Introduction to Private Equity

Key takeaways

• Private equity involves investing in companies not listed or traded on public exchanges.
• Private equity can complement public equity by offering the potential for higher returns, driven by an illiquidity premium and manager skill, alongside portfolio diversification with access to an expanded opportunity set.
• Private equity can be accessed through a range of investment vehicles—from traditional private funds to more accessible listed or semi-liquid structures—that invest in companies at various stages, from early startups to mature businesses.

What is private equity?

Private equity involves investing in companies that are not publicly traded, from early-stage startups to established businesses, with the aim of growing those companies’ value and eventually selling them for a profit, either to another private or strategic buyer or through an initial public offering (“IPO”).¹

Private equity is a common form of accessing private markets and dates to the Industrial Revolution.² Over time, it has evolved into a strategic allocation in portfolios, reflecting its growing role in long-term investment strategies.

How does private equity work?

The objectives of private equity investing are straightforward: buy, improve and sell at a higher valuation.

The private equity manager, commonly referred to as the General Partner (GP) or lead sponsor, typically takes a controlling ownership stake in a company and is responsible for driving strategic change. GPs typically take an active ownership role, influencing operational decisions, capital allocation, leadership changes and long-term planning to enhance value.

Private equity strategies differ depending on the target company’s stage of development, the level of ownership or control, and the purpose of the investment.

Four primary types are:

1. Venture capital
   Venture capital (“VC”) focuses on early-stage companies with high growth potential. VC investments are typically minority positions made in rounds of funding and can involve heightened risk given the unproven nature of the businesses. That said, the upside potential from successful exits can be substantial.

2. Growth capital
   Growth capital, or growth equity, targets companies that are beyond the startup stage but require capital to scale operations, enter new markets or accelerate growth. These typically involve minority equity stakes with less leverage than buyouts. Growth equity sits between early-stage venture capital and mature buyouts in terms of its risk/return profile.

3. Buyouts
   Buyouts generally involve the purchase of a controlling stake in a mature company, often financed with a mix of equity and debt (leveraged buyouts). The goal is to drive value through operational improvements, strategic repositioning and eventually an exit via sale or IPO.

4. Special situation
   A special situation refers to an investment in an established company that is facing operational, financial or other strategic challenges. In these cases, GPs seek to create value through operational improvements or financial restructuring. GPs seek to exit through sale or other realization events once the company’s performance has stabilized or improved.

These four stages reflect a continuum of risk and return, as outlined below, allowing investors to construct portfolios aligned with their objectives and risk tolerance.

Exhibit 1: The four types of PE strategies

How can investors access private equity?

Investors generally access private equity in three ways:

1. Primaries
   A primary investment involves committing capital to a newly raised private equity fund managed by a GP. A Limited Partner (LP) commits capital to a single fund, or sometimes a fund-of-funds, and the GP deploys capital over time as investment opportunities arise, ultimately building a diversified portfolio.

   Early in a fund’s investment period, as capital is deployed and fees are paid while portfolio companies are still being improved, investor returns may be negative. The fund’s net cash flow generally begins to increase in the later years when investments begin to mature and are sold, resulting in distributions. This progression from initial negative return to ultimately positive return is known as the J-curve effect.

2. Directs and co-investments
   Direct investing involves investing in a privately held company, often alongside a GP. When a GP seeks to acquire a company, they may invite select partners to co-invest. In some cases, investors may also invest directly in companies without a sponsor.

   Co-investments allow investors to gain exposure to a specific company as a co-owner. Because capital is deployed into a specific investment rather than committed to a blind pool of future opportunities, co-investments typically provide faster market exposure than primaries and can help mitigate the early phase of the J-curve. Co-investments can also enhance transparency and offer a two-tiered due diligence approach, first by the GP and then by the co-investor. In addition, they often carry lower fees than traditional private equity fund investments.

   However, co-investments require significant underwriting expertise and internal resources to evaluate potential opportunities. They also involve higher concentration risk, as investors are exposed to a single company rather than a diversified portfolio, and execution risk, as not all transactions ultimately close.

3. Secondaries
   Secondaries involve purchasing existing interests in private equity funds or direct investments. In these transactions, investors acquire the fund interests of existing Limited Partners who are seeking liquidity before the fund’s scheduled term ends.

   Secondary interests are often purchased at a discount to the asset’s net asset value (NAV), generally not due to impairment in the underlying investments, but because of the illiquidity of the LP stake and the seller’s need to receive capital back sooner than originally anticipated.

   Secondaries provide more immediate exposure to underlying portfolio companies and can reduce the impact of the J-curve by offering access to investments that are closer to realization or exit.

Exhibit 2: Building blocks of private equity investing

Why invest in private equity?

1. Breadth of opportunity
   Private equity allows investors to access opportunities beyond those available in public equity markets. In the U.S., public markets have been shrinking as the number of public companies has declined; in contrast, the number of private companies has risen.³ In the U.S., private companies make up 80 percent of the total number of companies with revenue greater than $100 million, while public companies represent only 20 percent.⁴

Exhibit 3: US public markets have been shrinking, while US private markets have been growing

2. Potentially attractive absolute and relative returns
   Private equity investors aim to optimize returns through influencing a company’s strategy over a longer time horizon. Once a business is acquired, improvements can be made to increase value prior to exit – making manager skill a primary return driver. Moreover, private companies are often smaller and can be accessed earlier in their growth cycle, potentially improving absolute returns.

3. Lower relative volatility
   Private equity has tended to exhibit lower long-term volatility compared to public equities because private company valuations are generally less influenced by short-term market sentiment.⁵ Sponsors often invest with longer holding periods and time horizons, reducing the pressure to sell during market volatility or manage to quarterly earnings reports.

What are the risks of private equity investing?

As in public equities, investors in private equity are subject to market risk and operational risk. However, private equity carries additional risks including the illiquidity of the underlying assets, limited regulatory oversight and fewer reporting requirements relative to publicly traded counterparts. Investors expect a higher return for their private equity investments in exchange for these heightened risks.

Private equity offers investors access to a broad and growing universe of companies beyond public markets, with the potential for enhanced returns driven by active ownership and manager skill. While investments require a longer time horizon and involve higher illiquidity and complexity, these characteristics have historically been compensated through diversification benefits and attractive risk‑adjusted outcomes. For investors able to tolerate these tradeoffs, private equity can serve as a powerful complement to public equity within a diversified portfolio.