If you’re an avid investor, you must have heard about private equity investments. It is a category of capital investments made into private companies and is one of the best investment options for individuals looking to diversify their portfolios.
Private Equity(PE) is a business funding method used by a wide range of businesses to help them grow. In fact, in the first five months of 2021 alone, the deal volume of private equities increased almost 22%, resulting in over 2,300 deals.
With a remarkable history of consistently higher returns and a drastic increase in popularity, it’s no wonder why many investors are looking to invest in private equities. Typically a form of medium to long-term funding, private equity allows accredited investors and investment firms to take on more risk in exchange for higher returns while diversifying their portfolios.
But what exactly is private equity, how does it work, and how to invest in private equity? These are lingering questions in the mind of every average investor. Fret not, in this blog, we will shed light on private equity investments and how you can successfully invest in private equities.
Let’s dive in.
What is Private Equity?
A private equity fund is a pooled investment provided by private equity firms, allowing a group of investors to combine their assets to invest in a company or business. It is a form of financing in which a private equity firm invests money in a company in exchange for equity or an ownership share.
Private equity is mostly a majority investment where the investor buys a controlling share(more than 50%) in a company or a business. However, some private equity firms also provide minority investments.
Private equity is often grouped together with hedge funds and venture capital as an alternative investment. Investing in private equity usually requires investors to commit significant capital for years, which is also the reason why it is only accessible to accredited investors and individuals with high net worth.
However, private equity is quite different from venture capital as it is more suited for mature businesses, often supporting management buyouts, instead of startups. It can be quite beneficial if the right conditions are met. While businesses can receive the investment and expert guidance required to flourish, investors can potentially earn a significant return upon exiting their investment.
Key Parties in Private Equity Investments
At a basic level, private equity investments involve three major parties. It is important to understand who they are and what roles they play before you can start investing in private equity-
- The investors who provide the capital(Individual Investors)
- The private equity firms that manage and invest the money(PE Firms)
- The company receiving the investment
Also known as retail investors, they are individuals who provide investment capital in hopes that they will receive significant returns over time. After the firm has invested its capital, they are typically known as a limited partner. A limited partner is protected from the possibility of losing more money than the original investment. High net-worth individuals, pension funds, and institutional investors are common examples of individual investors.
Private Equity Firms:
They take money from various limited partners, pool it, and make strategic decisions about how to invest it. These firms are also known as General Partners. Typically, there are three major types of private equity investment strategies-
- Venture Capital: Investment in an early-stage startup
- Growth Equity: Investment in a middle-stage company’s growth
- Buyouts: Buying a mature company with the objective of internal improvement
Most PE firms usually employ one of the three strategies or in some cases, invest across all three. As the return on investment depends on a company’s performance, private equity investments are long-term investments with a minimum tenure of at least 10 years. While this can be a drawback for some investors as you can’t access returns until the exit period, a long-term investment also provides peace of mind, acting as a passive investment.
Investors contribute the capital, private equity firms pool, manage, and invest the capital, and the companies use the capital to generate returns for their investors. After a particular time period, returns are paid out to the General Partners and split among limited partners based on their original contribution.
Who Can Invest in Private Equity?
Many retail investors often ask ‘Who can invest in private equity? While it can be a great option to diversify your portfolio with the potential for high returns, traditional private equity funds often have very high investment minimums, ranging from a few hundred thousand dollars to several million dollars. Because of this, private equity investments are often reserved for high-net-worth individuals or institutional investors like pension funds or private equity firms.
In addition to the high investment minimum, you will also have to qualify as an accredited investor, which means having a net worth(individual or combined with a spouse) of $1 million or an annual income of $200,000 each for the last two years.
Moreover, investors are also required to provide documented proof that they can sustain their income for at least 2 or more years.
How Does Private Equity Work?
Now that you understand the basic concept of private equity investments and the parties involved, let’s see how private equity works.
Suppose you invest $1 million through a private equity firm. The PE firm will collect your money and pool it with other investor’s money in a private equity fund. The pooled capital is then invested in various private equity instruments like venture capital, buyouts, growth capital, and more.
