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What is a private equity investment?

A private equity investment is a type of alternative investment. Individuals own a portion of a company that is not publicly owned, quoted or traded on a stock exchange. Private equity investment strategies include executing leveraged buyouts, contributing venture capital and investing growth capital.

How are private equity investments used?

Private equity generally refers to capital investment that is designed to bring about positive change in a company, such as:

  • Growing a new business: Investing growth capital to allow for expansion or development
  • Bringing about operational change: Restructuring or innovating an enterprise to make it more profitable
  • Financing an acquisition: Organizing capital to effectuate the purchase of another entity
  • Taking a public company private: Converting a hitherto public company to a private entity (delisting it) to enable the advantages attendant on private status; by no longer focusing on quarterly earnings, a company can pursue long-term growth strategies unavailable to public entities

Because private equity returns are achieved through operational improvements and financial restructuring, the experience and leadership ability of the private equity manager are paramount.

How does a private equity investment work?

When a management team invests in private equity, there are three parts to its strategy:

  1. Buy
    • An acquisition strategy is mapped out
    • Capital is sourced for purchase
    • An acquisition deal is completed
  2. Change
    • Once the company has been purchased, it is restructured or reorganized to enhance profitability
    • It becomes, in effect, a new company
  3. Sell
    • After the company has been turned around and transformed, it is put on the market
    • It is sold at a profit
    • The private equity investors share in the profits

Each stage represents a segment of the private equity management team’s acquisition strategy. This turnaround process is what sets private equity apart from other forms of investment: it undertakes corporate transformation, with profitability as its aim.

Private equity in a nutshell

Why should I invest in private equity?

  • The factors that drive returns in public equity markets have little or no impact on private equity, enhancing private equity’s diversification potential
  • Private ownership enables long-term strategic focus as opposed to the public market focus on quarterly earnings. This “patient” perspective has the potential to generate significant return on private equity investment
  • Private equity has exhibited attractive performance on both a risk-adjusted and an absolute basis

How does private equity compare to public equity?

By its nature, private equity possesses distinct characteristics that set it apart from public equity. Private equity can seize opportunities outside the reach of public equity; for example, it can draw on private information. Private equity’s active ownership contrasts public equity’s passive investors, and private equity investment can lead to greater entrepreneurship and risk-taking in the pursuit of profits.

Private Equity

Public Equity

  • Uses private information to make decisions
  • Investors as operators
  • Private concentrated ownership
  • Multi-year strategic planning
  • Ability to retain entrepreneurs and attract skilled managers through equity participation
  • Public information
  • Passive investors
  • Broad public ownership
  • Quarterly earnings focus
  • Traditional incentive structures (options, restricted stock grants)

How can companies use private equity investments?

Companies use private equity investment to strengthen and develop in ways that traditional financing cannot provide. Private equity investments can span all stages of a company’s life cycle.

  • Venture capital: Seed money and funding for start-up and early-stage companies
  • Development, expansion or growth capital: An investment to help mature companies bring a new product to market, invest in a new plant or acquire a company
  • Buyout capital: Funding used to purchase an existing company or one of its divisions
  • Mezzanine (subordinated) debt: Debt financing used in a buyout
  • Restructuring capital: Capital infusion for distressed companies undergoing financial or operational reorganization

Growth and development of a company using private equity investments

Private equity investment can play a key role in a company’s growth and development. Its ability to progress from early-stage venture capital to mature corporate finance demonstrates its versatility, power and attraction as an alternative investment.

Growth and development of a company: Stages of opportunity

What is an investor’s role in private equity?

Generally, private equity investment involves three phases:

  1. Capital commitment: An investor signs a legally binding agreement to pay a set amount of capital to a fund over a period of time, usually 3 to 5 years
  2. Drawdown: The fund manager draws down (i.e., "calls") the investor's committed capital in increments as the manager finds attractive investments, typically with notice between five and 15 days beforehand
  3. Distributions: The investor receives distributions as the manager "exits" investments (i.e., sells or takes the company through an initial public offering). These distributions are usually paid to the investor as cash, but sometimes they can be used to offset future drawdowns.

How do I invest in private equity?

There are several ways to invest in private equity. Some of the most prominent are:

  • A fund of funds owns the shares of a broad selection of private partnerships investing in private equities. It offers investors a cost-effective vehicle that reduces their initial minimum investment requirement. It can also provide diversification, since it might invest in hundreds of companies spanning a wide spectrum of venture capital types and industry sectors. Since its asset allocation is so diversified with such a multitude of individual investments, a fund of funds might also represent a hedge against risk.
  • Private equity exchange-traded funds (ETFs) track an index of publicly traded companies that invest in private equities – and they’re easy to own. Because you can buy shares on a stock exchange, there isn’t any minimum investment requirement. However, ETFs might include a management fee that wouldn’t be part of a direct private equity investment, as well as a brokerage fee.
  • By buying the public shares of private equity managers – companies that manage private equity funds – you can still invest in private equity and diversify your portfolio, because these managers invest in a whole range of funds, which spreads out the risk. But you won’t get the dramatic returns you might receive if you invested directly in a single fund that yields substantial profits.