How to Invest in Private Equity

There are two main ways to invest in private equity. The first is to invest through a private equity firm. This is the most common way to invest in private equity assets. However, it is also restricted to investors who are wealthy or experienced enough to qualify as accredited investors. The second way is to invest in ETFs and other funds that track the performance of private equity firms and related investments. This option is generally available to all investors, so it is by far the most accessible option. Here’s how it works.

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What Is Private Equity?

Private equity is a form of direct investment in companies. It exists outside of the stock market (or public equity markets), meaning that private equity assets are not publicly traded (hence the name). Instead, private equity firms make individual deals with the companies that they are buying or investing in.

While there are several different ways that private equity can work, in most cases a firm will make one of three main types of investments:

Startup Funding – The private equity firm will directly invest in a new or emerging company, funding it in exchange for ownership or a stake in future profits.
Venture Capital – The private equity firm will directly invest in an existing company, providing it with additional funding in exchange for ownership or a stake in future profits.
Acquisitions and Leveraged Buyouts – The private equity firm will purchase an existing company. The goal will be to make changes to this company and then re-sell it (either whole or in parts) for more than it was worth at the time of acquisition.

For example, you might invest $10 million in a private equity firm and express an interest in technology startups. The firm would pool your money along with its other investors in the tech startup portfolio and go looking for relevant opportunities in the market at large.

Now, say that the private equity firm finds XYZ App, a startup company looking to launch the next big app. The firm might provide XYZ App with $50 million in startup funding in exchange for 10% of the company. If the app succeeds, that 10% will be worth more money. That will increase the value of the investment portfolio, and you would get returns based on your proportional share in that portfolio.

What makes this transaction different from buying stocks is twofold: First, our app company was not publicly traded. This firm did not trade stocks on a secondary market like the NASDAQ or NYSE. Second, the private equity firm reached an individual deal with the company to fund it in exchange for a share of ownership. Unlike with publicly traded stocks, where investors chiefly make trades among each other, the private equity’s money went directly into the business.

Private equity is what is known as an alternative investment. This means that it is not one of the standard categories of investment products such as stocks and bonds. More importantly, private equity firms do not invest in products that receive standard Securities and Exchange Commission oversight. These are not publicly traded securities, and so do not have the same level of scrutiny and protection.

There are two main ways to invest in private equity: direct investment and ETFs.

Direct Investment in Private Equity

Direct investment in private equity means that you seek out a private equity firm and invest your money with them.

Per our example above, structurally this is not dissimilar to investing in any other fund-based asset. You buy shares of a private equity firm’s portfolios based on their options, your interests, and your risk tolerances. The firm will then pool your money with the rest of that portfolio and use that capital to make investments. The portfolio will generate returns based on the performance of its underlying investments, and you will receive a percentage of those returns based on your share in the portfolio.

The main difference is that, with private equity, the fund directly invests in other companies rather than publicly traded assets. (Although in the case of an acquisition, the private equity fund may purchase public shares of stocks to acquire the target company.)

The rewards of private equity can be high (imagine getting in on the ground floor of Facebook). However the risks are equally high (imagine getting in on the ground floor of Friendster). As a result, direct investment in private equity is restricted to accredited investors. This is generally defined as an investor with more than $1 million in assets or a minimum household income of $200,000 for single people and $300,000 for a married couple.

In addition, because of the scope at which private equity works, most firms require very high initial investments. It is common for private equity firms to require a minimum investment of between $10 million and $25 million up front.

If you qualify as an accredited investor and have the capital, the next step is to contact private equity firms and start looking for firms that match your interests. Major firms include The Carlyle Group, Blackstone and CVC Capital Partners. If you have an existing broker relationship, also consult with them for recommendations. You are looking for a firm that matches your needs in terms of investment categories and risk management, so don’t rush into anything.

Although, if you have $25 million lying around with which to invest, it’s unlikely you need us to tell you about money management.

ETF Investment in Private Equity

Most investors will be legally disqualified from investing in private equity directly, not to mention practically disqualified by the high capital requirements of this field. However there are many exchange-traded funds, or ETFs, which are built to track the performance of private equity firms. They can do this in several ways. For example, an ETF might invest in companies that themselves invest in private equity firms; it might invest in companies funded or acquired by private equity firms; or it might directly invest in private equity firms themselves.

Regardless of the underlying structure, an ETF attempts to track the performance of private equity firms. The goal is to give you exposure to this market without the high entry requirements of direct investment. It is rare, if ever, that an ETF can provide the same kind of high returns that direct investment does.

The Bottom Line

Private equity is a form of investing in which firms directly invest in companies, such as through startup funding and venture capital. While direct investment in private equity is restricted to accredited investors, you can invest in publicly traded ETFs that give you exposure to this market.

Tips on Investing

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