Crash Course: Private Equity Funds, Sponsors, and Investors

What Is Private Equity?

Private equity is an alternative investment class that acquires or invests in companies not listed on public stock exchanges. A private equity fund pools together the capital of multiple investors to make those investments. It offers individual investors and entities the opportunity to capture outsized returns in exchange for capital.

Private Equity vs Public Equity

Unlike investing through the purchase of publicly traded stocks, private equity fund investing involves much more substantial influence over the target company’s planning, operations, and more. In turn, the strategic changes made to a company often lead to maximized returns. This has historically seen private equity yield higher returns than public equity, barring poor economic conditions driving market volatility in recent years.

Private equity firms also have the opportunity to invest in companies before they have gone public, such as startups at the forefront of tech innovations. This early access allows them to invest while the company is still relatively unknown to the public, who have yet to drive up the price.

Private equity also differs from investing directly in a business as an individual or entity, as it provides structured and well-defined investment terms. Generally speaking, private equity investments are far more complex than either of these investment options.

To better evaluate whether a private equity fund investment is right for your portfolio, it’s important to understand how they work, the types of parties involved, and the considerations that should factor into your decisions.

The Who’s Who in a Private Equity Fund

A private equity firm manages a private equity fund. They are often called a private equity sponsor or financial sponsor.

• The fund is the investment or capital used to buy a controlling interest in a private company.
• The sponsor is responsible for operating the fund.

The Role of Private Equity Sponsors

The firm or financial sponsor is usually the fund’s general partner (GP). The GP manages the fund’s investments and may invest a small percentage of their own money into it.

Sponsors are typically investment professionals with years of experience. They are responsible for:

• Forming the investment fund (usually as an LLC or limited partnership)
• Planning, organizing, and executing strategies to raise capital
• Identifying and seizing upon investment opportunities
• Managing the fund’s portfolio of companies in which they have invested

Part of managing the fund is exiting investments. A private equity sponsor typically maintains their stake in a business for less than 10 years, usually between four to six years. The goal is to sell it at a higher value upon exit.

A private equity sponsor may manage more than one fund at any given time, and their investor bases may or may not overlap.

How Private Equity Sponsors Get Paid

Private equity fund sponsor compensation is typically structured in the same way as hedge funds. There is a small management fee that covers the cost of operating the fund and a performance fee that gives the fund a share of the fund’s profits.

Standard hedge fund fee structures are frequently referred to as ‘2 and 20’ – meaning a 2% management fee and a 20% performance fee. Some funds with exceptional track records will have higher fees. However, in an effort to attract more capital, the average management and performance fees today are much lower than these benchmarks.

The Typical Private Equity Investor

Private equity fund investors contribute the vast majority of the fund’s total capital. They typically enter the fund as limited partners (LPs), and range from institutions like pension funds and banks to high-net-worth individuals.

That doesn’t mean that any individual with substantial wealth or capital can invest. The vast majority of private equity funds limit access to verified accredited investors.

The Accredited Investor

The SEC defines an individual accredited investor as someone who meets at least one financial or professional criteria.

Financial Criteria:

• Individual income of $200,000 in each of the previous two years with reasonable expectations of continued income at the same level.
• Joint income with a spouse or partner of $300,00 in each of the previous two years with reasonable expectations of continued income at the same level.
• Net worth of $1 million or more individually or with a spouse or partner, excluding primary residence.

Professional Criteria:

• Investment professionals in good standing with a Series 7, 65, or 82 license.
• Directors, executive officers, or general partners of the company in which an investment is being made.
• Knowledgeable employees below those positions.
• Any family office or client who otherwise qualifies as accredited.

The SEC amended the definition in 2020, adding in the professional criteria. This widening of the accredited investor criteria has since opened up access to private equity for more individual investors.

Beyond the Individual

Entities seeking to invest in a private equity firm may also qualify as accredited investors. This can include corporations, partnerships, LLCs, trusts, 501(c)(3) organizations, employee benefit plans, and family offices and their clients.

To qualify, the entity will need to meet one or a few of the following conditions, depending on their structure:

• Own investments totaling more than $5 million.
• Own assets valued at more than $5 million in total.
• Be owned by an accredited investor.
• Be registered as an investment advisor or broker-dealer.
• Be a financial institution like a bank, insurance company, RIA, or something similar.

Whether the accredited investor is an individual or entity, they will still need to go through a verification process before investing in a fund.

Limiting Access to Accredited Investors

The reason for limiting private equity fund participation to accredited investors boils down to assumptions about investor sophistication.

Given that these investors have accumulated certain levels of wealth or years of experience,  they are assumed to navigate more complex and less regulated investments better than regular investors.

The strength of this assumption has been questioned since the expansion of accredited investors in 2020, when a broader pool of investors became eligible to invest in private equity. Ongoing discussions suggest that the standard for accredited investors may continue to evolve in years to come.

Anatomy of a Private Equity Fund Investment

Private equity funds are considered closed-ended funds. This means that they raise capital only for a specific period of time and from a limited number of investors. As of July 2024, the average time between the start of the capital raise and the close was 18.1 months.

 The Typical Minimum Investment

Private equity funds have historically required an average minimum investment of $25 million. Over time, some funds have lowered their threshold to investments ranging from $250,000 to several million. In recent years, some funds have even offered access for as little as $25,000. Each private equity fund will set its own minimum investment requirements. You can expect higher minimums when allocating to a larger fund with investments in companies across multiple sectors.

Those who cannot afford this minimum may still get exposure through other channels with far less investment, such as publicly traded PE companies, and ETFs. These vehicles also provide access to non-accredited investors who would otherwise not qualify for investment.

