Private Equity: What are PE Funds & How Does It Work?
A Complete Guide To Private Equity Investment
As an investor, you are most likely very conversant with stocks. However, most financial experts advise scattering your investments to include alternative assets such as private equity . Alternative assets investments act as risk hedges to help investors achieve a balanced portfolio.
Private equity investment re fers to investment in private rather than public companies. But then, there is much other information about private equity you may need to have before you invest in this alternative asset class. In this guide to private equity investment, l et's find out all about private equity.
What is Private Equity?
Private equity is a type of alternative investment involving funds not invested in private companies. In other words, private equity is composed of money that is not traded on a public exchange.
Institutional and retail investors pool their funds to invest directly in private companies or engage in buyouts of publicly traded companies. In the latter case, the result is usually the company's removal from the public exchange (delisting of stock).
Private Equity VS Public Equity
Private Equity
Information
Not under a legal obligation to publish its financial information or make stocks available to the public.
Investors
Only institutional or accredited investors can invest eligible to invest in private equity . This set of investors is usually high-net-worth individuals.
Ownership
Ownership is in a private company; companies not listed on the exchange.
Strategy
Multi-year strategic planning
Structure
Retains entrepreneurs and skilled managers through equity participation.
Public Equity
Information
Public equity is heavily regulated by the government and mandated to publish its financial information.
Investors
Investment is open to all members of the public.
Ownership
Ownership is in a public company; companies that are listed on the exchange, allow the public to buy their shares.
Strategy
Focuses on quarterly earnings.
Structure
Traditional incentive structure.
Who Can Invest in Private Equity?
Unlike public equity, not everyone is eligible to invest in private equity. And the reason is not far-fetched; the information of the private markets is not as transparent and easy to access, and it comes with a large ticket size starting from a million USD. The types of investors that are eligible for private equity investment include:
-Institutional Investors
Institutional investors include commercial banks, credit unions, central banks, and different investments that pool investors' funds to invest in several financial instruments for profit. Institutional investors are usually legal entities, meaning they exist separately from their owner(s).
It is, therefore, safe to say that institutional investors are organizations that invest on behalf of their members.
-Professional Investors/ Accredited Investors
According to financial regulation laws , professional investors, or in some countries called accredited investors have a unique definition, although differing by country. In Hong Kong, a professional investor can be:
- Individuals, either alone or with any associates on a joint account, having a portfolio of not less than HK$8 million or its equivalent in foreign currency; or
- Corporations or partnerships have either a portfolio of not less than HK$8 million or total assets of not less than HK$40 million;
Generally, professional investors/ accredited investors are considered to have more in-depth knowledge of financial management and can handle the types of advanced investments.
Advantages of Private Equity
For businesses, private equity can be instrumental in these ways:
- A handy solution for raising capital without applying for loans or trading the company publicly.
- The use of skilled managers in private equity enables the company to focus more on overall growth.
- It brings about operational changes to promote growth in the business.
For investors; both retail and institutional, private equity :
- Offer an opportunity to achieve high returns as they can start investing in a business in an earlier stage before it grows to a stage that is ready for public listing.
- Chance to invest in privately-owned companies that has a strong potential such as the business ventures owned by Elon Musk including SpaceX and Neuralink.
- Freedom from the long list of conditions and restrictions of trading on the public market.
- Offers financing and tax advantages.
Disadvantages of Private Equity
From a business perspective:
In contrast to public equity, there may be a limited number of potential investors, making it difficult to raise funds.
- Private equity investments may affect the business and administrative structure of the private company.
- Private equity invested ofte n demand majority stake, which may result in loss of ownership stake.
From the perspective of investors:
- Information of private equity investment is difficult to access, there’s no certain channel to obtain the most updated market information. The opportunities and updates are always circulated among certain stakeholders of a specific deal and the market insiders.
- Private equity investment is a long-term investment; it may take 5-10 years to liquidate. Not every investor may be willing to wait that long.
- It comes with a large minimum investment in many cases, which may involve a significant amount of money from millions of USD.
How Does Private Equity Work?
Private equities invest in private companies. However, this does not mean that they invest in any available private company. Private equities invest in private companies with the potential for returns.
This includes promising startups, growing companies, and distressed companies. The motivation for startups is that the company will reach its maximum potential and produce a profit with sufficient funding. More funds would boost business activities for established or growing companies, leading to more profits.
