How Private Equity Funds Work

Private equity is one asset class that seems to sit on the fringes of the investment world. There’s a good reason for that – private equity investments are available only to high-income/high-net-worth investors.

Many investments have democratized in the last decade, so it’s good to have a general idea of how private equity funds work. Like commercial real estate investing – which was once reserved for institutions and the wealthy but then became available to the average investor through real estate crowdfunding – private equity funds may someday be open to the masses.

Private equity is one of the most profitable forms of investment there is. And private equity funds are one of the best ways to take advantage of these potential investment goldmines.

What Is Private Equity?

As the name implies, private equity is capital raised from private sources. It does not rely on stocks and bonds. Instead, private equity firms raise capital from wealthy private individuals, pension funds, and other financial entities. Investors invest their money with a private equity firm hoping to earn higher-than-average returns on their capital. Examples of private equity firms include Blackstone Inc., KKR & Co. Inc., CVC Capital Partners, Carlyle Group Inc., and Thoma Bravo.

Private equity investments are restricted to high-income/high-net-worth individuals and are not available to the general public. That’s because investing in private equity carries a higher level of risk than more traditional investments such as stocks, bonds, and mutual funds.

Additionally, private equity is a more complicated investment requiring greater financial sophistication from anyone who invests in it. Private equity investments typically buy out a publicly-traded company and take it private.

Though there are specific common processes for private equity investments, each deal is unique. This is due to the variations in the businesses for sale, their financial condition, and the terms of each transaction. Investors are expected to know the technicalities of private equity and the risks they take by investing their capital.

In a typical deal, a private equity firm takes a majority or controlling interest in the company being acquired of at least 50% equity. This investment is set up as a limited partnership. The private equity firm serves as the general partner while each investor is a limited partner. This limits investors’ financial and legal liability to no more than the amount of capital they invested in the deal.

What Is a Private Equity Fund & How Does it Work?

A private equity fund is simply a fund that invests in private equity deals. The private equity firm itself acts as an advisor. How they are managed is similar to how other investment funds, such as mutual funds, work.

The fund will pool money together from multiple investors and invest in deals. But unlike other fund managers that merely oversee a portfolio of individual investments, a private equity fund is actively involved in managing the companies in the fund.

When a private equity fund is established, it will have a stated capital raising goal. Once that goal has been reached, the fund will be closed, and management will invest in various companies.

Much like mutual funds, a private equity fund allows investors to invest in multiple companies with a single investment. It’s a way to diversify private equity holdings within the same fund.

Private equity funds should not be confused with hedge funds. Though there are similarities between the two,  private equity funds purchase public companies, take them private, and manage them during the time of ownership. In contrast, hedge funds invest in publicly-traded investments and specific industry sectors that remain public until the fund sells its interest. The hedge fund doesn’t take control of the assets it purchases.

While a private equity fund invests in specific companies, hedge funds can hold widely diversified assets. The goal of the hedge fund is usually to create a portfolio of alternative assets that are likely to perform well when mainstream markets are down.

Who Can Invest in Private Equity?

As noted earlier, private equity investments are generally limited to institutions and individuals who are high-income, high net worth, or both. This type of individual investor is referred to as an accredited investor.

To qualify as an accredited investor, an individual must meet the following criteria:

1. Have earned income above $200,000 – or $300,000 together with their spouse (or spousal equivalent) – in each of the prior two years, along with the reasonable expectation of earning at least as much in the current year, or
2. Have a net worth of over $1 million (individually or jointly), excluding the value of their primary residence, or
3. Hold a Series 7, 65 or 82 license in good standing.

While you can open an investment brokerage account with no money, invest in a real estate crowdfunding platform with a few hundred dollars, or invest in a mutual fund with $3,000, private equity investments require much more. A private equity firm may set a minimum investment at $250,000 or even several million dollars.

However, it should be noted that non-accredited investors can still gain exposure to private equity investments through ETFs. There are a few ETFs available today that invest in private equity firms. These include ProShares Global Listed Private Equity ETF (PEX), Invesco Global Listed Private Equity Portfolio (PSP), and VanEck BDC Income ETF (BIZD).

