Private Equity (PE) is an “alternative” investment vehicle. It holds and molds capital resources you won’t find on the public exchanges. This investment class includes funds and investors directly invested in private and unquoted companies. These investors include institutional funds and accredited investors involved in buyouts of public companies resulting in the delisting of their public equity.
This differs from venture capital which focuses on first-phase companies with big growth promise. But private equity firms invest in mature firms with futures limited by the need for capital to make things happen or recover from losses.
Typically, private equity funds are owned by Limited Partners with control of 99 percent of the shares and General Partners holding the remaining one percent. It’s the General Partners’ job to execute and operate the investment.
It’s in the interest of the partners and the funds to work hard improving the companies they buy. They invest needed capital in new equipment, innovative technology, facility expansion, and more effective growth strategies.
They might acquire and integrate competitive businesses to create global leaders and master market share. But they also provide and/or corral the world-class expertise required to restructure or reconfigure the acquisition.
With all these private equity leaders have invested in experience and success, they also provide extraordinary access to meaningful influencers and interested parties. When they open up a business’s future, they profit, too.
How does it work?
Why should you be interested in private equity? There are no promises in any public or private investment. Every investment has a risk. But if you have the discretionary funds, the option has much going for it.
Long the go-to portfolio for institution investments, private equity is an alternative investment integrating multiple investment techniques and strategies complimenting traditional stock, bond, and other portfolios.
Given current improved economic conditions with low interest and inflation rates and climbing yet volatile markets, private equity opportunities offer real alternatives. But such investing can appear complex. You don’t invest in private equity through online no fee websites. It’s just not a supply and demand situation.
Private equity investments are typically made in “unquoted” companies. While a quoted company is listed on major stock and bond exchanges, an unquoted company is not listed in those markets. Its shares are no longer traded there.
Unquoted companies generally do not meet stock exchange listing standards or requirements. They may have low revenues, too few outstanding shares, or other disclosure issues. And, companies may have been “delisted” by the stock exchange as a punishment for not meeting standards or because they company chooses to delist.
The value of unquoted companies is not determined by the traffic on the big boards at the markets. Instead, the value of private equity funds is negotiated. Buyers and sellers make transactions when broker-dealers meet to set a price at which they will buy or sell. And, over the counter (OTC) transactions occur without publicity or scrutiny, a privacy preferred by many investors.
Because of this buy and sell mechanism, the value of unquoted companies is not easily priced. Investors will compare similar companies in similar industrial sectors. They will compare companies doing similar business in similar markets. Or, they might compare company resources, productivity, sales, and revenues.
When private equity interests move over the counter, the fund managers are responsible for adding value to the businesses in which they invest. So, when they sell those transformed acquisitions, they do so at significant profit. Their strategic success depends on assembling the skills to address the needs discovered during their due diligence.
What does private equity mean to you?
- High performance: Private equity investments have posted premium performance over the years. In periods of low inflation and low but steady growth, they have justified the risk. An extended run of low inflation shifts the focus of investors to spot businesses with growth potential and then investing in the conditions for better growth.
- Deep pockets: It’s the nature of Private Equity groups to have big money. They hold the kind of money that energizes growth. PE partners spend their money prudently. Marilyn Geewax of NPR says, “The equity firm buys a company through an auction. The firm then increases the value of the company by, for example, upgrading its accounting system, procurement process and information technology, or by laying off workers and closing unprofitable operations.”
- Self-Interest: Owners of PE firms are incentivized to make good decisions. They are paid management fees and a significant share of the proceeds of a reconfigured company. With their own interests vested in the funds’ interest, the individuals and the group have personal interest in commitment to outcomes of the PE firm and of the businesses they support.
- Portfolio diversification: Private equity options diversify your portfolio to improve the risk and reduce the volatility. The market also introduces sophisticated governance to smaller businesses and entrepreneurial efforts hitting their growth phase.
- Safety net: Private equity managers are good the unquoted company’s performance. They really take over to remake the business’s strategic systems. They may replace senior executives, rebuild the business plan, match the business with new customers, acquire related businesses, disrupt the market, and more. Their focus remains on making the business better until its value makes it marketable.
- Advantageous information: Although it’s not directly available to you, the private equity managers have unique access to an acquired business’s inside info. They are positioned to administer financial forensics to assess the company’s effectiveness and promise and to reduce the investment risk by proactively redirecting its financial performance. Those managers have more information and influence than you would ever have over a quoted company’s shares.
- Value-added Expertise: The majority of PE-backed enterprises do better than other businesses. What the numbers don’t show is the expertise behind the growth. PE firm partners, flush with CPAs and other financial professionals, have extensive experience in leveraging, restructuring, and restoring businesses as well as in the investment management process itself. Experts at creating value, they retain new management teams with rewarding shares.
- Meaningful Connections: PE groups are in the business of business, as it were. It’s in their interest and yours to help companies succeed. A PE group might acquire a business, fund equipment purchases, build new facilities, and more. The company’s growth means income for the fund and financial salvation for the acquisition.
What does private equity cost you?
Investing in private equity funds is not for everyone. There are meaningful limitations on your interest and ability to invest:
- Qualified investor: Funds will limit availability to “qualified” investors, people with $5 million or more available for investing. Moreover, they will set very substantial minimum investment requirements. The highest performing funds with the longest histories are in high demand. That means they can set the entry requirements. Those demands should make you consider how you have diversified your portfolio so private equity does not have imprudent share.
- Hefty fees: The cost of private equity is high. There are management fees amounting to 1.5 to 2 percent of your commitment amount. In addition, investors are charged 20 percent of the profits, what they call “carried interest.” So, you must consider the promise of the performance after fees. Trouble is, the funds promising the best experience after fees are in the highest demand driving up your entry requirements. It’s among the reasons private equity appeals to large institutions.
- Long haul: Private equity investments only work over the long term. They are not easily liquidated and usually have a 10-year commitment. And, this commitment can be stretched by fund managers in troublesome market phases. If they can’t get out of commitment, they won’t let you go. What it means to you is you must be in an asset class where you can distribute your funds without need.
- Image problem: The way private equity firms work leaves a bad taste in some investors’ minds. They have a reputation for picking struggling businesses and gutting them. They may retain the top talent, but they are known for large layoffs as they reinvent the company. The layoffs happen as the fund managers recognize redundancies or barriers to their six or seven year strategic plans.
Pools of capital!
Institutions, pensions, and other funds favor private equity firms because they spread the risk and have a proven track record. And, while they are attractive in principle, PE investing is more complicated than the larger public markets. Writing for The Wall Street Journal, Paul J. Davies notes, “Like wine, a fund’s vintage, or the year it started making investments, has a big impact on the returns investors see in the real world. And like wine, you get good and bad vintages.”
You can visit BSWLLC.com to understand the advantages and disadvantages of PE investment. The starting point is accepting that the first function of PE is to create profit. The PE partners purchase smaller businesses, effectively increase their value, and sell them for a gain in which you share.