Private equity typically refers to investment funds, generally organized as limited partnerships, that buy, restructure, and sell companies which are not publicly traded on a stock exchange.
Although some private equity funding comes from private individuals, most private equity funding comes from private equity firms.* These firms are often partnerships that obtain their investment capital from wealthy individuals, investment banks, endowments, pension funds, insurance companies, and various financial institutions.
Since the basis of private equity investment is direct investment into a firm, often to gain a significant level of influence over the firm's operations, a large capital outlay is generally required, which is one reason why larger funds dominate the industry. The minimum amount of capital required for investors can vary depending on the firm and fund. Some funds have a $250,000 minimum investment requirement, while others can require millions of dollars. However, advances in financial product structure in recent years have allowed individual investors, with smaller minimum investments, to utilize alternative investments like private equity. As a result, individual investors can now invest beyond the scope of conventional publicly traded stocks and bonds.
Private equity firms believe they have the ability and expertise to take underperforming businesses and turn them into stronger and more profitable companies. This is the primary source of value creation in private equity, though private equity firms also create value by aiming to align the interests of company management with those of the firm and its investors. By taking public companies private, private equity firms remove the constant public scrutiny of quarterly earnings and reporting requirements, which then allows the private equity firm and the acquired firm's management to take a longer-term approach in bettering the fortunes of the company.
Public companies today face increased regulation, higher listing fees, more disclosure requirements, and seemingly countless areas of greater legal liability. As a result, there are fewer public companies in existence today than there were in 1976, despite a more than tripling of U.S. GDP over the same time period. Since 1996, the number of public companies trading in the U.S. has dropped by approximately half, from more than 7400 to 3700.* This impacts mutual fund managers and individual stock pickers directly, in that they are all chasing performance in a dramatically smaller opportunity set. Meanwhile, the opportunity set for private equity has grown, as the perceived benefits of going public have declined.
The success of a private equity fund is dependent on the companies which are held in the fund’s portfolio. If the private equity firm is successful in executing their business model for restructuring the portfolio company, then the fund will ultimately have an increase in market value. Generally, the longer-term nature of private equity fund investments requires lengthier financial commitments and delayed financial returns. While public equity investors are paid in regular dividends and appreciation, private equity investors are paid through distributions. When investing in private equity, investment capital is often deployed to buy and manage multiple companies for 4-10 years. Each company is held until restructuring has created terminal value, so investors are subject to liquidity restrictions during the life of the fund. As a result, investors often expect an illiquidity premium in total return over liquid public equities.
With funds under management already in the trillions*, private-equity firms have become attractive investment vehicles for wealthy individuals and institutions who are pursuing less volatility, higher returns and historically low correlation to publicly traded markets. Understanding what private equity entails and how its value is created in such investments are the first steps in entering an asset class that is gradually becoming more accessible to accredited individual investors.