funds to purchase stakes in companies, generating revenue through management fees and a share of the profits. Private equity firms also sometimes engage in private credit by lending money to companies as convertible notes, SAFE's or alike.
In simple terms, private equity firms collect money from partners such as pensions funds, family offices and accredited investors. They pool the money in a fund and then use it to acquire portions of businesses and work as fund managers to increase the value of those companies.
What exactly does private equity do?
Private equity does what the investment requires them to do, to increase the value of it for monetary gain. They are paid in investment management fees and capital appreciation and the activity involves actively acquiring companies, creating value, restructuring operations, improving performance, and strategically planning exits to maximize profits and returns.
| Key Activities | Activity Description |
|---|---|
| Acquisitions | Private equity firms purchase entire companies or controlling stakes, typically acquiring, privatizing, and delisting them from public stock exchanges for strategic management. |
| Value Creation | These firms enhance the value of acquired companies through operational improvements, cost-cutting, strategic repositioning, and revenue growth, typically within 10 years. |
| Restructuring | They also actively restructure acquired companies to boost efficiency and profitability through asset sales, division consolidation, and capital structure optimization. |
| Operational Improvement | Private equity also focuses on enhancing operational efficiencies to improve the performance of the companies they acquire. |
| Financial Engineering | Financial engineering techniques are actively employed to enhance returns, leveraging debt for acquisitions, restructuring, and opportunistic refinancing. |
| Exit Strategy | Investments are actively exited through IPOs, trade sales, or secondary buyouts to generate returns and realize capital gains. |
How do private equity firms make money?
Private equity firms make money through carried interest, capital gains, dividend payments and management fees. They employ a two-part payment system: they charge management fees for running operations and receive carried interest as a share of investment profits.
- Carried Interest or Performance Fees: Private equity firms mainly generate profits through carried interest, a share of the profits from fund investments.
- Capital Gains: Private equity firms typically invest alongside partners in businesses and gain a profit when selling investments that have appreciated in capital.
- Dividend Payments: Some investments also pay dividends to their private equity owners during the holding period, providing direct cash flow to the firm.
- Management Fees: Finally, private equity firms charge investors an annual fee, covering operational expenses.
Who invests in private equity?
The investors in private equity are mainly pension funds, insurance companies, high-net-worth individuals, family offices and other types of institutional investors. Private equity is a cornerstone of global finance, drawing in diverse investors ranging from the largest funds in the world to wealthy individuals. These investors pursue strategic opportunities for superior returns and diversification beyond the traditional stocks and bonds investment. They foster economic growth within the private sector.
- Pension funds
- Insurance companies
- High-net-worth individuals
- Endowments and foundations
- Family offices
- Institutional investors
- Corporate investors
- Government investment funds
- Retail investors
How does private equity raise money?
Private equity firms raise capital from pension funds, insurance companies, wealthy individuals, family offices, foundations, and government-owned funds, who become their limited partners. These firms actively seek commitments during a fundraising period. Once the capital is secured, it is deployed to invest in private companies or real estate. The private equity firms manage these investments to generate returns for investors over a fixed period, typically 5 to 10 years. As of 2022, the average private equity investment time horizon was 5.7 years.[4]
Article Sources
- U.S. Security and Exchange Commission: “Private Equity Funds”
- Harvard Business School: “How to Get Into Private Equity”
- European Commission: “Crowdfunding Regulation”
- S&P Global: “Private equity buyout funds show longest holding periods in 2 decades”