For distressed companies or companies on the verge of failing, private equity funds usually restructure them and sell them out or trade them in public markets. The ultimate intention of private equities towards investing in different private companies revolves around profit.
Hence, they may decide to buy an underperforming private company, restructure and grow them and then sell them later or trade them publicly for profit. Alternatively, private equities may invest to gain ownership in the company.
This ownership entitles the investors to a share of the profit. Private equity firms do not run the businesses they invest in. Since the aim is maximum returns, they employ the beat hands - skilled managers to manage the investment.
They usually set out and work with a realistic growth plan with a time limit. This strategy helps the management to have a focus and take strategic actions that are directed toward growth.
What is a Private Equity Firm?
Private equity firms manage investments in private equity funds for a fee. Initiate d in the 1970s and 1980s, private equity firms provide a way for companies to make extra funds to support business growth. Private equity firms are divided into; general partners and limited partners.
General Partners (GP) concern themselves with the management and movements of funds.
Limited Partners (LPs) take on the responsibility of providing the funds for the firm's running. LPs are usually individual third-party and institutional investors, including insurance companies, pension funds, retirement funds, endowment funds, and high-net-worth individuals (HNWIs).
What are Private Equity Funds?
Private equity funds refer to funds that private equity firms manage. These funds pool the invested funds and invest them on behalf of the investors. Also, these funds are actively managed; by skilled investment managers.
Private equity operates similarly to mutual funds or hedge funds from the above two characteristics. However, a private equity fund maintains its peculiarity by investing in long-term investment assets; for ten years or more.
Types of Private Equity Funds Strategies
Types of private equity funds strategies include:
#1. Venture Capital (VC)
Venture capital (VC) invests i n startup companies, providing seed funding to support growth. In return for the funding, the venture company gets a share of the company.
#2. Buyout or Leveraged Buyout (LBO)
A buyout is an acquisition of controlling interest in a company. Buyouts occur when a private company thinks that a publicly-traded company is undervalued or underperforming. They may choose to buy the company.
#3. Distressed Funding
Distress funding refers to investment in troubled companies or underperforming companies. Distress funding strategy aims to find these companies' loopholes and make necessary changes to make the company more profitable.
#4. Real Estate Private Equity
Real estate private equity is an alternative investment that invests in the real estate markets. Real estate private equity investment includes acquiring, financing, and ownership of properties through an investment fund. Real estate private equity is professionally managed.
#5. Fund of Funds
Funds of funds invest in other funds, usually mutual funds and hedge funds. Instead of investing directly in stocks or bonds, this type of fund invests in funds already invested in these securities. Funds of funds investment are often referred to as multi-manager investment.
#6. Growth Equity
Growth equity is an investment in established companies to enable them to expand their activities further. So, growth equity becomes necessary when a growing company needs additional funds for expansion.
Things to Note Before Investing
Before you start investing in private equity firms, here are some things to keep in mind.
Illiquidity
Private equity is not the best investment pick for investors with short-term goals. The investment horizon of private equity is usually between 5 to 10 years or more. This means that the investor will have to wait a long before they liquidate their investment. Trading of private equity in the secondary market is also possible in some cases.
Fees and Expenses
Fees and expenses in private equity investments are usually higher than in public equities. The high fees result from active management of the investment; private equities commit the management of investments to experienced individuals to ensure that the goal of making a profit is achieved.
The fees and expenses you will encounter in the investment are contained in a document known as an offering. Typically, an offering contains the details of the agreements and terms that govern the investment.
Conflicts of Interest
Private equity firms often have interests that conflict with the funds they manage and, by extension, the limited partners invested in the funds.
Altive: Gain access to the strong return potential of private equity investment
According to McKinsey’s Private Markets Annual Review (Mar 2022) , private markets fundraising has reached a new high in 2021 and was up by nearly 20 percent year over year since 2003 to reach a record of almost $1.2 trillion. And the internal rate of return (IRR) of private equity has hit 27% i n 2021, making it the highest-performing private markets asset class of the year.
Although the return potential sounds promising, the lack of market information and large ticket size is still the hurdles for the majority investors tapping into private equity investment. Founded by former fund managers, Altive is aspired to unlock private markets investment opportunities to professional investors with a small ticket size from USD100k.
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