Demystifying Private Equity: A Comprehensive Guide for Beginners
VerifyInvestor.com
Investing is a smart way to increase your net worth and build the future of your dreams. Investment options for accredited investors are many and varied. Some of the more common investment vehicles include stocks, bonds, certificates of deposit, mutual funds, and buying real estate.
But for investors who want a diversified portfolio, and a rate of return that far surpasses benchmark stock indexes, there are other, exciting — if riskier — investment opportunities to consider.
What are they?
Alternative investments.
These types of investments — generally hedge funds, venture capital, and private equity (PE) — are not the common, traditional investment vehicles.
In this discussion, we will focus on one type of alternative investment — private equity investments.
Our purpose here is to demystify PE investments and provide a comprehensive guide for beginner investors.
As with any investment — whether it is traditional or alternative — there is a lot for an investor to know. And plenty to be wary of. This overview of PE investments will highlight the most important aspects of PE investing, but before you invest, do your due diligence and consult all legal, tax, accounting, and other professionals as needed.
Alternative Investments in a Nutshell
The investment landscape is ever-changing. Traditionally, a portfolio made up of 60% large-cap stocks and 40% bonds was a solid investment strategy. In our current economic uncertainties and given the financial changes caused by the effects of COVID-19, that’s no longer the case. Today, an entirely different approach to investing is required.
In response to the variable financial conditions, many investors are turning to alternative investments to realize significant returns on investment and diversify their portfolios. Some of the more commonly known alternative investments include hedge funds, venture capital, and private equity.
Alternative investments can be unique physical assets like artwork, or they can be funds that acquire and run companies — like private equity funds. Some alternative investments are available only to accredited investors.
Almost any investment in private assets (other than cash, stocks, or bonds) can be an “alternative investment.” Alternative funds, and private equity funds, in particular, deal in privately owned assets. These funds are not traded in the public market. They exist only in the private sector.
According to Bloomberg, alternative investments — including private equity (discussed more fully below) — offer higher returns than investments in the public market. Plus, they provide greater portfolio diversification. These investments are not without their risks of course, but they do offer a “huge and highly varied” opportunity for sophisticated and accredited investors.
But investing in private markets isn’t so easy to do. Most private investment opportunities are accessed through exclusive channels such as wealth management firms or between high-net-worth individual investors.
For the most part, the high minimum investment requirements for private equity investing, which can range anywhere from hundreds of thousands of dollars to several millions — make PE investing realistic only for institutional investors such as pension funds or private equity firms, or very high-net-worth individuals.
Nevertheless, PE investing is a very popular alternative investment.
But what, exactly, is private equity (PE), and how does it fit into the investment landscape?
Let’s see.
Private Equity Defined
At its core, private equity (PE) refers to investing in private companies that are not traded on the public stock exchange. Typically, this involves investing in private equity firms that buy and manage the companies and then sell them.
A private equity fund is considered a “pooled investment.” This means that the fund adviser (i.e., the PE firm) pools the capital provided by investors in the fund and uses that money to make investments on behalf of the fund.
Unlike other investments, (for example, venture capital or hedge funds), PE funds create value by purchasing private companies or businesses, running them to increase their value, and then selling them for a profit. This typical business model differentiates PE funds from other alternative investments.
It also makes PE investing a long-term investment.
In most PE investments, investors are required to hold onto their investments for several years — in some cases as much as 10 years or more — before they see a return on investment.
In addition, a private equity adviser must be registered with the Securities Exchange Commission (SEC). The fund itself, however, is not registered with the SEC. This means that there will be limited public disclosures regarding the fund itself. The impact of this is that investors do not have the same level of protections they would have if they were investing in a registered security. That’s because in addition to investor disclosures, registered securities require public disclosures regarding the fund itself and regular reporting to the SEC. In contrast, because PE funds are not registered with the SEC, the funds are not heavily regulated by the SEC and they have few, if any, standard disclosures or performance reports. Private equity investors do receive disclosures in the offering documents, of course, but PE funds are currently not required to make additional reports or disclosures throughout the lifetime of the investment. While there are proposals to require fund advisors to make periodic reports to correct for this, currently PE investments tend to be riskier than other types of investments.
