What Is Private Equity? - NerdWallet (2022)

What is private equity?

Known as an alternative asset, private equity lets accredited investors and institutional investment firms diversify their portfolios and take on more risk in exchange for the potential to earn higher returns than they might by investing in public companies.

At a basic level, private equity involves three parties:

  1. The investors who supply the capital.

  2. The private equity firm that manages and invests that money via a private equity fund.

  3. The companies the private equity firm invests in.

Who can invest in private equity?

Traditional private equity funds have very high minimum investment requirements, potentially ranging from a few hundred thousand to several million dollars. As such, most private equity investing is reserved for institutional investors (such as pension funds or private equity firms) or high-net-worth individuals.

In addition to meeting the minimum investment requirements of private equity funds, you’ll also need to be an accredited investor, meaning your net worth — alone or combined with a spouse — is over $1 million or your annual income was higher than $200,000 in each of the last two years.

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How private equity works

Let’s say you invest $1 million through a private equity firm (traditional private equity funds typically have very high minimum investments). The private equity firm would put your money in a private equity fund along with money from other investors and invest the pool of money in various private equity instruments, such as buyouts or venture capital (more on those below).

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Why invest in private equity?

Investors turn to private equity to diversify their holdings and aim for higher returns than the public market might provide. One key distinction to consider before investing is that private equity valuations are not influenced by the larger market. Whereas publicly traded companies must adhere to strict accounting practices set in place by the Securities and Exchange Commission, private companies are allowed more flexibility.So, while private equity funds certainly come with higher risk, historically, they have resulted in higher returns.

According to the Bain & Co. report, over the past 30 years, U.S. buyouts (which are considered the largest subset of private equity investments) have generated an average net return of 13.1%, compared with the 8.1% return of the public markets. This comparison is based on the S&P 500 and the Long-Nickels public market equivalent method.

However, the report also notes that since 2009, returns for the public and private markets have been roughly the same, at an annual average of around 15%. Looking ahead, experts believe the coronavirus will negatively impact deal activity and private equity returns in the short-term, and the long-term effects of such an unprecedented event are still unknown.

Limited partnerships

When you invest in a private equity fund, you can think of yourself as a secondary investor, or in official terms, a limited partner. You supplied the capital that helped make the investment possible, but you won’t be responsible for managing the newly purchased company, making any of the necessary improvements or handling the eventual sale or public offering. That’s what the firm does.

Limited partners get a return on their investment when the private equity firm sells the company it purchases. Typically, the firm will take about 20% of the profits, and the rest is split among the limited partners based on how much they contributed to the fund. Moreover, limited partners have limited liability, meaning the maximum they can lose is the amount they invested in the fund.

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How to get started investing in private equity

Research top private equity firms

To directly invest in private equity, you’ll need to work with a private equity firm. These firms will have their own investment minimums, areas of expertise, fundraising schedules and exit strategies, so you’ll need to do your research to find one that’s right for you. As a starting point, here are the 10 largest private equity firms in the world, based on how much capital they raised in the last five years. This list is compiled annually by Private Equity International, a global provider of private equity data and analysis.

  1. Blackstone

  2. KKR

  3. CVC Capital Partners

  4. The Carlyle Group

  5. Thoma Bravo

  6. EQT

  7. Vista Equity Partners

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  8. TPG

  9. Warburg Pincus

  10. Neuberger Berman Private Markets

Look for private equity exchange-traded funds

You can also take part in private equity investments without going through a traditional firm through private equity exchange-traded funds, or ETFs.

Private equity ETFs offer exposure to publicly listed private equity companies. This is one approach for those who want to take part in private equity but aren’t accredited investors or can’t meet the minimums required by private equity funds.By investing in ETFs that track these companies, their success is also yours, and you won’t have to front a hefty minimum investment to get in on it.

Types of private equity investments

Once you contribute to a private equity fund, the private equity firm can use your contribution in a few different ways to generate profit, depending on the types of deals the firm specializes in. Below are two common private equity investments.

Buyouts

A buyout is when a private equity firm buys a target company with the hope of selling it later at a profit. That company can be public or private, though if it’s public, it will be taken private through the purchase. Often, private equity firms use capital from the fund as well as borrowed money to complete the deal, using the assets of the company being purchased to secure the loan. When borrowed money is involved, the deal is known as a leveraged buyout.

In a buyout, the private equity firm might identify a company with room for improvement, buy it, make improvements to its operations or management (or help the company grow), then turn around and sell the company for a profit, known as an “exit.” In many ways, it’s similar to flipping a house — just replace the house with a company.

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Venture capital

Whereas buyouts seek to take control of mature companies, venture capital involves identifying early-stage startups looking to raise cash in exchange for equity in the company. The goal here is to invest in companies with high growth potential that can either be sold at a later date or taken public through an initial public offering, or IPO. After an IPO, the firm’s ownership stake could be converted to shares and sold on the public market for a profit.

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Risks of private equity

Illiquidity

As a limited partner, to see a return on your private equity investment you’ll likely need to hold it in a private equity fund for the long term, often as long as 10 years. Private equity funds work differently than more common fund types (such as mutual funds) in that limited partners typically must commit a set amount of money that the firm can use as needed within a specified period. When the firm requests an investment amount from its investors, it’s known as a capital call.

For example, a private equity firm may make various investments over a five-year period, calling on its limited partners for capital during that time. Then, once the firm has identified investments in target companies and raised the needed capital, it still needs to make improvements to the companies or spur growth before selling them. In 2019, the median holding period before a target company was sold was 4.3 years, according to a report from management consulting firm Bain & Co.

Compared with other types of investments that can be easily converted into cash, like stocks, the combination of capital call investment periods and the time it takes to sell a target company makes private equity highly illiquid.

