Private Equity: How to Start Investing
Private equity is a form of investment shrouded in mystery. It refers to any investment taken outside of the public stock markets where investors gain an ownership stake in a private company or asset. Private equity investments are typically made by accredited investors, family offices, or investment firms but there’s been a trend following the JOBS Act to open up private equity to retail investors.
Private equity can sometimes involve investing directly into the target company but often involves investors pooling their resources into a fund and then making investments from the fund into the target company.
How private equity works
If you’re investing in a private equity fund, the fund pools its resources from the various limited partners (LPs). A single general partner (GP), usually the private equity fund managers, make decisions with respect to the entire fund, including deciding where and when to make private equity investments. Those investments generally following four forms: buyouts, growth equity, venture capital, or real estate (more on that below).
In addition to meeting the accredited investor requirements, you also need to invest the minimum amount required by the fund. Private equity investors often raise multiple funds, and you’ll see common names like Private Equity Fund I, Private Equity Fund II, etc. Each fund has a lifecycle, anywhere between 3-10 years, where the fund raises capital, identifies investments, makes investments, exits investments and ultimately returns money to the investors.
The limited investors have no role in the day-to-day operation of the fund or the investment decisions. In exchange for the general partner’s work, the general partner often operates on a “two and 20 scale” which equates to a 2% annual fee of assets under management and a 20% cut of the profits generated by the fund. To use a real number example, a $1 million fund that liquidated its assets after three years for a total liquidation value of $4 million would see the following fees: $1 million × 2% × 3 years = $60,000 and $3 million × 20% = $600,000. The initial $1 million would be distributed as a return of capital to the initial investors and the remaining $2,340,000 would be distributed to the limited partners in the form of profits.
Types of private equity investments
Following a contribution to a private equity fund, the general partner can use your contribution in different ways to generate profit. The types of investments made by a fund are typically known in advance, so you are unlikely to be surprised that a real estate fund invested in a Silicon Valley tech startup.
Here’s a summary of a few common private equity investments.
A buyout is when a private equity firm buys an entire company with the hope of selling it in the future for a profit. The target company can be private or public (i.e.. a “go private” deal). The buyout involves the private equity firm taking complete ownership of the company with the intention of managing and operating the business. To secure the deal, a private equity firm may use a mix of equity provided by the fund and debt provided by a lending partner (i.e. a leveraged buyout).
Buyouts can happen for a variety of reasons. The private equity firm may have identified a company where they believe they can improve its management or operations (i.e. a fix and flip). The private equity firm may have purchased the company because they want to buy several smaller companies and package them together as a bigger company (i.e. a rollup). Finally, they may believe the company is worth more if broken apart and sold into its component parts (i.e. a breakup). No matter the reason, ultimately, the private equity firm hopes to have an “exit” that allows them to generate a profit for its investors.
A growth equity transaction is when a private equity firm makes a significant investment in an existing company that generates revenue but does not take an ownership stake. There are many small to medium-sized businesses that are succeeding in their market but which lack the financial resources to grow (or grow quickly) to the next stage. A private equity firm may identify such a company and make a significant investment in the company with a caveat that the investment be used to fuel the growth of the company.
Similar to a buyout, a growth equity investment is made with the intent to “exit” the investment at some point in the future for a profit for the investors. This can typically happen if a private equity firm undertakes a buyout of the company later down the road or if the target company goes public. Growth equity investments usually take the form of “series” investment, and because the company is mature, you might see a growth equity deal as a Series “D, E or F” investment (more about Series A, B, and C below).
A venture capital transaction is similar to a growth equity deal but typically involves a smaller investment amount and is earlier in the investment “series” discussed at the end of the Growth Equity section (e.g. a Series A, B or C). Venture capital investments are made when the target company has not yet proved itself profitable or is still in the process of building its business. These early-stage startups are looking to raise cash in exchange for giving up an equity portion of the company.
In a venture capital deal, the private equity firm is looking to invest in companies with high growth potential that can be sold at a later date through a buyout or taken public through an initial public offering. Venture capital deals are usually high risk and high reward since many early-stage startups fail for various reasons.
Private equity also operates in the real estate market. These private equity funds can raise hundreds of millions or billions of dollars of capital and focus exclusively on real estate transactions. Because many real estate transactions involve multi-million dollar purchases, a private equity real estate fund gives an investor the opportunity to invest in deals that wouldn’t be possible for an individual investor (e.g. the acquisition of a $200 million building).
You may be thinking that Public REITs (Real Estate Investment Trusts) are the way to invest in the real estate market.
Why would an investor want to consider private real estate over public real estate?
Real estate is typically not strongly correlated to movements in the stock and bond market. However, public real estate investments that are traded on the exchanges have a much higher correlation to the public market because they are in fact traded on the public market.
By investing in private real estate – investments that are not easily traded in the market – private real estate investing can provide an opportunity to move away from correlation with the stock market.
Risks of private equity
Illiquid investment class
If you invest in private equity, you will become a limited partner with no control over the operations of the fund. As such, you’ll likely need to hold the investment for the long term, possibly as long as 10 years. Compared to other types of investments which can easily and quickly be converted to cash, private equity is an illiquid market that takes a significant amount of time to recognize opportunities, execute on those opportunities and (hopefully) sell those investments for profit.
Transparency and data
Private equity funds are not required to register with the Securities and Exchange Commission, so the information they disclose is not regulated by the SEC. Without this public disclosure requirement, you may not receive as much transparency and data as you would from an investment in the public markets. The target companies and private real estate transactions also do not have publicly available data, so even if the fund discloses the assets acquired, you may have little or no other additional data about the assets themselves.
Should you invest in private equity?
It’s debatable. Warren Buffett famously challenged Ted Seides, a hedge fund manager, to a 10-year bet on whether the S&P 500 index would outperform a hand-picked portfolio of hedge funds. Buffet won by a landslide.
Investors turn to private equity to diversify their holdings and to achieve higher returns than they could find in the public market.
As the private equity market expands with more companies delaying the opportunity to go public, there’s an argument that the public markets are missing out on enormous growth phases, which are increasingly happening during a company’s time in private equity.
When finding a private equity investment, identifying funds with a proven track record is critical. It’s not unreasonable to expect that certain funds have developed an expertise working in niche markets – markets that may be too small for public companies – and that investing in such funds, despite their fees, will prove more lucrative than investments in the public markets. I wouldn’t put 100% of my investment into private equity but can see it being a reasonable portion of your overall asset allocation.
How to invest in private equity
If you want to invest in private equity, you’ll need to find a private equity firm willing to take you on as an investor. This usually means meeting the private equity firm’s investment minimums and investor profile.
Occasionally there will be “feeder fund” opportunities where a fund will aggregate a bunch of high net worth individuals into a single fund and then make an investment into a larger private equity fund that may have minimum requirements that would exclude the investors individually. This approach is not without its drawbacks, as the feeder funds will add a layer of fees to the transaction.