What is Private Equity?

Life in a Private Equity World

Not long ago, the glass of water you drink in the morning probably came to your home courtesy of your local government. Today, a private equity firm might ensure that same glass of water is available when you wake up in the morning.

The influence of private equity firms surrounds us—from common household items such as the clothes in your closet to the cosmetics in your bathroom, and now private equity firms are increasingly taking over services long provided by government agencies such as water utilities, along with the maintenance of roads and bridges.

Since the financial crisis of 2007-09, the private equity industry has become enormously influential—buying up businesses they consider underperformers, maximizing profits, and ultimately selling them. Since the Great Recession, the private equity industry helped stabilize the housing market in the United States too.

A buzzword in investment circles, private equity is the term describing investment capital from high-net-worth individuals, pension funds and institutions that is used to invest and acquire equity ownership of companies, along with providing many services traditionally associated with government agencies. Once the domain of the most sophisticated investors, private equity has become quite popular with mainstream investors too.

Over the last few decades, the private equity industry has outperformed the Standard & Poor’s 500, creating significant demand for private equity funds from individual accredited investors and institutions. A recent report by the American Investment Council found the private equity industry outperformed the S&P 500 by 4.5 percent in 2015. [1]

As a result, private equity firms have become attractive investment vehicles for high-net-worth individuals.

Private Equity as an Investment Strategy

Perhaps the best way to think of private equity is as an investment strategy.

Usually, investors will pool together capital into a structured vehicle designed to last many years. That capital is in turn invested into private companies that are undervalued and likely to grow, or into public companies that could benefit from an overhaul that can be more easily achieved through private ownership. By picking companies with large growth potential, investors seek to maximize their investment returns. The funds are used to purchase shares of private companies, or public companies that ultimately become delisted from public stock exchanges.

A unique asset class, private equity is an investment strategy that is totally focused on putting capital to work in private companies. From a historical standpoint, private equity has offered the highest returns among various asset classes such as stocks, bonds, real estate, along with investments available to institutional investors like pension funds and insurance companies.

The higher returns are largely due to the fact that firms receiving private equity capital gain from the long-term commitment of investors who are patient enough to let companies follow growth strategies that will in all likelihood generate large returns, but typically take more time than what public market investors are accustomed to.

These companies backed by private equity also benefit from the financial and strategic business expertise of the private equity executives in management. Many of these companies actively seek private equity investment, as opposed to bank financing, because of the benefits to their companies.

How Do Private Equity Funds Work?

Typically, private equity funds are structured as “limited partnerships” managed by general partners. These are the financial experts at management companies that help the businesses they are investing in succeed. The investors who provide capital to private equity funds are known as “limited partners.” The amount of required capital varies by firm. Some require millions of dollars, while some only require a minimum investment of $250,000.

By pooling capital, general partners and limited partners can maximize their returns. The structure permits limited partners to bolster their purchasing power, and gives general managers more leverage in creating long-term investment strategies. The private equity funds will invest in a number of companies over a period of time when various management and financial changes are made to improve profitability. When this happens, the private equity fund will usually sell their ownership interest to a financial investor through a public offering.

When the fund is formed, the investors or limited partners pledge to invest capital that will be allocated by the general partner during the life of the fund. This is known as the “commitment.” In return for the limited partner’s commitment to the fund, the general partners are required to pay investors a share of the profits earned off the fund. Usually, 80 percent of profits made above a minimum return are allocated to the limited partners, and general partners keep the remaining 20 percent, once the minimum return is met.

Lastly, since private equity investments are long-term funds, limited partners also pay management fees to the general partners that cover their operational expenses, salaries and overhead.

Since the financial crisis of 2007-09, private equity has become a key component of many wealthy investors’ portfolios. The data shows that investments in the industry have produced substantial profits, creating growing demand from investors looking for new ways to generate superior returns.    



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