For many people, investing means simply buying stocks or putting money in their 401K. However, there are other increasingly popular alternative methods. Private equity is one of them. Whether they are looking for greater profits, more stability, or want to diversify their portfolios, private equity is an intriguing option for many investors.
Learn about the pros and cons of Private Equity to know here.
Table of Contents
- What is Private Equity?
- How Private Equity Works
- Raising Funds
- Investment Portfolio Research
- Build, Improve, and Grow
- Selling the Portfolio
- Advantages to Private Equity
- Growth Potential
- Business Guidance
- Increased Flexibility
- Return Potential
- Versatility and Resilience
- Disadvantages to Private Equity
- Not a Level Playing Field
- High Risk
- Lack of Transparency
What is Private Equity?
Private equity is the allocation of funds and investments placed in private companies by investors, who then receive part stake or interest in the firm. It is an alternative way private companies can raise money without taking out loans.
Three of the most common types of private equity investments are buyouts, venture capital, and development capital.
Buyouts are when a private equity firm or team of investors buy a company with the hopes of selling it down the road for a profit. In an analogy, it’s similar to the concept of flipping a house.
In this case, the “renovation” might involve improvements to current operations, a change in business strategy, or overhauling the management team.
Venture capital generally involves investments in early-stage companies that have high growth potential based on an idea, concept, or test product. Investors will infuse cash into startups to kickstart operations in exchange for equity in the company.
Development capital (also referred to as growth capital) is a similar concept but usually involves a more mature/established company that is looking to revamp its operations. These types of companies are looking to pivot to new markets or expand their current operations and need additional funding to do so.
In all cases, for private equity investors, there is an expectation that over the long haul, they will see a profitable return on the money they have put in. Similar to public trading, investors can also go through private equity firms that charge management and performance fees.
Unlike publicly traded companies, private companies operate with less publicity. Private companies are often out of the public eye. Less emphasis gets placed on quarterly performance, meaning executives do not face the same short-term pressure.
Private equity funds help companies invest in new technology, strengthen their balance sheets or gain key advantages over their competitors.
Ultimately there are numerous advantages as well as some disadvantages for both companies and investors to consider when it comes to private equity.
How Private Equity Works
The process of a private equity investment is different within different private equity firms. But they all adopt a similar process which includes Raising funds, Conducting portfolio research, Improving efficiency, and selling the portfolio.
Investors of the same interests of investing can come together and raise capital to form a private equity fund. Once the fundraising reaches a specific targeted amount, it is closed and the private equity funds are used for investment in companies with high potential for growth.
Investment Portfolio Research
After raising the investment fund, private equity firms conduct research on potential companies to invest in. The raised private equity funds will be invested in the portfolio companies to make sure they maximize their performance and grow within the shortest time possible.
Build, Improve, and Grow
When private equity firms invest in companies, they aim to improve all areas of the company to maximize its performance. This involves improving company operations, increasing cash flow, cutting on costs, improving strategies and planning, and growing the business.
Selling the Portfolio
Once a private equity firm improves companies in its investment portfolio, it now plans and releases these companies by selling them to recover their investment.
Advantages to Private Equity
One immediate benefit of private equity for organizations is the infusion of money. Private equity groups and investors have substantial financial resources that can help organizations in significant ways.
For companies, new resources might mean getting a new idea off the ground, shaking up their internal structuring, acquiring a rival, or even avoiding bankruptcy. It can be either a lifeline or a window to new opportunities.
For companies, the flexibility that comes with an infusion of new capital can be a gamechanger. Transformations can be felt in tangible ways, such as buying new equipment, upgrading facilities, or gaining increased exposure through new marketing initiatives. They also function in more subtle day-to-day operations.
Through venture capital, private equity can help companies grow and succeed in ways that might otherwise not be possible. This benefits investors as they see their initial investment grow along with the company.
In private equity investing, there is potential for massive upside by investing in a company at the right moment. That might be on the ground floor, as it launches a new product or when it makes a key acquisition.
How do private equity firms and venture capitalists decide where to invest? It depends on several contributing factors, including:
The Industry/ Offering
- Does the business have a competitive advantage?
- Are they in an emerging industry?
- Does the product/offering have good margins?
- Does the company have solid leadership?
- Is there consistent growth?
- Is it profitable (or close)?
- Is there a sustainable cash flow (for buyouts)?
The Management Team
- Can the management team be trusted?
- Are the right people in place to ensure long-term growth?
Return On Investment
- Higher risk means higher reward
- Given the exposure, venture capital funds look for very high ROI opportunities
- Did debt play a major role in the transaction (leveraged buyout)?
Private equity investors will take a hands-off approach by simply purchasing a company or providing seed money in many instances.
There is also more potential to offer guidance and business advice. This is particularly true when dealing with startups or smaller businesses.
The relationship between private equity firms and small businesses is often paramount to long-term investment success. Private equity cannot only be beneficial to long-term growth, but it can also help turn around a struggling or failing business.
This was highlighted at the start of the COVID-19 pandemic. Many small businesses saw a tremendous hit to their balance sheets.
At the time, many private equity firms stepped in with financial resources and business advice to help keep these companies afloat. In this sense, private equity is sometimes a more proactive and opportunistic approach to investing than traditional investment methods.
This is also true in the case of buyouts. Investing in a failing company or other distressed assets can be a massive opportunity. When a company gets bought out, the venture capital team assumes control of the daily operations. While some investors prefer to put a team in place, others may take a more hands-on approach.
Private equity investors need to weigh a lot of variables, and that sometimes means taking more initiative. Having influence over the revamping of a company can be valuable if the right team is in place.
With guidance inevitably comes some degree of influence. A significant advantage to private equity investing is the accessibility private investors can have with companies in their portfolios.
