If you have a diverse investment portfolio you’ve probably bought publicly traded stocks on the open market. But some investors operate in an alternate, well-funded investment universe. In the world of private equity, well-funded investment firms make big investments in private companies, often with the goal of taking over those companies and making them more profitable.
The Basics of Private Equity
Private equity is simply an ownership stake in a company that does not have publicly traded shares. Sometimes the company is well-established and its owners have chosen to retain total control. It also might be a new company that is not yet valuable enough to go public. In some cases, a group of investors will buy all outstanding shares and remove a company from public exchanges, which is called de-listing.
Investors on the private equity side tend to be highly selective. They target companies with lots of potential; distressed companies with valuable assets; and other specialized cases. If a private equity firm is doing the investing, it often will have business management expertise in addition to deep pockets. These firms can take an active role in restructuring or streamlining a company before selling it for profit.
Playing the private equity game usually requires lots of money up front, often hundreds of thousands or millions of dollars. Investors need abundant resources to buy in and pay top talent if they take a role in company management. They’re betting on potential value in target companies, but sometimes the companies do not become profitable. So investors also need to diversify their investment risks.
Overall, investing in private equity requires deep pool of financial and business resources. For that reason, collective action-namely private equity firms-is common and quite effective.
What Do Private Equity Firms Do?
Private equity firms are not passive investors. They often buy 100% of a target company, or at least a controlling stake, and may do a lot of work to streamline its operations, cut costs or improve performance. Also, they don’t play for keeps, because these firms buy into companies to make a profit on their eventual sales and through management fees.
PE firms buy into companies for various reasons. Some targeted companies need a financial boost to develop new products or technology. Established companies with lots of assets and serious problems are other targets. In these cases, a private equity firm may buy in and use its expertise to improve performance and increase value.It also may cut costs or liquidate the company and sell remaining assets at a profit.
Sometimes PE firms buy target companies with leveraged buyouts. The firm borrows a portion of the sale price from a third party and pays it once it sells the target company.
Private equity firms sometimes are compared with venture capital investors, but there are important distinctions between them. Whether PE firms borrow or put up their own money, they often buy most or all of the target company. Venture capitalists may take an equity stake in a company, but that stake rarely exceeds 50%. Furthermore, venture capital focuses on startups with strong growth potential and developing ideas or products. PE firms for the most part target underperforming companies with longer track records.
How Do Private Equity Firms Earn Profits?
PE firms make most of their revenue through two channels: management fees and performance fees. The management fee is based on an assessment of the company’s value and is not tied to performance (that is, firms collect no matter how the company is doing or what it’s worth). Meanwhile, the performance fee is a cut of any profit made from the sale of the target company. 20% performance fees are typical, although they vary. Management fees can run between zero and 3%. Current research suggests the average is around 1.5%
Most private equity funds have general partners and limited partners. General partners choose the investments and form the brain trust. It’s their business expertise that guides the restructuring or improvement of the target company. All others are limited partners who put up money but do not make decisions. Almost everyone involved will have high net worth.
How high? Very. Many funds have a minimum investment of $250,000. Table stakes as high as $25 million are not uncommon.
How Can You Invest Private Equity?
Some investors can provide private equity on their own, but they must own considerable assets. SEC guidelines require at least $200,000 in annual income and a net worth of $1 million for private equity investors. So most investors join PE firms as limited partners.
But there still are a few ways to start without substantial personal wealth.
You can invest indirectly in private equity through other types of funds. A few exchange-traded fund (ETF) track indexes of companies investing in private equity funds. Other ETFs may include private equity in a larger mix of investments. Funds of funds (FOF), as the name implies, invest in other funds, which may contain private equity, mutual funds or hedge funds.
You also can buy stock in a business development company. Most are companies on public exchanges that look for growing or struggling companies with lots of potential value.
As with actual private equity firms, most of these options have fees for management and performance, but they bypass the steep entry requirements. They are more sure-and-steady investments and usually can’t match the robust-and sometimes spectacular-profits PE firms can deliver.
The Bottom Line
For the most part, private equity appeals to serious and experienced investors. It often requires a lot of money up front and can carry substantial risk, which is why private equity funds spread their capital across many investment opportunities. Ambitious investors with means can invest with a PE firm directly, through participation in a larger fund or by investing in the stock of major funds. PE investments don’t always pay off, but when they’re successful they can generate large returns much faster than publicly traded stocks.
Tips for Investors
- While the high-stakes, high-dollar world of PE might not be practical for you, a financial advisor can help you put together a more traditional investing plan. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Understanding your risk tolerance and investing goals is a key part of any long-term financial strategy. Take advantage of Smart Asset’s Investment Calculator to better visualize your goals and preferences.
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