Private equity (PE) is something that you have probably heard of. In 2019, private equity (PE) firms had an estimated $3.9 trillion in assets, a 12.2 percent rise from 2018.
Investors seek private equity (PE) funds because they generate higher returns than the stock market. There may be some facets of the industry, though, that you do not fully grasp. Read on to gain an understanding of private equity (PE), its value creation process, and its main strategies.
List of Contents
- What Is Private Equity (PE)?
- In the World of Private Equity (PE)
- Private Equity (PE) Companies: Different Varieties
- The Value-Adding Process of Private Equity
- Why Invest in Private Equity?
- Minimum Investment Requirement
- Fund of Funds
- Private Equity ETF
- Special Purpose Acquisition Companies (SPACs)
What Is Private Equity (PE)?
A private equity (PE) investment is a financial investment in a company that is not traded on a public exchange. Private equity (PE) is a form of investment capital provided by wealthy individuals and corporations that buy into or take over publicly traded companies to make them private again and remove them from public markets.
Institutional investors like pension funds and huge private equity (PE) organizations supported by accredited investors make up the private equity (PE) business. Private equity (PE) involves direct investment, typically intending to influence or control a company’s activities, necessitating a sizable cash outlay; thus, funds with more significant financial resources tend to dominate the sector.
There is no universally accepted minimum investment quantity for accredited investors. The minimum investment for some funds is $250,000, while it may be several million dollars or more for others.
Such dedication is driven by the hope of earning a profit (ROI). Private equity (PE) partners source capital and invest it wisely to maximize returns for their investors over four to seven years.
In the World of Private Equity (PE)
Top executives from Fortune 500 businesses and prestigious management consulting firms are among those who have found a home in the private equity (PE) industry. Accounting and legal expertise are in high demand in the private equity (PE) industry, making law firms an attractive hiring ground for potential new workers.
Private equity (PE) firms’ fee structures vary but usually include a management charge and a performance fee. Though incentive systems can vary greatly, it is usual for managers to be paid 2% of assets per year plus 20% of gross gains upon sale.
It’s easy to see why the private equity (PE) market is so attractive to talented individuals: a PE firm managing $1 billion in AUM can have no more than two dozen investing professionals, yet 20% of gross profits might yield tens of millions of dollars in fees.
Associate salaries and bonuses can reach the low six figures at the middle market level ($50 million to $500 million in deal value), while vice presidents can make close to $500,000 on average. However, principals can make more than $1 million yearly in compensation (including realized and unrealized).
Private Equity (PE) Companies: Different Varieties
There is a wide variety of investment strategies used by private equity (PE) companies. Some investors are purely financial backers, while others are strictly passive shareholders who rely on the company’s leadership to drive expansion and profitability. Others in the private equity (PE) industry describe themselves as active investors since buyers view this method as standardized. In other words, they aid management in carrying out day-to-day business activities, contributing to the development and success of the organization as a whole.
Private equity (PE) businesses involved in a particular industry may have extensive connections at the C-suite level, including CEOs and CFOs. It’s possible that they’re also pros at finding synergies and efficiency in the workplace. Sellers are more likely to be receptive to an investor who can offer something unique to the table that can increase the company’s worth over time.
Private equity (PE) firms, sometimes known as private equity funds, compete with investment banks for the right to acquire and finance profitable businesses. Large investment banks like Goldman Sachs (GS), JPMorgan Chase (JPM), and Citigroup (C) typically facilitate the most important deals.
When it comes to private equity (PE) firms, their funds are often only available to certified investors and may have a cap on the number of investors allowed. Additionally, the fund’s founders will typically have a sizable share in the company.
However, the shares of some of the biggest and best private equity (PE) funds are publicly traded. The New York Stock Exchange (NYSE) is home to organizations like the Blackstone Group (BX), which has participated in the acquisition of companies like Hilton Hotels and MagicLab (NYSE).
The Value-Adding Process of Private Equity
The primary roles of private equity (PE) firms are:
- Agreement formation and finalization
- Management of Investments
To secure a steady stream of promising acquisition targets for assessment by private equity (PE) specialists, deal originators must establish, cultivate, and expand their network of M&A brokers, investment banks, and other transaction professionals. Several companies employ full-time workers to find business owners and contact them. Funds raised through M&A deals need to be utilized and invested successfully, which requires locating proprietary deals.
Investment banking fees can be avoided through internal sourcing initiatives, lowering transaction costs. The chances of a successful acquisition are reduced when banking and finance professionals act as the seller’s representatives and conduct a complete auction process. Therefore, deal originators work hard to build relationships with transaction experts to secure an early introduction to a potential deal.
It’s worth keeping in mind that investment banks frequently raise their own funds and, as a result, may act as both a transaction referral and a rival bidder. That’s right; some IBs go head-to-head with PE firms for the best deals on profitable businesses.
