Private equity is one of the largest sectors in finance, yet it remains a mystery to most people. As retail investors typically don’t have direct access to private equity funds, they become somewhat of a black box. So, what exactly is private equity, and how does it impact you and your financial situation?

Unless you’re a seasoned institutional investor or a long-term professional, chances are you won’t be directly interacting with private equity firms in financial transactions. However, these firms are major players in the financial realm and can still affect your investment portfolio in various ways.

Let’s delve into private equity to understand what it is, how it operates, and its diverse impacts on investors and the economy.

What is Private Equity?

Private equity is a channel for business and investment that serves as an alternative to trading publicly listed securities (such as buying stocks and bonds on public exchanges). It typically involves acquiring ownership stakes in non-publicly traded companies or purchasing publicly traded companies and taking them private.

Private equity funds usually operate as investment partnerships between private equity firms and a group of limited partners. These limited partners may include insurance companies, foundations, endowment funds, or other institutional or high-net-worth investors.

Private equity funds are highly illiquid investments, focusing on long-term growth. Limited partners should be aware that withdrawing investments before the specified time window (usually several years) may be restricted.

As meticulously arranged opportunities, these ventures are often inaccessible to ordinary retail investors. However, regular investors may gain exposure to private equity through employer-sponsored retirement plans such as 401(k) or 403(b).

Private Equity Firm Explained

The primary objective of a private equity firm is to acquire companies and leverage them to generate profits for both investment partners and the companies themselves.

Typically, private equity firms invest in established companies with potential but facing some form of financial distress or mismanagement. The aim is often to purchase a majority stake or controlling interest in one of their portfolio companies and utilize that control to make significant changes to the business.

With their managerial influence, private equity firms may enact changes in personnel, operations, or many other areas of the company. These adjustments are aimed at developing the portfolio company, enhancing its profitability, or both.

The goal for such companies is usually to sell or “exit” them for a profit after managing the business for several years. Exits may involve selling the company to another investor or corporation, or taking the company public through an initial public offering (IPO).

Private Equity Firms vs. Private Equity Funds

The terminology here can be a bit confusing, so it’s necessary to distinguish between private equity firms and private equity funds.

A private equity firm is an organization that pools assets (primarily companies) to create investment opportunities for the firm and its partners. One of the pools of capital is the private equity fund, which is invested in by the firm’s portfolio companies and limited partners.

Each firm may and often does operate multiple funds at any given time.

Using the analogy of more familiar mutual fund concepts, this distinction becomes simpler. Private equity firms are akin to mutual fund issuers like Vanguard or Fidelity. In this analogy, each private equity fund issued by the firm is equivalent to a mutual fund or ETF. Limited partners are investors in that fund, which is not a publicly traded security but privately invested in its portfolio companies.

However, there are significant differences between private equity and mutual funds, and these differences are more complex than the types of assets within the funds.

For example, the active role private equity firms play in managing their portfolio companies goes far beyond the scope of typical index funds. Private equity investments transform the buy-and-hold investment approach into a hands-on practice of making companies profitable.

Private Equity vs. Venture Capital

Like private equity, venture capital (VC) is a term most investors have heard of but rarely interact with, hence it can also be shrouded in mystery and ambiguity. As they are very similar and have considerable overlap, it’s worthwhile to take a moment to differentiate between the two.

Broadly speaking, venture capital is a subset of private equity. Although it’s a large industry that often has its own space in discussions, it’s different from what people typically refer to as private equity funds.

Venture capital shares most characteristics of private equity we’ve discussed so far. It’s a channel where professional and institutional investors pool assets to privately invest in companies they believe have potential for development and profit. It’s a long-term strategy, with limited liquidity and little access for retail investors. Additionally, venture capital often relies on ownership stakes in companies’ management to directly influence their growth and profitability.

One of the main differences between venture capital and private equity is the scale of their portfolio companies. Private equity firms tend to target larger, more mature portfolio companies. These companies usually have a long history or future potential but also come with issues that the firm believes can be addressed to increase profitability. In contrast, venture capital often targets smaller companies or startups with higher expansion and growth potential.

How Private Equity Funds Make Money

Ideally, private equity generates profits for three main stakeholders: the issuing company, limited partners, and portfolio companies. In this arrangement, each party has different goals and prospects, and returns come from different sources; benefiting one doesn’t necessarily mean everyone benefits. Let’s look at each separately.

Investors (Partners)

Investors or limited partners of private equity funds have the most direct financial arrangement. At a high level, they contribute capital to the initial pool to establish the fund and hope to profit from a combination of growth and income.

Returning to the mutual fund analogy mentioned earlier, the role of investors is very similar to those purchasing mutual funds. They contribute to the pool of assets and await returns.

While many investors in private equity funds are large institutions, finding financial advisors who can offer private equity fund investment opportunities to clients is becoming increasingly common. Though the cost may be higher and the selection more limited compared to opportunities with larger institutions, the potential for diversified returns may make private equity allocation worth considering.

Private Equity Firms

How private equity firms profit from their funds is slightly more complex but usually comes from two sources: management fees and performance fees.

Management fees are recurring expenses the firm incurs for managing its portfolio companies. They typically stem from a percentage of assets under management (AUM). Performance fees are a portion of profits the firm extracts from the portfolio companies.

The most common arrangement is a 2% management fee and a 20% performance fee, also known as the 2-20 rule.

Portfolio Companies

On the surface, portfolio companies owned by private equity funds are also expected to profit. By injecting investor capital and engaging in the management of the companies, opportunities are provided to expand the scale and profitability of these companies.

However, this isn’t always the case. Often, a combination of asset stripping and heavy debt burden will bring considerable profits to the private equity firm and its investors but leave the companies burdened. We’ll delve deeper into these issues in the next section.

Criticism of Private Equity

While the private equity industry can be profitable for investors, it has faced much criticism over the years. Critics argue that private equity often harms companies, industries, and even entire economies.

One of the most significant criticisms of the industry is that private equity firms often serve their own (and their investors’) profit at the expense of the companies they invest in, sometimes causing irreparable damage. Some standard practices, such as downsizing and selling off company assets, exacerbate the wear and tear on companies after extracting value for investors.

In addition to asset stripping, private equity firms are often criticized for their use of leveraged buyouts (LBOs), which are one of the most common methods for companies to acquire other companies. LBOs represent private equity firms burdening portfolio companies with often insurmountable debt loads, while the firms themselves can walk away unscathed.

The carried interest loophole is a mechanism through which private equity managers and executives can reduce their tax bills, also a frequent target of criticism.

Growth and Profits of Private Equity

Private equity isn’t a core component of the average investor’s portfolio, so it remains somewhat mysterious to most. Although it’s a phrase commonly heard in business and investment news, it’s typically not something day-to-day investors (primarily high-net-worth individuals) deal with. However, private equity has a significant impact on the financial sector and the economy, even indirectly affecting many people’s retirement savings.

Given the significant role private equity plays in shaping and reshaping markets, it’s prudent to familiarize yourself with how this investment channel operates and who the key players are. Even if you’re not considering purchasing private equity funds next week, understanding the concepts and mechanics of this world can be an investment in your future prospects and preparedness.