Making a Private Equity Investment

When discussing minimum investments, we use the term ‘capital commitment.’ This is because investors are actually committing or pledging to provide up to the stated minimum investment. Rather than making one lump sum payment, the investors make an initial investment and then provide additional capital as needed over a defined investment period.

Many more variables influence the shape, size, and mechanics of a private equity fund investment. These factors are detailed in a document called the offering memorandum or private placement memorandum. This memorandum outlines a business plan and potential risks to assist prospective investors with understanding the investment.

Different Types of Private Equity Funds

Private equity funds invest in a wide variety of privately held companies across every sector and in every part of the world. They may gain exposure through equity, debt, or a combination of both.

Private equity funds usually augment their available capital with money borrowed from banks. Where and how a PE fund invests depends on its structure and strategy.

Leveraged Buyout Funds (LBOs)

These funds invest in later-stage or mature companies by buying a controlling interest in the company, such as a control in operations or management. The fund’s long-term goal is selling the company to another firm or taking it public. The buyer often takes on a significant amount of debt alongside the purchase.

Venture Capital Funds

Venture capital funds are typically handled by a venture capital firm, although they technically fall under the private equity umbrella. These funds invest in start-up or early-stage companies with little control or stake in the company. They use straight equity instead of combining equity and debt.

Growth Equity Funds

These funds invest in mature companies looking to expand. This may include companies entering a new space or emerging market. Growth equity funds target scalable businesses poised for growth. They typically only take a minority stake in the company with a focus on an exit at a higher multiple.

Real Estate Funds

As their name suggests, these funds invest in real estate and Real Estate Investment Trusts (REITs). Real estate funds typically require higher amounts of capital to invest. These funds target value through appreciation, rather than relying on regular dividends like a REIT.

Private Equity Fund Risks

Investing in private equity does not come without risk. As an alternative investment, they involve more complicated strategies and calculations compared to investing in an index fund.

Liquidity

Private equity fund investments tend to be relatively illiquid, meaning that the investment cannot be readily converted to cash. Lock-ups established in the offering memorandum may impose a heavy penalty on investors seeking an early exit – if such redemptions are allowed at all. As such, private equity funds may introduce risk to an investor’s portfolio by limiting their ability to pivot or seize on new opportunities.

Limited Regulation

Private equity funds are not subject to the same levels of regulatory scrutiny as mutual funds or publicly traded companies. As such, investing in one requires extensive due diligence to avoid bad-faith actors. Investors should pay close attention to reporting provided by the fund and monitor its adherence to the offering memorandum terms.

Interest Rates

PE funds often borrow money to increase the risk capital at their disposal. This means that interest rates and the lending climate have an outsized impact on the fund’s  ability to perform. If interest rates are high, borrowing capital becomes more expensive and difficult to secure. With lesser assets available to invest, the fund may not be able to afford high potential allocations or move quickly enough to make one.

Market Volatility

In theory, one can argue that private equity fund investments are ‘safer’ than investing in a traditional hedge fund. Instead of frequent, risky trading subject to market volatility, capital is carefully and deliberately deployed. Fund sponsors may also have far more influence over the target companies in their portfolio, offering theoretically stronger control over performance.

However, a private equity fund’s target companies are not immune to macroeconomic trends. Issues like supply chain disruptions or significant market downturns, as seen in recent years, may directly impact a target company’s performance and ultimate survival.

The timing of these events, their relevance to a target company, and their severity are all largely unpredictable variables. As such, while private equity funds may not face the same types of volatility that hedge funds regularly navigate, they still need to weather big-picture storms.

The State of Private Equity Today

In 2021, SEC Chair Gary Gensler testified before Congress that there were more than 18,000 private equity funds on the market – a 58% increase over five years.

Since then, the private equity ecosystem has only continued to grow. The number of PE-backed companies in the US has steadily risen over the past 25 years, now more than double the count of public companies. Private equity has arguably reshaped the US corporate landscape, offering new growth opportunities to mid-sized companies through private credit funds.

However, market uncertainty, recession fears, and higher interest rates have led to more conservative positioning in many funds in recent times. Falling market valuations have made it less appealing for funds to sell off or exit their holdings, causing many to pause on deals. Private equity has historically outperformed the stock market; however, in 2023 private equity returned 9% on average, while the S&P500 saw approximately 25% returns.

By 2024, funds had built up record-high ‘dry powder’ reserves – another name for the total capital and relatively liquid assets available for use by the fund. In fact, PE firms held 40% of their assets for longer than four years.

Despite these recent trends, private equity remains popular among investors and is still an attractive way to diversify an investment portfolio. There are signs that the PE market is on its road to recovery, with interest rate cuts lowering the cost of capital and bolstering economic confidence. Such tailwinds have seen PE funds revitalized and dealmaking picking up speed once more.

Is a Private Equity Fund Right for You?

Deciding whether to invest in a private equity fund will depend on a variety of factors. Investors should ask themselves:

• Can I afford it?
• How will it function in my portfolio?
• Will the lack of liquidity compromise my personal investment strategy?
• What is my risk tolerance?

The answers to these questions and more will help you make smart decisions on private equity fund investments. As always, we encourage thorough due diligence and consulting with a professional before taking the leap.

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We think you’ll also like:

1. Key Private Equity Considerations for Would-Be Investors
2. Beyond the Fringe: Alternative Asset Classes Go Mainstream
3. 6 Things to Consider When Selecting a Private Equity Investment

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Real Estate Investing 101
2. Tech Talk: Current Opportunities for Investing
3. Leveraged Finance

This article originally published on May 2, 2023.]

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