In recent years, the private equity sector has attracted a lot of attention, especially from high net worth investors asking, “Should I invest in private equity?” These investments are in private, non-publicly traded companies, so many investors in mutual funds and stocks don’t necessarily have access to this sector. Private equity firms you’ve probably heard of include The Blackstone Group and The Carlyle Group.
Mechanics of investing in private equity
Typically, private equity investors are investing for ownership in mature businesses. Ordinarily, they claim to invest to maximize the company’s value and then sell it at a profit. In this, they’re similar to venture capitalists (VCs).
However, unlike VCs, they usually purchase a majority ownership stake of 50% or more in the target company. Private equity firms own several businesses, known as portfolio companies, at the same time. It’s diversification in action, avoiding putting all their eggs in one company’s basket.
The strategy for private equity firms is to raise money from limited partners (LPs) to form a private equity fund. Once the capital goal has been reached, the fund closes. It then invests in the portfolio companies they’ve targeted. The firm’s team begins the work of turning around the portfolio companies and bringing them to profitability.
The ideal candidate for private equity investment is a company that’s either stagnant or in some trouble but, with some capital and management oversight, has the potential for good growth. It does take time to turn troubled companies around, and the lifespan of a private equity fund is typically ten years. It’s not a fast cash strategy.
When the fund successfully sells a portfolio company, profits are returned to the LPs after fees. On occasion, the company goes public instead.
Who can invest in private equity?
It’s been a somewhat exclusive club for a long time because many investments are only available to accredited investors. The SEC doesn’t regulate Private companies that don’t trade on a public exchange.
Therefore, accredited investors must have a net worth of at least $1 million and an income of $200,000 or more ($300,000 for married couples) over the past two years. These investors have to have more investing experience and therefore are up to doing their research and making decisions about private firms.
The buy-in for traditional private equity is usually pretty significant as well. Though some funds allow a minimum contribution of $250,000, others require millions.
There are some other ways to invest for those who don’t meet the accreditation minimums. Equity crowdfunding allows you to buy an ownership stake for as little as $2,000, depending on income. As a bonus, the SEC regulates these platforms.
Or you can buy shares of private equity ETFs (exchange-traded funds). They’re publicly traded, like all ETFs, but invest in private companies.
Types of private equity to invest in
Often the deal is done via leveraged buyout or LBO. The purchase involves both equity and plenty of debt (hence the “leveraged”), which the company eventually must repay. Once the company regains and improves its profitability, the debt becomes less of a burden.
Another type of private equity investing is “distressed funding,” which involves companies filed for Chapter 11 bankruptcy. Sometimes the goal of the fund is to restructure the firm and turn it around to sell at a profit. Other times it’s to strip the business for spare parts and gain on the assets, which is why some private equity firms have a bad reputation.
Venture capital is a type of private equity investing. Unlike other private equity funds, however, VCs usually don’t buy an ownership stake. They go after promising new businesses to take to profitability and sell instead of mature ones.
Finally, there are specialized LPs, which often invest in real estate. Most of their investments are in commercial or multifamily real estate. Specialized LPs may also take on infrastructure projects like bridges and roads.
Advantages of private equity investing
Potentially high reward
Because these are private companies, the information publicly available is minimal. Good private equity funds have a substantial investment team that picks great candidates for turnaround. The potential profit from rescuing a portfolio of troubled businesses and turning them around is massive.
As a limited partner, you’ll just be sitting back and letting the money flow. The fund’s investment team are the general partners (GPs) doing all the work.
Disadvantages of private equity investing
Unlike public investments that trade on an exchange, you can’t just sell your stake in the fund any old time you feel like it. Investors are usually required to keep their money invested for a minimum of three to five years.
That allows the GPs to work their magic, but it also means that money is not available to you if you need it.
Think mutual fund fees are high? If so, you might get blown away by the payment structure of private equity, which is similar to hedge funds. They’re allowed to charge an unlimited amount of fees because SEC doesn’t regulate them, unlike mutual fund managers.
Performance bonuses are standard for the GPs in a private equity fund. The fee structure is usually the “2 and 20” approach. The annual fee is 2% AUM (assets under management) with a 20% performance bonus on the profits.
Potentially high risk
As you know, there’s no free lunch in investing! The high potential upside comes along with a high potential downside. Even a talented team isn’t guaranteed to turn every company around, and you could very quickly lose money in this investment.
With publicly traded stocks on an exchange, it’s tough to fudge prices or performance. However, private equity firms typically use IRR (Internal Rate of Return) to demonstrate performance. However, that number isn’t realized until the business is sold.
Therefore, over the life of the fund, they’re reporting interim, estimated IRRs. They can pick and choose comparable businesses to generate a number that looks better than the ultimate return.
Ways to invest intelligently in private equity
Skip the funds and their high fees
Investing directly into a firm allows you to avoid all the layers of the management structure. If you still prefer a more passive investment, use private equity ETFs.
Commit capital to specific deals
Instead of investing in one fund, you can agree to buy in deal-by-deal. This way, the management fees don’t start ticking until the money is invested. Not only that, you decide which deals you want to be a part of.
Diversification across GPs
Just as you diversify your stock investments in different companies and funds, do the same for your private equity investments. Research the fund managers and make sure you’re comfortable with their style.
Are you interested in further diversifying your portfolio? Please feel free to give us a call at 619.255.9554 or email us to set up an appointment.
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