Transparency, regulation and data

Private equity funds aren't registered with the Securities and Exchange Commission, so private equity firms aren’t required to publicly disclose information about their funds (unlike, say, a mutual fund, which is subject to public disclosure requirements).

Moreover, privately held companies — often the targets of private-equity acquisitions — aren’t subject to public scrutiny. It’s up to the private equity firm to identify companies with healthy, complete and accurate balance sheets. This leads to varying risk levels within the private equity universe: Mature companies in a buyout may provide transparency on years of earnings and operations data, while an early-stage startup has very little of this information. This makes investing in an unproven startup through venture capital inherently more risky than investing in a growth-stage company with established revenue and market share.

» High risk tolerance? Learn more about alternative assets

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FAQs

What is private equity in simple terms? ›

Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange. Private equity firms earn money by charging management and performance fees from investors in a fund.

What is private equity with example? ›

Private equity is the category of capital investments made into private companies. These companies aren't listed on a public exchange, such as the New York Stock Exchange. As such, investing in them is considered an alternative.

How do you answer private equity? ›

What to Include in Your Answer to “Why Private Equity?”
  1. Highlight that you have some transaction experience.
  2. Express an interest in a sector that the PE firm invests in.
  3. Position yourself as a long-term thinker or investor.
  4. Show that you know what the PE firm has invested in.
Nov 11, 2020

Why is private equity the best? ›

Private equity investors work with portfolio companies over the long-run, often 5-8 years. Hedge funds investments can be as short as a few weeks. So private equity teaches you the art of long-term view. Private equity also gives you the ability to work closely with the company over an extended period of time.

What is the goal of private equity firms? ›

The purpose of private equity firms is to provide the investors with profit, usually within 4-7 years. It comprises companies or investment managers that acquire capital from wealthy investors to invest in existing or new companies.

How is private equity different from public equity? ›

Public Equity

The term “private equity” denotes shares of owner‑ ship in companies that are not (or not yet) listed on a stock exchange. The term “public equity” refers to shares of companies that already trade on a stock exchange.

What companies does private equity own? ›

  • The Blackstone Group Inc.
  • KKR & Co. Inc.
  • CVC Capital Partners.
  • The Carlyle Group Inc.
  • Thoma Bravo.
  • EQT.
  • Vista Equity Partners.
  • TPG Capital.

Why are private equity funds important? ›

Private equity funds are pools of actively-managed capital that invest primarily in private companies with the intent of creating value in the companies in which they invest by improving operations, reducing costs, selling non-core assets and maximizing cash flow.

Why do private equity firms buy companies? ›

Private equity firms invest money in mature businesses in traditional industries in exchange for an ownership stake – also called equity – in that company. Private equity firms invest in businesses with the goal of increasing the value of the business over time and eventually selling that business.

What are PE interviews like? ›

The main types of PE interview questions you will encounter include technical knowledge, transaction experience, firm knowledge, and culture fit. In addition, you may also be asked to complete a practical financial modeling-related case study.

What questions do they ask in a private equity interview? ›

9 Questions to Ask Every Private Equity Firm
  • 1) How large is your fund? ...
  • 2) What is your target return profile and strategy? ...
  • 3) What role will you play in the relationship during and after the transaction? ...
  • 4) How many investments will the partner have active at one time? ...
  • 5) What is the typical board composition?
Jun 10, 2021

Is private equity a good investment? ›

Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.

Is private equity High risk? ›

As typical risk measures cannot be used and as the average performance is often considered to be higher than in public markets, risk in private equity is often perceived as being high.

How do private equity firms create value? ›

PE firms have generally created value in their portfolio companies in three ways: deleveraging, multiple expansion, and operational improvements aimed at increasing revenues, margins, or both.

What happens when private equity buys a company? ›

When a private-equity firm (PE) acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

Why is it called private equity? ›

Private equity firms are, as their name suggests, private — meaning they're owned by their founders, managers, or a limited group of investors — and not public — as in traded on the stock market.

What is private equity in a business? ›

Private equity (PE) refers to a constellation of investment funds that invest in or acquire private companies that are not listed on a public stock exchange. So-called PE funds may also buy out public companies, take them private, and then restructure them for potential future growth.

What is the difference between private equity and investment banking? ›

Private equity firms collect high-net-worth funds and look for investments in other businesses. Investment banks find businesses and then go into the capital markets looking for ways to raise money from the investment crowd.

Is private equity better than public? ›

Generally, public equity investments are safer than private equity. They are also more readily available for all types of investors. Another advantage for public equity is its liquidity, as most publicly traded stocks are available and easily traded daily through public market exchanges.

How big is the private equity market? ›

The global private equity market is estimated to register a CAGR of approximately 11%, during the forecast period. Private equity buyouts reached an all-time peak of 5,106 deals globally, with an aggregate value of USD 456 billion in 2018.

How long does a private equity fund last? ›

Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions).

What happens when your company is bought by private equity? ›

A company is bought out by a private equity (PE) firm, and the purchase is financed through debt, which is collateralized by the target's operations and assets. The acquirer (the PE firm) seeks to purchase the target with funds acquired through the use of the target as a sort of collateral.

What is the difference between private equity and investment banking? ›

Private equity firms collect high-net-worth funds and look for investments in other businesses. Investment banks find businesses and then go into the capital markets looking for ways to raise money from the investment crowd.

Why do private equity firms buy companies? ›

Private equity firms invest money in mature businesses in traditional industries in exchange for an ownership stake – also called equity – in that company. Private equity firms invest in businesses with the goal of increasing the value of the business over time and eventually selling that business.

Is private equity a good investment? ›

Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.

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