Executing a deal requires careful consideration of management, the market, past and projected financials, and value evaluations. After getting approval from the investment committee to make an offer on a desirable acquisition target, the deal specialists will do so.
If the parties agree to proceed, the due diligence process will be carried out with the help of financial institutions, lawyers, accountants, and consultants, among other types of transaction experts. Management’s claimed operational and financial numbers must be verified as part of the due diligence process. This is a crucial step since it is where experts can unearth deal-killing issues, such as primary, hidden obligations, and dangers.
Why Invest in Private Equity?
Private equity ventures typically attract institutional investors and high-net-worth individuals. Among these are pension funds, huge endowments at universities, and private investment firms. Their contributions are crucial to the economy because they allow high-risk, early-stage businesses to get off the ground.
Typically, the funds are invested in up-and-coming businesses in high-growth sectors like telecommunications, software, hardware, healthcare, and biotechnology. When acquiring a company, private equity firms look for ways to improve it to become more valuable to investors. A new management company may be implemented, complementing businesses may be acquired, expenses may be slashed drastically, or underperforming divisions may be spun off.
Some of the below companies, which have received private equity capital over the years, may be familiar to you.
- A&W Restaurants
- Network Solutions
- Cisco Systems
These companies might not have become household names without private equity funding.
Minimum Investment Requirement
Investing in private equity is not something that the typical person can do without some serious preparation. The standard investment threshold for private equity firms is $25 million. Some companies have lowered their minimum requirements to $250,000, but this is still too high for most people.
Fund of Funds
When it comes to investing in private equity, a fund of funds is the holding company for numerous separate private partnerships. It allows businesses to boost efficiency while cutting costs and expanding capital. Because a fund of funds may invest in hundreds of startups across many various stages of venture capital and industrial sectors, this can also offer better diversification. Moreover, a fund of funds may present less risk than investing in private equity directly due to its size and diversity.
Because of SEC regulations on holding illiquid securities, mutual funds are limited in their ability to make direct investments in private equity. Up to 15% of a mutual fund’s assets can be invested in illiquid securities without violating SEC regulations. The regulations of most mutual funds often prohibit investment in illiquid equities and debt instruments. For this reason, private equity mutual funds usually take the form of fund of funds.
The extra cost to the fund or fund management is a negative aspect. The minimum investment required to participate may be anything from $150,000 to $2,000,000, and the management may not allow you to do so unless your net worth is at least $1.5 million.
Private Equity ETF
There is an option to invest in private equities by purchasing shares in an ETF that follows an index of publicly traded businesses doing so. Minimum investment requirements are moot when buying shares through the stock exchange.
In contrast to making a direct investment in private equity, the management fees associated with an ETF are similar to those of a fund of funds. In addition, a brokerage fee may be charged whenever you buy or sell shares.
Special Purpose Acquisition Companies (SPACs)
Publicly traded shell corporations are another option for investing in private-equity investments in undervalued private businesses; however, these investments are more speculative and thus more dangerous. One potential issue is that the SPAC may only invest in a single company, limiting the benefits of diversification. In addition, the IPO statement suggests that they may be racing against the clock to raise capital. That can lead individuals to invest without thoroughly investigating the opportunity.
Investing in private equity carries several significant dangers. Smaller investors may pay more fees than they would with more traditional investments like mutual funds if they choose private-equity investments, as was indicated before. As a result, profits can go down. Another concern is that as access to private equity investing expands, it may become more difficult for financial institutions to identify promising investment opportunities.
In addition, you may not be able to make an apples-to-apples comparison with other investments because of the short track records of some assets in private equity vehicles with lower minimum commitment requirements. In addition, you should be ready to make a long-term investment of at least ten years; otherwise, you risk losing out when businesses emerge from the acquisition period, become successful, and are eventually sold.
However, there may be additional dangers for businesses focusing on a single sector. Many corporations, for instance, limit their investment activities to those in the high-tech industry. A few of the potential dangers they face are:
- Taking a chance on new technology: will it actually work?
- There is a chance that a new market won’t form for this technology, which is called a “market risk.”
- The potential for the company’s management to create a viable strategy is a risk.
Investing 2%-5% of your portfolio in private equity carries some risk, but the potential rewards might be substantial if you’re ready to take the plunge.
A recession is a period of economic decline, where there is a sustained decrease in economic activity, income, and employment.
Public equity refers to investments made in publicly traded companies that are listed on a stock exchange. In contrast, private equity investments are made in companies that are not publicly traded.
Private equity investments typically last between 7-12 years, based on the fund and multiple stages such as sourcing, acquisition, management, and exit.
Evaluating potential returns focuses on analyzing the rates of return, along with considering the duration and structure of the investment.
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