The term “private equity” refers to an alternative investment class that either 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 an opportunity to potentially capture outsized returns in exchange for capital.
Private equity fund investing differs from investing through the purchase of publicly traded stock in that it involves much more substantial influence over the target company’s planning, operations, and more.
This differs from investing directly in a business as an individual or entity by providing structured and well-defined investment terms. Generally speaking, private equity investments are far more complex than either of these 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 what considerations should factor into your decisions.
A private equity fund is managed by a private equity firm, 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 firm or financial sponsor is usually the general partner (GP) of the fund. The GP manages the fund’s investments and may invest a small percentage of their own money into the fund.
Generally speaking, sponsors tend to be investment professionals with years of experience. They hold responsibility for:
Part of managing the fund includes exiting investments. A private equity sponsor will typically maintain their stake in a business for less than 10 years, but usually between 4-6 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. Their investor bases may or may not overlap.
Private equity is frequently discussed in the context of the overall hedge fund universe. Fund sponsor compensation usually gets structured in the same ways. This includes 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. But in an effort to attract more capital, the average management and performance fees today have actually dipped down to 1.36% and 16.05% respectively.
Private equity fund investors contribute the vast majority of the fund’s total capital. Typically they enter the fund as limited partners (LPs). These investors range from institutions like pension funds and banks to high-net-worth individuals.
That doesn’t mean any individual with substantial wealth or capital can invest. The vast majority of private equity funds limit access to verified accredited investors. After issuing revisions to their rules in 2020, the SEC now defines an individual accredited investor as someone who meets at least one of the following criteria:
The SEC further stipulates that entities seeking to invest in a private equity firm may qualify as accredited, as well. This can include corporations, partnerships, LLCs, trusts, 501(c)(3) organizations, employee benefit plans, and family offices and their clients. To qualify, entities should:
Depending on their structure, entities qualified as accredited investors may need to meet one or a combination of those conditions. Whether the accredited investor is an individual or entity, they may need to go through a verification process before investing in a fund.
The reasoning behind limiting private equity fund participation to accredited investors boils down to (right or wrong) assumptions about investor sophistication. Because these investors have accumulated certain levels of wealth or experience, we believe they can better navigate investments that are more complex and less regulated than traditional ones.
Private equity funds are considered closed-ended funds. This means they only raise capital for a specific period of time from a limited number of investors. The average time between the start of the capital raise and the close currently sits at 15.4 months.
Private equity funds have historically required an average minimum investment of $25 million. In recent years, some funds have offered access for as little as $25,000. 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 publicly-traded PE companies, ETFs, and funds of funds for far less. These vehicles also provide access to non-accredited investors who would otherwise not qualify for investment.
We use the language “capital commitment” when discussing such minimum investments. This is because investors are actually “commiting” or promising to provide up to the stated minimum investment. This includes an initial investment with investors providing additional capital as needed over the defined investment period.
Many more variables influence the shape, size, and mechanics of a private equity fund investment. These factors get detailed in what’s known as an offering memorandum.
Private equity funds invest in a wide variety of privately held companies across every sector 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.
These funds invest in later-stage or mature companies. The fund buys a controlling interest in the company, like 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 is often taking on a significant amount of debt alongside the purchase.
While technically under the private equity umbrella, venture capital funds are typically handled by a venture capital firm. 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.
These funds invest in mature companies looking to expand. This might include 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.
Like 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 are targeting value through appreciation instead of relying on regular dividends like a REIT.
Investing in private equity does not come without risk. As an alternative investment, they do involve more complicated strategies and calculations than, say, investing in an index fund.
Private equity fund investments tend to be relatively illiquid, meaning 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 a portfolio by limiting its ability to pivot or seize upon new opportunities.
Private equity funds are not subject to the same types of oversight as a mutual fund or publicly-traded companies. As such, investing in one requires extensive due diligence to avoid bad-faith actors. It also means investors should pay close attention to reporting provided by the fund to monitor its adherence to the offering memorandum terms.
As PE funds often borrow money to increase the risk capital at their disposal, interest rates and the lending climate have an outsized impact on their ability to perform. If interest rates are high, borrowing capital becomes more expensive and difficult to secure. With a lower amount of assets available to invest, they may not be able to afford high potential allocations or move quickly enough to make one.
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 have far more influence over the target companies in their portfolio, too, offering theoretically stronger control over performance.
But a private equity fund’s target companies will not be immune to macroeconomic trends. Issues like supply chain disruptions or significant market downturns may directly impact a target company’s performance and ultimate survival.
The timing, relevance to a target company, and severity of such influences are largely unpredictable. So while private equity funds may not face the same types of volatility that hedge funds navigate regularly, they still need to weather big-picture storms.
Investors interested in private equity funds will find no shortage of options. SEC Chair Gary Gensler testified in Congress in 2021 that there are more than 18,000 private equity funds exist funds on the market – a 58% increase over five years.
More recent figures are harder to pin down, but assets under management (AUM) in private equity reached $7.2 trillion in 2022. Following 2021 record highs in AUM, private equity did see outflows in the latter half of last year. Even so, experts predict the market will balloon to more than $18 trillion by 2027.
Private equity sponsors will not necessarily deploy these assets, though. Market uncertainty, recession fears, and higher interest rates have led to more conservative positioning in many funds. By the end of 2022, funds were sitting on a record $1.96 trillion in “dry powder” – or the total capital and relatively liquid assets available for use by the fund.
Even with 2022 outflows and a slower pace of dealmaking, private equity remains popular among investors.With inflation wreaking havoc on more traditional investment portfolios, alternatives appeal to investors who can access them – and for good reason.
According to a study from the Chartered Alternative Investment Analyst Association (CAIA), private equity between 2000 and 2021 delivered twice the 10-year returns of the stock market. They also beat out stocks in terms of volatility. The annualized standard deviation in returns over those 21 years came in at 16.1% compared to 17.1% in stocks.
Whether or not investing in a private equity fund makes sense for an investor depends on a variety of factors. Investors should ask themselves:
The answers to these questions and more will help you make smart decisions regarding private equity fund investments. As always, we encourage thorough due diligence and consulting with a professional before taking the leap.
If you’re interested in hearing more about private equity, our Due Diligence Before Investing webinar is an excellent place to start. Want to learn more about other distinctive investments? You may find the following webinars interesting:
For more information about our on-demand webinar series, click here.
This is an updated version of an article from 2019. ©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
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