Private equity investing involves investing in privately held companies with the goal of acquiring a significant ownership stake in the business. Private equity firms raise capital from investors, such as high net-worth individuals, pension funds, and endowments, to acquire equity stakes in businesses.

Private equity investing offers the potential for attractive returns, but it also involves higher risks compared to other types of investments due to the illiquid nature of private equity holdings and the longer time horizon required for investments to mature.

Continue reading to learn more about this investment strategy.

How Does Private Equity Investing Work?

The private equity investment process is different from public market investing. Many steps need to be taken before a private equity deal can be made. A single investor or a private equity (PE) firm uses investor money to invest in private companies. PE firms have teams that proactively search for potential companies to buy in ongoing sourcing. Once it finds a business the firm believes has potential, it will start the deal origination process.

Before submitting an offer, the PE firm will ensure it’s a good investment by analyzing the company. It looks at things like the company’s profits, management and business structure to determine if it has the potential to grow with the funding given. If it passes this round of evaluation, the PE firm will submit an offer.

If the offer is accepted, the PE firm looks for ways to improve the business. It will ensure the funding is used appropriately to spur growth and could bring in a new management team, cut costs and restructure the business model.

The PE firm provides ongoing management and monitoring of the company until the fixed private equity investment term is up. When that time arrives, the firm looks for ways to successfully withdraw the investment, hopefully leaving the business successful and making investors significant money.

Example of Private Equity Investing

For this example of private equity investing, let’s pretend a private equity firm identified and sourced a business that it believes could yield a great return on investment. It does its due diligence and evaluates the business. The private equity firm wants to buy this business for $100 million. It presents the opportunity and asks for a minimum investment of $10 million that will be held for a fixed term of 10 years. It collects the money, makes the offer and successfully completes the deal.

For the next 10 years of ownership, the private equity firm looks at ways to make the business more efficient. It replaces the management team, invests in new technology, cuts costs and helps the business expand. The business grows its profits, opens new locations and triples its value by the end of the 10-year period.

After a successful exit at the end of the 10-year period where the business tripled its value, investors get their share of their return. An investor would get triple their investment, minus management fees and the private equity firm's share of profits.

Things to Consider with Private Equity Investing

Private equity investing can be a great way to get sizable returns and diversify your portfolio. But investors should ensure they understand the ins and outs of private equity before investing. Here are a few things you should know about private equity.

Investment Horizon and Illiquidity

Private equity is an illiquid investment. Typically, investments are tied up in the investment for 7 to 10 years and cannot be liquidated during that period. Having a lot of illiquid investments in your portfolio can increase its overall risk. Once it’s invested, it’s not accessible until the long-term investment horizon is over.

Capital Commitment and Risk

Private equity requires a large capital commitment. Minimum investments are usually millions of dollars, though they occasionally can be as low as hundreds of thousands. The money could be lost, so investors need to be comfortable even if there is no return on investment. Investors also need solid risk management techniques, such as a diverse portfolio.

Diversification and Portfolio Construction

Constructing a diverse portfolio is one of many investment strategies that improve your portfolio’s overall chance of success. Having investments across asset classes and markets can mitigate risk. For example, if the stock market trends downward, but the real estate market is booming, your real estate investment returns may balance out your stock market losses. Private equity is a unique investment that can diversify your portfolio and help boost greater returns overall.

Due Diligence and Risk Assessment

Private equity is a big investment and should be taken seriously. Investors should do their own due diligence on a company before investing and ensure that the private equity firm is doing thorough research. Risk factors may include market conditions for the company’s industry, trends and major competitors. Investors also need to trust their private equity firm.

Fee Structure and Costs

As with any type of investment, the investor pays fees to the portfolio or fund manager. Investors in private equity pay a management fee, which is typically around 2%. This fee is deducted from the return and paid to the private equity firm. Additionally, private equity funds typically take about 20% of the company’s overall profits, which is considered carried interest.

Regulatory and Legal Considerations

Private equity investors are not regulated by the U.S. Securities and Exchange Commission (SEC) like other investments, but they still have to follow certain regulatory guidelines. For example, investors need to report their profits on their personal taxes.

Private equity firms are also required to comply with the Investment Advisers Act of 1940 and many anti-fraud acts. This looser regulatory requirement gives private equity funds a little more freedom in their investing but can also require more due diligence on the investor's side.

Tax Requirements

Limited partners, or investors, are required to report their share of the company’s profits and losses — shown on a Schedule K-1 — on their personal tax returns. Since they are limited partners, they won’t be required to pay the self-employment tax that goes to Social Security and Medicare.

General partners, or private equity firms, are taxed a little more favorably. Their 20% of profits received get preferential capital gains treatment.