Read more >>> How to Become an Accredited Investor

Why Invest in Private Equity?

The primary reason to invest in private equity is to get the benefit of large investment returns. A firm will purchase a controlling interest in a publicly-traded company, take it private, then reorganize it. At the end of the term, which can last anywhere from a few years to as much as ten years or more, the private equity firm will again take the company public by launching an initial public offering (IPO).

By purchasing an interest in a private equity deal, investors hope to buy into investments at a lower price than the cost after the IPO. While big returns are not guaranteed, these deals can be spectacularly successful: An investment of $1 million in a private equity deal may turn into $10 million with a successful IPO.

The private equity firm must have hands-on experience managing companies in specific industries. The general idea is to apply their expertise to the existing business, improve it, and raise its market value by increasing sales and profits.

Unlike venture capital firms which invest in startups, private equity firms invest in well-established companies. The private equity firm buys a controlling interest and uses its expertise to improve the company, ultimately raising its market value.

At the end of the investment term, interest in the underlying business(es) will be sold to another company or investors through the IPO. At that point, investors will – hopefully – receive a return on their original investment, plus profits on the sale of the business (less fees retained by the private equity firm – see below).

What Are the Risks of Private Equity Investing?

Though private equity investing has the potential for large returns, there are also major risks investors need to be aware of before proceeding:

Large Upfront Investment

Of course, “large” is a relative term for investing. But since the typical minimum for a private equity investment is anywhere from several hundred thousand dollars to several million dollars, the amount of money an investor has tied up in a single deal is substantial. A large investment, by its very nature, means more risk for the investor. Significant investments = potentially big losses, and not all private equity deals are success stories.

Lack of Liquidity

Unlike stocks, bonds, funds, and many other investments, there’s no marketplace or exchange where private equity investments are bought and sold. The investor is expected to remain invested for the entire term of the projected investment period, which can be as long as a decade or more.

This means an investor might not be able to exit a failing investment position, or might they might not be able to move capital into more profitable investments.

High Fees

While exchange-traded funds often have expense ratios below 0.10%, private equity deals come with much higher fees. The typical fee arrangement is known as a “2-and-20 rule,” which is also common to hedge funds. There’s usually a 2% management fee and a 20% performance fee.

For example, let’s say the annual management fee was 2% of the total assets under management. That works out to $5,000 per year on a $250,000 investment. If the investment lasts ten years, you’ll pay $50,000 in management fees. It is possible the management fee could be paid out of the profits generated by the company. But given that the private equity firm wants to increase the value of the business, those profits may be retained in favor of future growth.

Performance fees are generally around 20% of the net profits generated by the private equity deal. So let’s say you invest $250,000 in a deal that produces a $1 million profit on the sale. In this case, you’d pay $200,000 for the performance fee – $1 million X 20% – and collect an $800,000 net profit.

Of course, the performance fee is only charged if the investment is profitable. It may seem like a big cut of profits (and it is). But it also incentivizes management to seek the highest return possible on the deal.

 Conflicts of Interest by Firm Managers

Private equity firms specialize in specific industries where they have the potential to produce the greatest returns, so they may work on deals that compete with one another.

For example, the firm might be working on taking two private companies that are engaged in the same industry. This can happen when the firm invests in one company and then later in a competitor while the first deal is still in progress.

While management should disclose such conflicts to investors, disclosure won’t eliminate them.

FAQs

Bottom Line

As you can see, private equity investing is a high-risk/high-reward undertaking. That’s why it’s currently reserved for institutions and wealthy individuals.

But maybe you’re already an accredited investor, or you will be at some point in the near future. If so, you may consider speculative investments with higher profit potential. Private equity investing may be the perfect vehicle for some of your portfolio.

For everyone else, crowdfunding may one day come to private equity investing. And when it does, everyone will be able to get in on at least a small slice of the action.

Further reading:

How to Invest 100k: 8 Best Ways to Invest Money Right Now
What Is a Real Estate Investment Fund?
How Privatization Affects Investors

The post How Private Equity Funds Work appeared first on Investor Junkie.