What Is Private Equity? | Bankrate

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Private equity is a type of alternative investment that pools investors’ money to make investments. A common private equity strategy may involve buying part or all of a company, restructuring it and then selling it for a profit, often back into the public market. 

Here’s how private equity works, some of its pros and cons, and the types of investors that typically participate.

How does private equity work?

Private equity investments are made by a specific group of investors, as opposed to public equity, such as publicly traded stocks, where anyone can own a piece of the pie. Private equity investments are organized by private equity firms, which source deals and solicit capital from accredited, high-net-worth investors and institutions to participate in the PE fund.  Private equity funds aren’t subject to the same SEC oversight as public companies are (they aren’t publically traded), but the fund advisers are usually regulated under the Investment Advisers Act. There are some exceptions to this, though, like if the adviser is managing less than $150 million in U.S. assets or only advising on venture capital deals. 

Private equity firms can range from huge companies, like Blackstone and KKR, to smaller, more boutique firms. Each firm can manage more than one fund (pool of money).

For the Blackstones and KKRs of the world, the firm itself typically serves as the investment adviser to its funds, meaning these institutions have registered with the SEC themselves. For smaller, more boutique outfits, the firm — or a related entity — is also the investment adviser, but in some, very rare cases, an individual can serve as the investment adviser. 

PE firms often buy established or publicly traded businesses with the goal of increasing their value over time and then selling them for a profit back on the public market. PE firms typically use substantial debt financing to acquire companies, a factor that often makes the companies riskier. These firms are known for their reputation of ruthlessly cutting costs to make the companies they buy more profitable down the line. 

PE firms are typically responsible for sourcing deals, executing transactions and raising capital. For these services, private equity firms are paid substantial fees from the fund’s investors.

The types of private equity strategies include:

• Venture capital
  

  Venture capital involves investing in early-stage companies that may be unprofitable and lack a proven track record. These funds generally take on more risk than other types of private equity.

• Growth equity
  

  This is when a fund invests in established companies that need funding for expansion.

• Leveraged buyouts
  

  Leveraged buyouts, or LBOs, target mature companies that can generate cash flow from Day 1. LBOs buy a company using a combination of debt and equity. The debt is used to increase returns to equity investors.

How to evaluate a private equity investment

Here’s what to look out for when evaluating a private equity investment:

• Assess the target company’s financial health, including its historical performance and growth prospects. This could include analyzing the company’s business model, its competitive advantage and any relevant industry trends. Additionally, evaluating the management team’s expertise and track record is crucial, as they can impact the company’s success.
• Understand the investment structure, as well as terms and potential risks. Many PE investments take on substantial debt, and many investments end up in bankruptcy due in part to high debt levels. So it’s important to carefully analyze the investment, estimate the potential return and consider how it aligns with your risk tolerance and investment goals.
• Don’t forget to look at the often substantial fees and whether you’re able to lock up your money for years in the fund. If ESG investing is important to you, add that to your list, too.

Who can invest in private equity?

In general, an investment in a private equity fund is usually restricted to institutional and accredited investors. Institutional investors include banks, insurance companies, university endowments and pension funds, among others. Individual investors typically must meet the accredited investor criteria, which could mean earning an income of over $200,000 ($300,000 with a spouse), having a net worth over $1 million, holding certain professional credentials or being a knowledgeable employee of a private fund.

Here’s an outline of the specific requirements for accredited investors. In certain cases, there’s an even higher threshold to invest in PE fund structures. In these, a qualified purchase would be the minimum requirement, which is generally having $5 million or more of assets.

It’s important to note that while retail investors may be excluded from directly investing in private equity, indirect investment is possible through pension plans and insurance companies that may have private equity funds within their portfolios.

Since the topic of private equity and its investment qualifications are complex, it may be helpful to speak to a financial advisor about whether private equity fits into your long-term financial goals. 

Drawbacks and risks of private equity

Before making any investing moves, you’ll want to consider the disadvantages of investing in private equity, including:

Bottom line

Private equity can be a lucrative investment option, but it comes with a variety of risks and considerations, not least of which is that you’ll need significant financial resources to participate. That said, with the right research and opportunities, private equity could be a way to diversify your portfolio and potentially increase your returns.

— Bankrate’s Logan Jacoby contributed to an update of this article.