Advantages of Private Equity Investing

Like any investment, private equity has its own advantages and disadvantages. Here are a few advantages of holding private equity in your portfolio.

• Potential for Higher Returns: Private equity typically earns a higher return than public market investments. Because of the large amount of capital required for these investments, a successful investment can provide millions of dollars in profit.
• Access to Unique Investment Opportunities: By looking at private companies, investors can expand their portfolios into unique investment opportunities. Looking at private equity opens new doors and increases the type and amount of investments that investors could add to their portfolios.
• Long-Term Investment Horizon: The private equity investment horizon is typically 7 to 10 years. The investor or firm purchases the company and uses the investment money to help the company grow. At the end of the investment period, investors get a return determined by the company’s profits or losses during the period.
• Alignment of Interests: It can be hard to sort through the public market and find companies that align with your interests and values. Private equity investments are much more personal. Investors can find companies in industries that interest them and help that company grow. It’s also an opportunity for value-based investors to help companies align with their values, such as being more energy-efficient.

Disadvantages of Private Equity Investing

No investment is without drawbacks. Here are a few disadvantages of private equity that investors should consider.

• Illiquidity: Private equity is a completely illiquid investment. Once the investment is made and the funds are taken, they cannot be pulled until the end of the long-term investment horizon, which could be 10 or more years. Not every investor is comfortable having that amount of capital unavailable to them for that long. It’s important that private equity be balanced out with liquid investments.
• High Minimum Investment Requirements: Private equity is typically only attainable for institutional investors and the ultra-wealthy. Most minimum investments are in the millions of dollars. Sometimes they drop into the hundreds of thousands, though this is rare. This minimum investment changes depending on the prospective company, but investors should be ready to invest a large sum of money.
• Lack of Transparency: Fees for private equity funds are higher than public market investments. There can occasionally be a lack of transparency between the private equity firm and investors. This can leave investors unsure of what they are being charged in fees, what the fees are for and where they go. A lack of transparency is frustrating for investors who want to understand where their money is going. Investors should choose a firm that is transparent and honest.
• Risk and Uncertainty: There’s no guarantee a company will be able to grow with the investment given. Markets continually change, and many factors are out of an investor’s control. The industry could change, new competitors could emerge or the macroeconomic landscape could shift. And since private equity investments require large initial investments, that risk increases.
• Limited Control: Once the money is invested in the fund, there’s not much the investor can do. If the market begins to trend downward, investors can’t switch their strategy and pull out of the investment. It’s a passive investment, and that lack of control can be frustrating to some investors.

Comparison: Private Equity Investment vs. Public Market Investing

Public market investment is the most common type of investing, while private equity is an alternative asset. Here’s a comparison of private equity investments vs. public market investing.

Investment Approach

Both public market investing and private equity involve buying ownership of a company. However, in private equity investing, investors are contributing to a fund that buys complete ownership of a company. Public markets sell securities or fractions of ownership of a company. So if there are a million securities sold for one company, and a person purchases 100 shares, they only own 0.01% of that company. These shares are sold on a public market whereas private equity invests in private companies.

Investment Horizon

Private equity investments are long-term. Once the deal is made, investors won’t be able to sell or pull out their shares until the defined investment period is over. On the other hand, securities purchased on the public market can be bought or sold at any time. Some investors may hold them for years, while others may only keep them for the short term.

Liquidity

Because public market investments can be sold easily, they are a liquid investment. The investment can be turned into cash by selling the stock. Meanwhile, public equity investments are long-term, and the funds are inaccessible until the end of the investment period, making them more illiquid.

Risk and Return Profile

Private equity has historically better returns than the public market, but it comes at a much bigger risk. More factors are at play for private equity, including the investors' lack of control of the funds.

Transparency and Reporting

Public market investments are required to follow stricter regulations than private equity, which gives investors increased transparency. Companies are required to make regular reports on their profits and the state of their companies so that investors can make informed decisions. Private equity does not follow those same rules, so there can be a lack of transparency between the companies, the private equity firm and the investor.

Accessibility

When comparing public equity investments vs. public market investing, public investments are much more accessible. Public markets are designed to be accessible to everyone. Securities can be purchased for as little as a couple of dollars, though security prices depend on the company and its supply and demand. Investors with a relatively small portfolio can work with a broker or run their own accounts. However, private equity’s large minimum investment makes it unattainable for most people. Unless an investor is ready to commit millions of dollars, private equity is probably not for them.

Is Private Equity a Good Investment?

Private equity’s large minimum investment deters many investors. But if you can afford to have that much money to be illiquid for the investment period, it can benefit your portfolio. It offers investors the unique chance to influence the growth of a company, thus diversifying your portfolio and potentially achieving strong gains.

Frequently Asked Questions