So, how does all this work?
Briefly, there are several main players in a PE fund. They are the general manager (usually the firm that establishes the fund), the fund manager, and the investors.
Typically, PE funds are set up and managed by private equity firms which are structured as Limited Partnerships (LPs). The PE firm takes on the role of general partner in the LP. Any subsidiary that manages and advises the fund is the fund manager. Finally, the investors are the limited partners.
In short, to create the fund, a private equity firm raises capital from accredited investors. It then manages the fund on behalf of the investors in accordance with the terms and conditions specified in the limited partnership agreement (LPA), which controls the fund’s purpose and how it will be carried out.
The general partner makes all final decisions regarding the fund’s operations. The manager is responsible for seeking out investment opportunities and developing a strategy. The limited partners (i.e., the investors), on the other hand, have no involvement in the running of the fund. Their role is limited to providing capital.
The general partners charge management fees and transaction or deal fees for the services they provide to the fund. These fees generate enormous wealth for the general partners. Investors need to be aware of these fees and how they are used.
The Role of Private Equity in the Investment Landscape
The private equity industry has grown rapidly through the years despite economic uncertainties and downturns. The growing interest in PE stems from its potential to earn investors superior long-term returns when compared to public investments.
While the beginnings of private equity can be traced to the early 19th century, most modern PE firms emerged on the investment scene in the early 1970s. Private equity deals garnered significant attention throughout the 1970s and 1980s, and the private equity market reached its height in the 2000s.
In the years following 2000, private equity has taken a downturn and came under closer scrutiny from the SEC. Nevertheless, private equity investments continue to play a significant role in the investment landscape.
While many feel that private equity deals have run their course and are not as attractive as they once were, at least one analyst believes that the long-term outlook for private equity may be getting even better than it was in 2021 when private equity buyouts totaled a record $1.1 trillion.
Knowledgeable analysts believe that alternative funds provide access to the global market and the widest possible class of assets and continue to be a central part of the financial landscape.
Who Can Participate in Private Equity Opportunities?
Private equity funds are generally only available to accredited investors and qualified clients.
Accredited investors can be entities or individuals.
Qualified clients can include:
institutional investors
university endowments
pension funds, and
The reason PE opportunities tend to be limited to these categories of investors is that the initial investment for a private equity deal is almost always extremely high. It can range from hundreds of thousands to several million dollars.
Additionally, PE investments may require a “capital call” or “drawdown” from investors. A “capital call” or “draw down” refers to the practice of a fund-collecting capital from the limited partners (i.e., the investors) as the need arises. Capital calls require PE investors to be able to provide the agreed-upon capital whenever it is called for — meaning, of course, that a PE investor must be able to have the necessary funds available at any time.
How is Private Equity Different from Other Investments?
As noted previously, private equity investments are considered “alternative investments.” They are not traditional investments like stocks and bonds or mutual funds.
What makes private equity investments different from other investments?
Quite a few things as it turns out.
Here are just some of the main differences between PE investments and other typical investments:
Private Assets - First, one of the more obvious differences between PE investments and other investments is expressed in the name of this investment category. PE investments are investments made in privately held assets.
While other investments are made in publicly traded stocks or bonds, PE investments are made in strictly private assets. In most cases, these private assets are privately held companies.
How the Fund is Structured - Private equity investments are also structured differently than traditional investments.
Most PE business models consist of a PE firm that raises capital and invests that capital into a fund. The fund is frequently set up as a fixed-term limited partnership. The fund is then managed by the general partners (GP). The general partners are usually the firms that set up the fund. The investors who provide capital for the fund are the limited partners. The limited partners have very little say in how the fund is managed. Their role is simply to provide the capital for the fund to conduct its business. Limited partners agree to pay fees and provide capital for the fund.
Most private equity deals are designed to take over a private company, run that company for a number of years to increase its value, and then to “exit” the deal — in other words, sell the company. At that point, the fund returns the proceeds from the sale to the investors — minus 20%.
