What Is Private Equity?

What Is Private Equity?

Broadly speaking, private equity refers to investing in privately owned companies, rather than those whose stock is traded on a public stock exchange—though certain investors may pursue buyouts to take public companies private. With a private equity investment, you typically own a stake in a private company, such as a software startup or biotech business, and often have a say regarding how the company operates. The primary goal is to earn substantial returns at a later date through various exit strategies, such as selling the company or taking it public.

Private companies normally have fewer shareholders than public companies do. This allows for private equity firms or funds to buy major stakes or entire businesses, pushing out individual private equity investors.

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How Does Private Equity Work?

Generally, private equity firms and funds pool money from major investors like pension funds, university endowments and people with a high net worth. Armed with this pooled money, managers of private equity firms and funds sift through private companies and settle on investment targets. These targets may be in a narrow or broad set of business sectors, such as tech, health care or clean energy.

Example: A private equity firm comes across a promising software startup with growth potential. The firm combs through the startup's finances, vets the management team and assesses the chances for success, deciding to invest $10 million. The firm might be the company's sole private investor or be among a group of private shareholders.

Private equity firms and funds usually hold ownership stakes in private companies for three to seven years. During the ownership period, private equity advisors might look for ways to beef up the business by, for instance, improving efficiency, coaching the management team and seeking new vehicles for growth.

After the normal five- to 10-year hold period, the firm or fund might pursue a return on its investment through a sale of the company or a listing of the company's stock on a public exchange.

Types of Private Equity Strategies

Private equity strategies boil down to three main types: venture capital, growth equity and buyouts.

Venture Capital

Private investors invest venture capital in early-stage startups. In exchange for a monetary investment, investors receive a share of a startup's ownership. Most venture capitalists take less than a 50% stake in an early-stage startup.

At this point in a startup's life, the company might not have even released a product or turned a profit. As such, a venture capitalist may be making a risky bet on a startup's success (or failure).

Growth Equity

Private equity investors pump money into established companies, rather than startups, that are on a growth path. In exchange for this money, investors receive an ownership stake—usually a minority stake.

The company might put its investment toward expanding operations, breaking into new markets or making acquisitions—all aimed at elevating revenue and profit. To spur the company's growth, a private investor might encourage the company to increase staffing or upgrade technology, for instance.

Generally, a private investor holds a growth equity stake for three to seven years.

Buyouts

A third private equity option is a buyout. Usually, this means a mature company moving from a public stock exchange to private ownership. Either a private equity firm or management team carries out a buyout, with the existing investors cashing out their stakes. Once a buyout is completed, the private equity firm or management team becomes the lone investor.

When a buyout occurs, all of the company's investors cash out their shares. The private equity firm or management team then becomes the sole investor.

Who Can Be a Private Equity Investor?

Participation in a private equity investment typically is limited to accredited investors and qualified clients. Among those who meet eligibility requirements are insurance companies, university endowments, pension funds and people with a high net worth. In the high-net-worth category, you must have a net worth of at least $1 million, either on your own or in tandem with a spouse.

Even if you don't fall into one of those buckets, you might be a private equity investor and not realize it. For instance, you might benefit from private equity investing if you own an insurance policy or participate in a pension plan. Insurance companies and pension plans are among investors that might earmark some of their portfolios for private equity investments.

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Benefits of Investing in Private Equity

Here are some benefits of investing in private equity:

• Potentially healthier returns: Because of their higher risk, private equity investments might deliver better returns than traditional investments do.
• Portfolio diversification: Adding private equity to your investment portfolio limits your exposure to one asset type, such as stocks in publicly traded companies. This could help smooth out the volatility of your portfolio.
• Access to different opportunities: Unlike everyday investors, private equity investors may gain exposure to real estate projects or promising tech startups that wouldn't otherwise be available.

Risks of Investing in Private Equity

The positives of investing in private equity aren't without a few risks, including:

• Locked-up cash: When you make a private equity investment, you're entering what typically is a long-term commitment. To see strong returns, a private equity investor must be willing to ride out ups and downs for several years. By contrast, a traditional investor can readily sell stocks, bonds and other regular assets.
• High risk: When you make a private equity investment, you're normally taking a gamble. For instance, your entire investment might be wiped out due to factors beyond your control, such as economic instability or the shutdown of a startup. Though there is risk in investing in the stock market, for example, there's much less risk of the company going completely under than with private equity investing.
• Lack of information: Investors in publicly traded companies enjoy access to all sorts of data about revenue, profit and other business barometers. That might not be the case with a private company. Unlike public companies, private companies aren't required to divulge financial information.

How to Invest in Private Equity

You can make a private equity investment in several ways, such as:

• Investing in funds run by private equity firms: When you put money into a private equity fund, you're entrusting it to a private equity firm. The firm combines investors' money and decides where to invest the pooled money. The firm oversees all aspects of the fund. Keep in mind that private equity funds aren't registered with the U.S. Securities and Exchange Commission (SEC). However, one or more of the firm's in-house advisors might be registered with the SEC.
• Purchasing shares of stock in a private equity firm: A number of private equity firms are publicly traded, meaning their stock can be bought and sold through a stock exchange.
• Buying shares of ETFs: An ETF, or exchange-traded fund, is an SEC-registered investment vehicle. Through a stock exchange, you can buy shares in ETFs. These funds pool money from investors and invest it in a mix of assets, such as stocks and bonds. Some ETFs invest in publicly listed private equity firms, which are involved in private equity investing.
• Participating in a crowdfunding platform: Some private companies turn to online crowdfunding platforms to raise money for business operations or new products. Through crowdfunding, private investors, friends, relatives, work colleagues and others can invest in a private company.

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The Bottom Line

Private equity enables qualified investors, such as retirement funds and wealthy people, to invest in privately owned companies rather than publicly traded companies. Benefits of this investment method include potentially higher investment returns and access to ownership stakes in up-and-coming startups.