Private equity investments can be an important addition to a diversified portfolio. It has potential for greater risk and greater return than public equity markets.
Private equity markets are dominated by institutions and accredited investors, but there are opportunities for other investors to participate.
Private equity is capital funding off exchange. Investors are used to capital funding on exchanges, through the issuance of stocks or bonds for an organization to raise capital.
These investments can generally be readily sold or purchased on the public exchanges on which they are listed. Private equity, which has no such ready means of exchange, is illiquid.
What Private Equity Does
Private equity is used to raise capital for a variety of reasons. Common reasons are to purchase a public company and take it private, to invest in startups as venture capital, or to buy a division or other portion of a public company as a private entity.
Using private equity to finance these transactions has a couple of benefits.
By taking an organization private, the private equity investors can make changes and improve the long-term health of a company free from the scrutiny and short-term focus of being a publicly traded entity.
Publicly traded firms are under enormous pressure to deliver quarterly numbers that meet expectations, even when it is not in the company’s best long-term interests to do so.
Being privately held provides a degree of isolation from such short-term focus.
Private equity is frequently involved in distressed company financing. This can be in the form of a purchase of a financially troubled company or the purchase of a company or a portion of a company in bankruptcy proceedings.
Large companies may sell a division or a product line to private equity investors when that business unit is not meeting expectations or is not a good fit with the organization’s core business. This provides the selling company with capital it believes it can better use elsewhere.
Not all private equity funding goes to the acquisition of publicly held companies. There are opportunities to purchase privately held companies and grow them — either to list them publicly or to sell them to another entity. Private equity funds are frequently used in venture capital funding.
Why Private Equity
There’s a lot of money being made in private equity. It therefore attracts some of the best and brightest into its folds to put together and run these organizations.
Private equity managers put together the deals to invest into organizations and frequently dictate the path for the organization to grow and become profitable or more profitable.
They may replace managers, reduce staffing levels, or otherwise dictate steps to make the entity more valuable in the marketplace.
Private equity deals are frequently leveraged.
Leveraged buyouts are one example of the use of private equity — capital raised via private equity is coupled with debt to fund the purchase of an entity.
If the managers raise the value of that entity, their profits accrue to the investors, not to the lenders. Leverage, while adding risk, amplifies the potential returns of private equity funding.
Private equity firms typically charge an annual management fee based on the value of the capital involved. They also typically garner a larger relative share of profits in exchange for the risk they take. Other investors typically do not assume any risk beyond the potential loss of their investment.
There is mixed information about private equity’s correlation with public equity. Though some studies show low positive correlation others show high positive correlation. There does not seem to be a definitive answer, but there is consistency that the correlations are positive and less than one.
Though not ideal information, it is useful in that there is less than perfect positive correlation, which provides at least some value for diversification purposes.
Though we can comfortably say there is some positive correlation with public equity markets, private equity enjoys the advantage of being less subject to investor whims and their associated volatility. Which is at least an advantage on the downside.
How to Invest in Private Equity
Institutional and accredited investors have an advantage of direct availability of private equity offerings. Regular retail investors don’t have such access, as these are higher-risk investments with greater potential for significant loss.
Two ownership forms bear mentioning: Limited partnerships are often used for private equity holdings. The managing or general partners assume all the risk and typically receive an outsized share of gains as well as ongoing management fees.
Limited partners, which are your regular investors, have no risk beyond their invested capital.
Special Purpose Investment Companies can be used to raise capital for private equity investment. They often are used to raise funds to purchase a specific company and take it private, although they can be used in other forms.
Retail investors may not find an outlet to participate directly but can invest in some publicly traded business development companies that work in the private equity sphere.
The Bottom Line
High net-worth individuals and accredited investors can participate in private equity investments and potentially see greater returns than they might obtain with publicly traded equity investments.
They also assume greater risk when doing so.
Private equity investments are generally illiquid, and appropriate only for a modest amount of most investor’s capital.
Regular retail investors have fewer options, but still can invest through ownership of publicly traded companies that make private equity investments.
They may not have the upside of investing directly, but they don’t have the same risk either.
Private equity has enjoyed significant growth in the last couple of years. There is the distinct possibility of some increased availability for retail investors through oversight changes. Meanwhile, the average investor still has some opportunity to participate through public equity firms that make private equity investments.