Private Equity Strategies: How to Invest Your Money?
While there are various strategies for investing in private equity, you can use the following criteria to differentiate between the three major strategies- venture capital, leveraged buyouts, and growth equity.
Strategy 1: Venture Capital
Venture capital firms raise money from institutional investors like pension funds, endowments, or family offices and invest it in early-stage startups with high growth potential in exchange for an ownership stake.
While most Venture Capitalists expect nearly 50% of their portfolio to plummet, if they invest in the next big company like Google or Tesla, they can still earn potentially higher returns. This strategy often attracts quite a different group of professionals compared to other categories within private equity. Most business executives like former CEOs, product managers, Vice Presidents, and Engineers likely invest in startups with high growth potential.
Venture Capital can be further categorized into 4 stages- seed stage, early stage, late stage, and pre-IPO stage investing, the latter two being more like growth equity.
- Size: Most venture capital firms have around $10-$20 billion in assets under management across all funds. Mid-sized VC firms have around $1 to $5 billion, and smaller firms have around tens to hundreds of millions.
- Stage of Investment: Early stage to growth stage
- Industry: Heavily focused on technology and healthcare. Some VC firms also invest in retail, education, cleantech, and other industries.
- Investment Strategy: Minority-stake deals. Focuses solely on growth and higher returns.
- Geography: Diversified. Most investing takes place in North America and Asia.
Strategy 2: Growth Equity
Growth equity is when a firm invests minority shares in a company with an established market and business models that require additional capital to fund a particular expansion strategy. It is also known as ‘growth capital’ or ‘expansion capital’
Unlike venture capital, there is limited risk in growth equity as the company will not ‘outright’ plummet. In the worst-case scenario, your investment will grow less than you expect. Most growth equity firms buy secondary stakes in the company by purchasing it from employees or other investors.
In growth equity, companies often receive no cash or minimal cash as the focus is on picking the best companies and finding ways to boost growth outside of additional capital. However, firms that operate like late-stage venture capitalists do invest capital to support the growth and expansion of firms.
- Size: Tens of billions of dollars in assets under management. The top growth equity firms are at over $30 billion. Smaller and newer firms could have a few billion or hundreds of millions.
- Stage of Investment: Growth Stage( anywhere from just achieved market/product to ready for an IPO)
- Geography: North America with a special focus on emerging markets.
- Industry: Technology and Healthcare. Some firms also invest in media, telecom, retail, and financial services.
- Investment Strategy: Minority-stake deals. Focuses on accelerating growth.
Strategy 3: Leveraged Buyouts
Unlike Venture Capital or Growth Capital, which involve minority-stake investments in startups or growing firms, leveraged buyout firms focus on acquiring majority control- usually 100% ownership of mature and established companies.
LB firms invest a combination of debt and equity to improve their potential IRR, more debt means they have to contribute less of their own capital. The split of debt/equity varies based on the industry and the geography. The total amount of debt is usually based on a multiple of EBITDA and not the total purchase price.
Returns from leveraged buyouts are mostly focused on financial leverage as the companies are already mature and there are only limited growth opportunities. This is like a double-edged sword, while leverage enhances returns, a highly leveraged deal can turn out to be a disaster if the company performs poorly.
Some LB firms also aim to improve the company’s operations through restructuring, cost-cutting, or price increases. However, these strategies have become less and less effective as the market has become more saturated.
Moreover, the targeted IRR(internal rate of return) on leveraged buyouts have also dropped over time. It used to be around 30% but has fallen to 20-25%, especially on larger deals.
- Size: The largest private equity firms have hundreds of billions in AUM. However, only a small percentage of those are devoted to LBOs
- Stage of Investment: Mature Companies
- Geography: Highly-diversified. Less activity in frontier and emerging markets as fewer companies have stable cash flows.
- Industry: Diversified. Most firms avoid industries like biotech as they are too speculative.
- Investment Strategy: Financial engineering, operational improvements, roll-ups and industry consolidations.
These are the three basic strategies to invest in private equity. Now that you have an understanding of the basic strategies, let’s learn how to invest in private equity.