Capital Calls - Unlike other fund investments, for example, mutual funds, private equity investments require investors to commit to provide a certain amount of money to the fund throughout the lifetime of the fund. Known as a “capital call,” (see above) investors agree up-front to provide capital (up to a specified amount) whenever the firm calls upon them to do so.
Illiquidity - Another major difference between private equity investments and traditional investments is the amount of time required to hold the investment.
Because private equity firms or funds most often buy, run, and sell private businesses, PE investments are long-term investments. It can take 10 years or more before an investor will see a return on investment. And during that time, the fund may call on its investors to provide capital at different intervals as needed.
This combination of the longer holding periods and the capital calls makes PE investments illiquid.
Lack of Required or Periodic Disclosures by the Fund - Yet another major difference between private equity funds and other typical investments is that because the PE funds themselves are not registered with the SEC there is less regulation of these funds. This means that PE funds typically do not have to meet the SEC public reporting requirements. PE investors do, of course, receive disclosures regarding the fund in offering documents. However, unlike publicly traded mutual funds, PE funds do not have mandatory standard disclosures or periodic reporting requirements (for example, detailed quarterly reports or disclosures regarding expenses). This renders disclosure regarding the fund’s performance during the lifetime of the fund discretionary with the general partners.
Further, because they are privately held, the companies themselves which are the subject of the investments, are not subject to public scrutiny. That means that it can be difficult to find out much about the company itself or the PE fund. This lack of transparency and lack of disclosure makes investing in private equity risky.
Private equity investments provide a wide range of opportunities and can be an effective tool for diversifying an investment portfolio. But they are not without their risks.
Thinking of Investing in Private Equity? Some Facts to be Aware of.
While there are plenty of factors to be considered before investing in private equity, let’s look at just some of the issues a first-time investor should be aware of before jumping into an investment opportunity.
This isn’t a comprehensive list by any means. There are plenty of other factors an investor should consider, so be sure to consult with your securities counsel and other professionals before you invest. Do your best to educate yourself on all aspects of private equity investing and always conduct your own due diligence.
With all that said, let’s take a look at some additional factors to consider before investing in PE.
Capital Calls and Illiquidity of PE Investments
Some of the same things that make PE investments different from other typical investments are the very issues an investor needs to be aware of before participating in a PE opportunity.
As mentioned above, PE investments require capital calls and are illiquid investments.
Liquid assets or investments are ones that can easily be converted to cash without materially affecting their value.
Because private equity investments are long-term investments, it can be as much as 5 to 10 years before one will see a return on investment. Since the investor’s ability to sell is severely restricted, private equity investments are considered to be “illiquid.”
Another fact to consider is that PE investments require investors to agree upfront to provide a certain amount of money throughout the investment period for “capital calls.” This means that the investor must keep money available for the PE fund to use as needed.
Investors are Limited Partners
Another aspect to consider if thinking about investing in private equity is the role an investor plays in PE funds.
Most PE funds are structured as limited partnerships (LPs). The firm establishing the PE fund is usually the general partner, relegating all investors to the role of limited partners.
Although this structure limits the personal liability of an investor, it also means that investors have little to no say in how the fund is managed.
Fees and Charges
Another major issue that arises with PE investments is that of fees charged by the fund and conflicts of interest.
Investors in a PE fund agree up-front to pay certain fees and expenses. These fees and expenses are generally disclosed in the offering documents. However, investors need to be vigilant about what fees and expenses they are being charged and exactly how those costs are being applied to the fund they are participating in.
Not all companies fully disclose the fees and costs they are charging. In addition, fund managers may shift costs from one fund to another.
Quite often fund managers will manage a number of funds. This can create conflicts of interest that are not disclosed to the investors. It can also lead to the misapplication of fees and charges as they get shifted from one fund to another.
Private equity investment has steadily risen in popularity over the years. Many PE deals have provided their investors with unparalleled returns on investment. However, investing in PE is not without its risks and limitations.
Accredited investors need to be aware of the advantages and disadvantages of investing in private equity. At VerifyInvestor.com, we offer a world-class accredited investor verification service. Our services are fast, efficient, cost-effective, confidential, and reliable. We help companies fully and easily comply with their legal obligations to verify investors as accredited investors.