Private equity is a self-descriptive classification of an investment style that refers to investments made in “privately held companies” in exchange for “equity.” These investment deals generally occur off stock exchanges and during the nascent stages of business formation up to pre-IPO fundraising. However, many private equity deals are now taking public companies private.
The major players in the private equity world include insurance companies, pension funds, endowment funds, private equity partnerships, private equity funds, and, increasingly, hedge funds.
To invest in private equity or hedge funds that allocate to private equity, clients must meet the Securities and Exchange Commission’s (SEC) definition of an accredited investor, making over $200,000 a year for two years or having a net worth exceeding $1,000,000.
Private equity investments are often illiquid, unlike their publicly traded brethren, and require high initial investment minimums that exceed $25,000 to $250,000.
Most accredited investors who allocate to private equity will do so through private equity funds and sometimes through hedge funds, both of which are fee-heavy. Under these arrangements, the first 10-20% of gains generated go to the fund manager as a performance incentive, followed by an expense ratio of 1-2%. For an introduction to expense ratios, check out my guide: Expense Ratios: A Hidden Cost You Pay.
Taking Ownership
Once a private equity fund has pooled assets together from its various accredited individual or qualified institutional investors, it can purchase ownership stakes in multiple private companies or take a public company private. In the case of the former example, existing private companies that are recipients of these cash infusions give partial or complete control away by selling ownership stakes. In return, recipient companies can use the funding to grow, scale, cash out founders, restructure the business, or all of the prior, depending on the deal.
If the target firm fizzles and goes bankrupt, the private equity fund writes off the investment and will attempt to salvage cash by liquidating the business or its ownership stake.
Concurrently, if the target firm becomes more profitable and desirable, the private equity fund can distribute its share of profits to fund investors. These profits can occur as a steady income stream if the business remains private or as a one-time payment by taking the firm public or selling it to another private buyer.
The above scenarios are vibrant illustrations of the value private equity investors can bring to the marketplace/ However, many detractors of private equity funds assert that the funds are detrimental to society and company longevity due to their strip-and-flip business model.
Under the strip-and-flip template, firms acquire companies with the intent of stripping out unproductive business units and streamlining production with lower costs in mind. The result is oftentimes layoffs at the acquired firm, the selling off of various legacy business divisions, and business restructuring to improve profitability.
Since this is an investing blog, I will not dive deeply into the complex emotional and social intricacies and ethics that private equity buyouts create for their workforce and broader society. Still, winners and losers will naturally emerge, and regulators must consider the adverse effects marginalized communities can experience when approving such deals.
Commissioned studies completed in tandem by Harvard, the Census Bureau, and the Universities of Maryland and Michigan found a net decrease in jobs at target firms of 1% after two years. Concurrently, though, earnings per ownership share increased substantially, as did firm productivity, the latter of which the authors propose as a net social gain.
Whether or not productivity gains and their positive impact on consumers outweigh job losses for workers is something that I will leave for the reader to decide when considering investing in companies that facilitate these deals.
An emerging sector for some
The private equity sector has long existed for institutional and extremely wealthy investors but is in its infancy for accredited investors who do not have stratospheric wealth. Fees remain high, and access remains somewhat limited due to a historical lack of competition.
Private equity will likely become less expensive as the sector opens up through increased offerings with lower minimums, increased competition, and increased participation, similar to what happened in the mutual fund sector.
Still, the sector will likely never experience full democratization comparable to the mutual fund sector since safeguards inhibit broader market access. Speaking of which, why is private equity limited to accredited investors?
Investment drawbacks
Private equity has many drawbacks compared to traditional public equity investing through mutual funds, ETFs, and stocks. These include a lack of liquidity, high minimums and fees, a lack of transparency, and more.
Since private equity investments occur off exchanges, selling ownership stakes is difficult and expensive. Why? Investors must abide by the offering firm’s cash redemption schedule (usually limited to quarterly windows and dollar/percentage amounts) or find a secondary market buyer, which may or may not exist without a steep discount or broker fee.