By investing large sums of money, private equity groups can gain increased influence over the direction of the company. Investors in private equity may be able to gain greater control over where their money goes.
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The private sector is substantially larger than the public sector, meaning a wider variety of investment opportunities. This ranges from the size of companies you can invest in, to the diversity of different sectors.
The different types of private equity also provide varying degrees of involvement and risk. Whereas some forms of private equity investments such as venture capitalism may require higher degrees of research and due diligence, other forms may be more hands-off.
There is a lot of flexibility with private equity in determining where and when you want to invest and the level of risk you are willing to tolerate.
Different stages include:
- A concept or idea
- Currently funded by the entrepreneur (limited resources)
- Resources needed to get an idea off the ground
- The offering is already in production (or just starting)
- Not yet sold commercially
- Needs additional financial resources for production
- Not yet commercially tested
- Established company
- Successful sales record
- Rapid growth with new markets
- Additional funds are needed to expand outward
Preparing to go Public
- Track record of success
- Preparing to list on the stock exchange
- Need to strengthen the balance sheet
- Prepare to attract additional institutions
- The company gets bought out
- Venture capital investors take control of the company
- Confirmed cash flow
- Look to restructure in hopes of sale down the road
Private equity can be a component of an overall larger investment portfolio. As it represents a massive and diverse range of options, it presents an opportunity to balance your portfolio and weigh stability and risks along with upside.
From a company perspective, there is also flexibility. Venture capital can free up resources that allow a business to pursue new avenues.
Outside of the scrutiny of the public market, private companies can pursue more creative and inventive strategies. Without the pressure of short-term growth and quarterly earnings, executives can pursue longer-term strategies without worrying about the wrath of investors.
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In addition to driving growth, private equity has also proven to be a successful long-term investment, outperforming many other assets including public markets.
According to detailed reports from Mckinsey “Private equity (PE) continues to perform well, outpacing other private markets asset classes and most measures of comparable public market performance.”
Further advantages can be seen in reports that chronicle annual returns over the past few decades. Private equity investors saw yields of around 10.48% over twenty years, outpacing other investment opportunities. Between 2000 and 2020, private equity outperformed the Russell 2000 and the S&P 500.
When it comes to venture capital, return on investment can skew much higher if a private equity investment gets made at the opportune time. There is no question, private equity investing can be high risk, but the reward potential is massive.
Even for those looking for more safety and stability in their long-term investments, private equity represents an appealing alternative to the public market based on current valuation levels and market factors.
As noted by global consulting agency Deloitte “ As the public market equity valuations rise, PE funds may become relatively more attractive to investors on a valuation basis. The S&P 500’s forward price-to-earnings ratio has reached a decade-high level. In this scenario, more investors may look at asset classes such as PE for opportunities.”
Versatility and Resilience
Despite volatility over the last few decades, the private equities market has been enormously resilient. This was again on display during the COVID-19 pandemic. Economic tumult and mass decline hit most sectors, but investors found opportunities in private equity.
Even as many sectors declined, private equity investors pivoted to high growth areas like PPE, healthcare, and remote-based communication services. Even in times of crisis, there is opportunity in private equity.
A 2020 Harvard-backed study further highlights how private equity can outperform public markets in an economic downturn. In these instances, private equity investments have shown less volatility.
Overall, PE marketing sustained less substantial losses and offered more opportunities.
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Disadvantages to Private Equity
You may be wondering, why doesn’t everyone invest in private equity? When something sounds too good to be true, it usually is. While the advantages of private equity are apparent, there are also some substantial disadvantages worth considering.
Not a Level Playing Field
Private equity investing is an inherently uneven playing field that favors the wealthy. There is often an incredibly high barrier to entry from an economic perspective. Minimum entry requirements can range from $250,000 to 25 million. This means this type of investing is often inaccessible to the average retail investor.
Private equity is most often an opportunity for large institutions or high net-worth individuals. It does not usually offer the same type of inclusion or accessibility as the public market.
Though everyday investors may have an opportunity to access private markets through being part of a larger investment group or using a private equity firm, they are less likely to enjoy the benefits highlighted above. While there is still a high-growth opportunity, they are less likely to have a hands-on influence in their investments, leaving it to professionals to manage and allocate their financial resources.
Private equity investments are often more complex and generally managed by established professionals and institutions.
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While some private equity investments represent incredible growth potential, they also come with a significant degree of risk. There is a speculative nature to investing in early-stage companies. Often, this means investments will not pan out. It is estimated that only about 10-15% of startups grow at all.
Some common reasons why early-stage companies might fail include:
- A bad management team
- A failed product launch
- The market does not respond to the offering
- New competitors emerge
- Technology quickly becomes obsolete
Any one of these factors can derail momentum for a new company and leave private equity investors holding the bag.
There is a similar risk attached to a buyout. It is never a foregone conclusion that a company will wind up selling for more than it was purchased for. Market conditions can change drastically in a short period.
Lack of Transparency
A big issue with private equity is a lack of transparency or clear information. In public markets, companies need to be forthright about their financial positions. There are a lot more compliance rules and regulations. Some of these rules exist in private equity, but there is often more of a gray area. With PE, there are less stringent enforcement mechanisms.
Researchers and investors are finding it increasingly difficult to calculate key metrics like company valuations and performance attribution because companies either aren’t as forthright or have not been established long enough to compile sufficient data. This makes determining associated risks and fees a complicated proposition.
As the Institutional Investor study notes, “Without true transparency, it’s hard to prove definitively that private equity works and to make the economic case for it.”
Private equity is a lot murkier than traditional investments and this may come at the expense of investors who are left in the dark.
When it comes to private equity investments, there are a lot of variables beneath the surface that need exploring. The benefits are numerous, but so are the risks.