While many investment-related articles focus on listed equities, the market with greater profit potential is most definitely private equity (PE).
And you don’t need a billionaire next door to get you in. You just need to do your homework and think strategically.
In fact, there are tens of thousands of private equity opportunities in the United States alone – and they’re all ripe for investment. To put that into perspective, the number of public companies equates to only 19% of the total number of private U.S. companies with 500 or more employees.
And with such a low interest rate environment, assets are continuing to pour into the space.
Take a Hike
With equities, one could go on a familiar, well-marked trail with a map and a destination, or one could venture out into the wilderness with no map and only their knowledge of the outdoors. This is PE.
While the path may be less familiar, the destination is more likely to be a breathtaking, untouched view. In other words, PE, unlike a listed stock, is more unique, complex, and unpredictable.
PE is any equity investment that isn’t traded on an organized exchange. It’s one of many types of investments that fall in the category of an alternative investment and can come in many shapes and sizes – such as a leveraged buyout, angel investment or venture capital, mezzanine capital, or distressed equity.
In other words, the investment can come at many stages of a business’s life. In each case, these are private deals between the company and the investor whereby money is exchanged for an equity stake in the business.
There was an explosion of PE deals in 1990. Firms that invested in these deals, both then and today, specialize in the business of providing capital for what they believe are worthy enterprises. They put their capital to work at a risk in the pursuit of exploring new business opportunities, while their clients are both institutional and individual investors who seek their expertise.
Private Equity Structures
Most PE firms are organized as legal structures – either limited partnerships (LPs) or limited liability companies (LLCs). These structures indemnify both the external investors and the principals. An advantage they have over C-corporations is that the life of the firm is limited to a specific amount of time (typically 10 years) thus avoiding double taxation.
The professionals who manage the firm are known as general partners (GPs). GPs typically invest around 1% to 5% or more of their personal capital in the fund, and they make all of the investment decisions. They’re able to vet new investment ideas through their network of entrepreneurs, attorneys, and industry contacts.
Limited partners are the external investors. They pledge a specific amount of capital for the new venture fund.
PE is generally considered off limits to mainstream investors and available only to institutional investors, such as pension funds, foundations, endowments, sovereign wealth governments, or high-net-worth individuals. The reason being, regulatory initiatives have aimed to protect investors from the many risks that are characteristically inherent in PE deals.
The first risk is the hefty upfront minimums required, which can run into the millions of dollars.
Second is their illiquid nature. Unlike listed stocks with real-time quotes or funds with end-of-day valuations, private equity may have only monthly or quarterly liquidity. As such, you cannot easily trade out of a PE deal as your money is locked up for a specified period of time. Lastly, keeping track of capital calls is a greater challenge with PE.
The challenges of raising capital for these deals has led to a market of tiered investment opportunities: primary, secondary, and co-investments opportunities.
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Primary investments indicate that the investor is putting money into a newly offered fund or vehicle whereby the majority of capital in the fund is considered “dry powder,” meaning it has not yet been put to work and sits in cash or a cash equivalent account.
Furthermore, the holdings in the fund are largely unknown. What is known is the particular strategy that the fund is focusing on – be it the sector, geography, etc. – based on the particular expertise of the GPs.
A secondary investment is typically more mature in nature and is a later-stage investment, whereby there’s a greater knowledge of the underlying holdings.
Lastly, a co-investment allows an investor to put his/her money alongside the firm through a direct investment into a single entity.
The Exit Strategy
In an ideal world, investors in private equity are hoping for a liquidation event. This can take the form of an IPO (initial public offering), a merger, a takeover, or recapitalization. The exit strategy for a PE deal is typically 10 years, but can be as low as three.
Like any investment, the higher the risk, the greater the potential for reward. (Note the word potential, as there’s no guarantee of reward at all.)
So has this risk paid off over time? In fact, it has. The track record of private equity puts it among the best-performing asset classes.
Look at the U.S. Private Equity Fund Index as compiled by Cambridge Associates as of June 30, 2014. They calculate the end-to-end pooled return as compared with selected benchmark statistics.
Here’s what a 20- and 25-year return looked like for various asset classes, net to limited partners, invested in 1986 in percentage terms.
Getting in the game early can be quite an attractive proposition. Before a stock goes public, the management has free rein to accomplish what it wishes without having to answer to a large constituency of investors with voter rights. (Investors generally vote based on a short-term outlook rather than what may be best for the company’s long-term growth.)
As of the end of 2014, there are approximately 6,000 active private equity firms managing $1.1 trillion globally, according to Bain and Company. And opportunities in the space are gradually becoming available to a greater number of investors.
You can visit Bain’s 2015 report for specifics and industry insights.
Putting Capital to Work
Without PE or investment banking experience, its best to leave it up to professionals.
Nevertheless, there’s a high degree of uncertainty as to whether a fund will end up a winner or a loser based on its initially reported gains, and this poses a real challenge for LPs needing to make a call as to whether to invest more with GPs when they come knocking with new offerings.
You should do your homework, whether it be a direct investment or with a PE firm. Get to know company management, their strategic objectives, their industry edge, and how your investment will be deployed – be it in human capital, technology, research and development, facilities expansion, marketing, etc.
And nowadays there are a number of publicly traded private equity vehicles – food for thought for another article.