What is private equity investing?
Many investors first consider venture capital (VC) when investing in businesses – but that isn’t the only way to access private capital investment opportunities. Private equity (PE) gives investors many of the same advantages as VC while employing several distinct investment strategies.
In this article, we’ll share an overview of private equity as an alternative asset you might consider. You’ll learn:
- What private equity is and how it works
- The advantages and challenges of private equity investing
- Trends in the private equity market
- How to invest in private equity
- How private equity compares to franchise investing
Let’s start with the basics.
What is private equity?
PE is a form of alternative investment in which a specialty investment firm purchases an existing business or funds the startup of a new business. PE operates differently than venture capital, in which VC funds will invest in a portfolio of startups. Unlike VC, private equity firms typically provide financing to companies in exchange for either partial ownership or a stake in the company’s profits.
To drive returns, private equity firms typically employ strategies such as leveraged buyouts, venture capital, growth capital, distressed investments, and mezzanine capital. Following is a brief definition of each:
- Leveraged buyouts occur when private equity firms acquire majority stakes in businesses, financing the acquisition through debt;
- Venture capital provides early-stage funding to startups and emerging companies with high growth potential;
- Growth capital investments occur when firms invest in successful, mature businesses seeking cash for expansion or new initiatives;
- Distressed investing funds companies that are facing financial difficulty or bankruptcy;
- Mezzanine investments provide subordinated debt or preferred stock to small and mid-sized companies. These companies seek additional financing and may require investment assistance due to their risk profile.
Each of these methods provides the promise of potentially high returns for moderate risk. According to December 2021 data, PE firms often have short turnaround times (around three to five years) in their investments and returns that average 15 percent.
Why invest in private equity?
PE can be an effective means of diversifying an investment portfolio – as long as investors are prepared to leverage the benefits and account for the risks.
Benefits of private equity investing
Private equity investments offer a variety of benefits for investors, such as:
Return potential: PE investments offer higher potential returns compared with other forms of investing. By investing in small and mid-sized companies across various industries and leveraging market trends, private equity investors can increase their chances of attaining higher returns. PE firms typically have shorter investment time frames of around three to five years, which enables them to maximize profits.
Better deals: Access to private deals is a significant advantage for private equity investors. These deals, which are not traded on public markets, offer exclusive terms and less competition when negotiating. PE funds provide access to high-growth businesses or distressed assets and generate unique returns compared to public investments.
Diversification: Private funds offer investors diversification benefits. By investing in different companies, they spread out risk and reduce the chance of major losses. Diversification across industries, countries, or investment types also mitigates risks that are associated with specific asset types. Moreover, PE funds provide access to unique investments not available to the public market, which enables exposure to a wider array of assets.
Tax advantages: Private equity investments offer such tax advantages as deferred taxes on capital gains and access to deductions that may not be otherwise available. PE firms, structured as partnerships, allow general partners to pass through investment losses to individual partners for tax savings. These advantages are especially beneficial for high-net-worth individuals or those with significant income from other sources seeking deductions.
Lower volatility: Investing in private equity offers less volatility than public investments. Private equity funds are not subject to the fluctuations of stock and bond markets, which results in better performance during downturns. With greater control over portfolio composition, PE allows for precise risk management and protection from market volatility. Private equity firms also benefit from longer investment periods, providing a buffer against short-term turbulence.
Challenges of private equity investing
Along with the benefits come challenges that must figure into your investment rationale. Among the biggest challenges of PE:
Due diligence: Investing in PE requires extensive due diligence. In other words, beyond the existing financial and legal research, you should also consider general industry trends, competitor analysis, and a deep dive into the company’s operations. As most investments through private equity come with a heavy risk of failure, this due diligence is essential for understanding the risks associated with any given investment.
Lack of liquidity: Private equity investments are often illiquid and may not offer an immediate return on investment. This lack of liquidity can benefit long-term investments but diminish the value of short-term gains from entering and exiting certain market positions quickly.
High fees: Private equity funds typically charge higher management fees than other investments. This is largely because PE firms manage larger funds than those managed by individual investors or mutual funds, which increases their overhead costs. PE firms tend to take a larger percentage of returns from successful investments as compensation for their services.
Trends in private equity investing
There’s an abundance of dry powder present in the private markets right now. A strong spring has resulted in trillions of dollars of undeployed capital waiting to deploy. Much of this capital can be found in private equity.
The capital boom in PE can be attributed to several factors:
- Healthy PE fund performance: Private equity has outperformed public equity markets in recent years, and this attracts more investors to the asset class.
- Interest rate hikes: Increases in interest rates drive down the yield of public investments. During these times, savvy investors seek alternative investments like private equity.
- Institutional investor interest: Diversification is an important tool for pension funds, endowments, and other institutional investors, making private equity a popular choice.
- Private equity preferences in high-net-worth individuals: Sophisticated investors continue to seek options like private equity to generate higher returns than those offered in stock and bond assets.
Whether you’ve already invested in PE or intend to invest in the near future, be aware that the situation could play out in several ways. Capital potential may boost deal activity, leading to higher valuations for desirable companies and increased deal competition. The alternative is for PE firms to become more selective about investment targets, but that could lead to fewer investment opportunities. There is also the risk of delayed exits for investors, as illiquidity is higher in PE than in other asset classes. A cooling M&A landscape might delay divestment plans.
How to invest in private equity
If you’re an investor who’s interested in private equity, your first step is to demonstrate accredited investor status by showing a minimum net worth in accordance with SEC regulations. Once accreditation has been established, you’ll conduct due diligence and choose a fund. Look for a PE fund that:
- Invests in companies of your desired stage or sector;
- Aligns with your goals and personal values;
- Shows a track record of success in investments.
For non-accredited investors, other options for investment include indirect investment through publicly traded PE stocks, exchange-traded funds (ETFs), and funds of funds that invest in private equity.
For direct investment, once approved, legal representatives for the parties draw up a contract with detailed terms. Choose to make a lump sum payment or set up regular payments.
How private equity compares to franchise investing
Although private equity investment and traditional franchise investment are both considered alternative assets, they differ in their approach:
Investment structure: PE allows investors to gain exposure to a portfolio of companies or assets, while franchise investing involves buying the rights to a specific business. Both avenues require significant upfront investment and have a longer time horizon than stocks and bonds.
Diversification: Private equity funds have more potential upside since their investments are usually diversified across different industries. Comparatively, traditional franchise investors are exposed to the success of only one business venture and can be significantly impacted by any changes in their respective industries.
Liquidity: Private equity funds are more liquid than traditional franchise investments since they can negotiate liquidity terms with invested companies. PE investors receive regular distributions and can exit at specific milestones like IPOs or acquisitions. In contrast, franchise businesses require a large upfront investment and are less liquid, as they must sell their license to another participant to exit.
Recession resistance: PE funds and franchises are well-equipped to withstand economic downturns. Both methods benefit from diversified investments, balancing out risks across industries. Strong franchise networks offer resources and advice to help franchisees through difficult times.
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