How to Invest in Private Equity? Step-by-Step Guide
Understand the Basics of Alternative Investments
Before starting your private equity investment journey, make sure to acquire a basic understanding of alternative investments. In theory, alternative investments are any investments besides stocks, bonds, or cash. Private equity is one of the many strategies that comprise the alternative investment asset class.
If you are having trouble understanding, you can opt for online courses on alternative investments to gain a comprehensive understanding of the field.
Become an Accredited Investor
After understanding the basics of alternative investment, the next step is to become an accredited investor. Most fields of alternative investments like private equity, hedge funds, and some types of real estate require you to be an accredited investor.
In order to qualify as an accredited investor, the United States Securities and Exchange Commission has the following criteria-
- Have an annual income of $200,000($300,000 combined with a spouse) in each of the last two years. You are also required to show proof that you can sustain this income for at least two or more years.
- Have a net worth of $1 million(excluding the value of your primary residence) either individually or with a spouse.
You can’t invest in private equity or alternative investments if you don’t qualify as an accredited investor. This is because alternative investments like these often have a very high investment minimum. You can still choose to invest in traditional investment vehicles like stocks, bonds, real estate, etc.
If you fall into this category, you have to share financial statements with the firm you invest with to verify your net worth and income.
Research and Choose a Private Equity Firm
This is virtually the most important step in the process as the firm you select will be responsible for allocating your investment capital and controlling investment decisions. While many private equity firms spread investments across industry and strategy, they also often occupy niche intersections.
Make sure to make a decision based on your knowledge, experience, and personal requirements. For instance, if you are looking to invest in tech-based companies, find a firm that specializes in technology.
It is also crucial to conduct your due diligence and research a firm’s previous investments and the returns provided to its limited partners in the past. You can find all the information in a firm’s portfolio. You can also go through the firm’s corporate social responsibility reports which provide details about the companies it chooses to invest in.
Another important factor to consider is the minimum investment requirement. The standard minimum investment requirement for private equity is close to $25 million. However, most firms have deviated from such a high investment minimum to attract more investors. Some private equity firms even offer minimum investments as low as $25,000.
Once you have selected a firm suitable to your interests, the next step is to establish connections in the field. Most HNIs use family offices, which are basically privately held companies that handle investments for ultra-wealthy individuals.
Track the Progress of the Industry
After selecting the investment firm, verifying your credentials, and making your investment, the control of your investment will be managed by the private equity fund manager. Although you won’t see any returns for the first few years, you can still track the industry trends to stay updated on your investment
While private equity investments may seem lucrative at first glance, there are several risks associated with it. For starters, the fees of private equity investments for smaller investors can be higher than what you would normally expect from traditional investments. Moreover, the more people invest in private equity, the harder it becomes for private equity firms to locate worthwhile investment opportunities.
Investors who are interested in private equity should also be prepared to commit their money for at least 10 or more years otherwise you may lose out as companies emerge from the acquisition phase, become profitable, and are eventually sold. Despite its drawbacks, if you are willing to take these risks, the potential returns of investing in private equity can be huge.
Frequently Asked Questions(FAQs)
Ans. You are required to become an accredited investor for investing in private equities. To qualify, you must have an annual income of $200,000 for at least two years. Or you can have a net worth of $1 million(excluding the value of your primary residence). However, if you don’t meet these criteria, you can indirectly buy into private equity through investment vehicles like ETFs, publicly-traded PE stocks, and funds of funds, that invest in private equity.
Ans. A private equity fund is managed by the private equity fund manager also known as the General Partner. The GP also makes all of the fund’s investment decisions and contributes 1% to 3% of the fund’s capital to ensure he has stakes in the game. In exchange, they earn a management fee of 2% of fund assets and may be entitled to 20% of the fund’s profits above a preset minimum.
Ans. While private equity funds are exempted from regulation by the Securities and Exchange Commission(SEC) under the Investment Company Act of 1940, their managers are subjected to the Investment Advisors Act of 1940 as well as the anti-fraud provisions of federal securities law.