Private equity (PE) has become increasingly popular with the media and investors alike. Since its early days, the asset class has grown swiftly. Many investors tend to write off private equity altogether because, like most financial investments, it initially seems complicated and inaccessible. In reality, though, it is neither of those things. This guide will answer all your questions about private equity and how it works, helping you decide how it may fit into your portfolio.
Table of contents
What is private equity?
Before we get into the specifics, we must first examine the alternative asset class. The category of alternative investments covers all types of non-traditional asset classes. Assets categorized as cash, publicly traded fixed income, or equity assets are traditional investment assets. Private equity does not fall into this conventional bucket. Instead, considered an alternative investment class sub-category.
Private equity represents an investor’s stake in non-public businesses. A non-public company does not trade on the stock market, and private individuals or private equity firms finance its operations.
As a simple example, consider how the founders and early investors of a business may support the company’s growth and be provided shares in exchange for capital financing. The investors’ stake is private equity, provided the company does not also sell shares to other investors through a public stock exchange.
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What are the benefits of private equity?
From a corporate perspective, it is advantageous to accept financing by issuing private equity. It can allow the business to access capital without the stock market pressures. Publicly traded companies must report their earnings quarterly. Investors can punish firms when growth strategies do not pay off immediately. This reporting requirement can be onerous. Having your financials scrutinized quarterly for a long-term strategy can often lead to sub-optimal results.
Private equity is not only beneficial for the underlying company, but it is advantageous to the investors as well. As with most alternative investments, private equity allows a valuable opportunity for diversification within an investor’s portfolio. since alternatives do not have the same risk and return profile as traditional investments. Including private investments within a portfolio can often boost risk-adjusted returns over the long term, due to higher returns. Investors can also demand a liquidity premium because private equity shares are less liquid than those selling on the public markets.
How does private equity work?
From an investor’s point of view, the process begins when they commit to a private equity firm for a specific amount. The firm then uses these funds to provide financing to a non-public company. In the case of a private equity fund, multiple non-public companies. Investors will benefit as the underlying company grows.
Usually, investments into private companies are for a more extended period. Investors must commit funds for a set time frame — often years. Down the line, once the underlying company is sold to another investor or becomes publicly traded through an initial public offering (IPO), the initial investor will receive a return on their investment based on the private company’s growth.
Who invests in private equity?
Historically, institutional investors — including private equity firms, pension funds, and endowments — have dominated the private equity space. This is because institutional investors had large sums of money and found significant diversification and return benefits associated with private equity. Today, the asset class has expanded but is still heavily relied on by institutions.
For example, as of March 31, 2021, the $497.2 billion Canada Pension Plan fund (CPP) had allocated 26.7% to private equity holdings. Unless you had access to hundreds of millions of dollars, private equity was often out of reach for many investors.
Recently, the asset class has become more accessible to individual investors, especially if they are considered accredited investors. These investors usually have to complete an attestation that they are accredited based on their higher net worth or advanced financial knowledge.
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Private equity vs. venture capital
Venture capital is a type of private equity. However, not all private equity is considered venture capital. What is the difference between private equity vs venture capital?
Venture capital (VC) is a subtype of private equity. It involves financing for companies in their beginning business stages and has the potential for extensive growth. A VC investor is issued shares in exchange for providing funds to a start-up or other early-stage business. As the underlying business grows or goes public through an IPO, the shareholder can see their investment appreciate.
With venture capital investing, the underlying business has little or no financial history, increasing the risk for its investors. In some cases, those risks can pay off and reward the shareholder with a large windfall. This is by no means guaranteed, though. Several venture capital firms have lost large sums of money on their investments. Caution and expert advice are imperative when investing in VC or private equity in general.
How to invest in private equity
For individual investors, one of the best ways to invest is through a fund. The fund will use contributions from accredited investors to purchase ownership in several companies that do not trade on the public exchanges. In return for their initial investment, investors will become fundholders and participate in the fund’s gains and losses.
The advantages of a fund go beyond having a professional choose the underlying companies. These funds allow the unitholder a simple way to diversify amongst private equity holdings. This ensures that the asset class consists of numerous companies. And, of course, diversification can be extremely beneficial, especially to reduce risk.
Private equity funds can fall into a specific investment style, and fund managers choose investments based on their prospectus. Typically, funds can be passively or actively managed and can be venture capital or leveraged buyout funds. Funds focused on venture capital will provide financial backing for businesses early in their business cycle. Leveraged buyout funds, or LBO funds, instead choose to invest in more mature companies using debt as a form of leverage to amplify investor return. The goal for both VC and LBO is to sell the company once it is more profitable or has begun trading on the public stock exchange. It is common for the time horizon to be longer for VC funds than for LBO funds.
How to value a private equity fund
Determining the valuation for private equity is a process that is very different than valuing a publicly-traded company. The secondary market is far less liquid, and in some cases non-existent, for private equity. Less liquidity means it is more challenging coming up with the actual market value of a company — something that can sometimes only be determined when sold to a third party.
The value of a fund is the combined value of each of the companies where it has an ownership stake. One of the metrics commonly used to estimate the value of those companies at any given time uses the company’s earnings before interest, tax, depreciation, and amortization — EBITDA for short. While it is not a perfect valuation measure, it is a starting point. It can be combined with other valuation methods as appropriate (eg. a company comparable valuation).
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What is a private equity firm?
Private equity firms provide financing to non-public businesses. Some firms will focus on venture capital and search for relatively new companies for investment. Others may focus on leveraged buyouts. In some cases, they may even take a publicly-traded company private to enhance its profitability.
Depending on the size of the ownership stake, the firm may appoint new management and therefore have more control over the private company’s day-to-day operations. A shift in the executive team can be significantly beneficial when the firm has expertise in the industry.
Some of the best firms raise capital by taking commitments from investors, often more prominent institutional investors, for a set amount of money. Given the scope of the investment, minimum investment amounts are typically quite high. The firm then takes that money and, in turn, provides capital to a private business it deems attractive. Each investment will have different parameters, and they are highly customizable based on the underlying company’s needs.
A firm makes money from selling a business at a profit, plus a combination of management fees and performance fees that it charges its investors.
Sometimes, firms rely on loans or other forms of debt financing to supplement investor funds, or when they find an attractive investment but do not yet have capital from clients to invest. In this case, leverage will amplify the returns, whether positive or negative, of the investment.
Takeaway
Private equity can be a valuable component of the modern-day portfolio for individual and institutional investors alike. The asset class can, however, carry more risk due to an illiquid secondary market. It does provide the opportunity for returns that are uncorrelated with traditional asset classes – enhancing your return efficiency overall. While the asset class can boost portfolio returns, be sure to enlist the help of a professional wealth manager. They can provide you with the specifics of the investment.
Ultimately, private equity has become popular and more widespread for a reason, and it is worth considering how it may benefit your portfolio. While you may not be buying into the next Uber or Facebook, there are plenty of other successful and exciting ventures available in the marketplace today. Finding the right opportunity for your portfolio may lead you to more success than what you can find in the public markets today.
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