Additionally, private equity firms have fewer regulatory reporting requirements and only have to offer limited transparency since they work exclusively with accredited and institutional investors. Thus, corroborating or refuting information is more complicated.
Lastly, private equity funds are all actively managed, which means that the company an investor chooses to do business with directly impacts returns through fees and investment decisions. Thus, selecting the wrong fund manager or fund type can dramatically affect returns, as can the associated costs.
Investment benefits analysis
While private equity often carries opaque risks and many drawbacks, one unique benefit is that investors gain admission to a section of the economy that is otherwise not accessible.
For example, the United States had ~21,000 companies that generated revenues above $100 million in 2022. Of these companies, private entities outnumbered their public brethren by over 6 to 1, making up nearly 87% of the marketplace, according to Hamilton Lane, a leading private equity and credit purveyor.
Consequently, investors participating in the private equity market can diversify their portfolios further since they own more than just a (relatively) smaller pool of public companies.
Another attractive benefit of private equity is that it has outperformed the aggregate global public equity market from 1990 to 2020, according to data compiled by Hamilton Lane, Cambridge Associates, and Capital IQ. However, it is essential to note that past performance does not predict future returns and that data from Hamilton Lane may have a bias due to its vested interest in the private markets.
Still, while a myriad of non-attributable factors likely affected the returns of private and public companies for the past three decades, research has shown that an illiquidity premium exists with this investment class.
An illiquidity premium refers to the increased return an investor experiences when investing in a less liquid asset.
According to NYU Stern researchers, investors who put money into illiquid investments generally yield increased returns due to the increased risks associated with being unable to access their assets. This finding applies to private equity and all investments, including US treasuries, which yield different amounts depending on how long they must be held prior to redemption.
In the case of private equity, the excess returns generated from illiquidity materialize due to a lower relative price paid for an ownership stake when the target company is more likely to fail. But, if the firm succeeds, the investor experiences more upside. Therefore, private equity funds must make strategic, diversified bets.
While previously mentioned that private equity for ordinary accredited investors is still in its infancy, returns have decreased as competition in the private markets has increased, and the illiquidity premium has gone down.
Still, one notable trait of private market funds is that they tend to have a lower correlation with US and international stock index returns. But, as a caveat, private market companies are more difficult to value and are more subjectively valued than their real-time traded public brethren.
For ordinary investors seeking private market access
For investors who cannot meet the accredited requirements to invest in private equity or want a lower initial investment minimum, some mutual funds and ETFs exist, known as fund-of-funds, or operate similarly to fund-of-funds.
Private equity fund-of-funds are mutual funds or ETFs that invest in a mixture of private equity funds. Mutual funds and ETFs that don’t meet the fund-of-funds criteria also invest in companies that specialize in private equity investments (and are publicly traded, like Blackrock), directly in private equity partnerships, or companies that serve an auxiliary function for the private markets.
Limitations of investing in these fund-of-funds or similar vehicles include fund fees assessed on top of underlying fund fees, creating a substantial performance drag, and limited control over what funds/companies one can select since they are pre-bundled.
In closing
Private equity funds are increasingly touting their products as an exciting new investment class to advisors and their accredited clients. While private equity has benefits, it comes with substantial risks that are difficult to quantify, plus restrictions that make them less appealing than their publicly traded brethren.
Private equity is unsuitable for most investors, especially those desiring easy access to their portfolio’s value while concurrently maintaining investment transparency. Further, its hefty fee structure and lack of indexing make private equity unappealing to those who have embraced indexing to build wealth.
While private equity could fit into one’s portfolio if they are accredited and willing to lock up substantial chunks of money for extended periods with opaque risks, this group is a minority.
Lastly, private equity funds stress that they are only a place for some of an investor’s capital and act as a spoke in a well-diversified portfolio. Therefore, proceed cautiously and only allocate what you can lose if choosing this investment style.
But enough of what I have to say! What are your experiences with or thoughts on private equity? Have you invested in these deals before, or have you known someone who has? If so, how did it go, and what was your impression? Please let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time
