Back in the day, only wealthy individuals and institutions could invest in private equity funds. However, it has been gaining popularity among ordinary and retail investors.
Investing is usually coursed through a private equity firm. The firm pools a large amount of money from one or several investors to buy a significant portion of a company and sometimes the whole business. Next, to sell for profit at a higher price, the firm works to improve the company’s performance.
But what exactly is private equity investing? This article will help you understand the basics of private equity funds and provide tips on investing successfully.
What is Private Equity, and How Does it Work?
In the traditional private equity investment setting, institutions and individuals must invest up to $25 million. In some cases, though, $250,000 is enough.
This type of investment is likened to buying a piece of a company that isn’t publicly traded on the stock market. Investors can contribute capital to private companies’ growth, expansion, or restructuring by investing in private equity funds. Investors can access private markets by investing in these deals, complementing their allocations to public markets.
In recent years, many private equity managers have emerged as limited partners, managing acquisitions and venture capital allocations on behalf of other investors. There have always been many private companies, such as family businesses and partnerships, but with the proliferation of leveraged buyouts, private equity (PE) has emerged as a separate asset class.
Private equity investment allows accredited and institutional investors to diversify their portfolios while taking on a little more risk and earning higher returns than they might from public companies. There are three basic parties involved in private equity:
- Capital investors
- An investment firm that manages and invests in private
Private equity funds fall into two categories: venture capital and buyout or leveraged buyout. Investing in venture capital (VC) funds enables funding to small, early-stage, and emerging companies with high growth potential that do not have access to other forms of financing.
As small startups lack access to large amounts of debt, VC funds are essential sources of capital for startups with innovative value propositions. Investing in unconfirmed emerging businesses carries risks, but venture capital funds can generate extraordinary returns as investors.
Unlike venture capital funds, leveraged buyout (LBO) funds typically take a controlling interest in mature businesses. LBO funds use a significant amount of leverage to increase the rate of return. The size of buyout funds is typically significantly larger than that of venture capital funds.
How and Why Does Private Equity Work?
In the long run, private equity is expected to generate high returns on investment. Investors can expect these returns primarily by taking a higher risk and investing in illiquid, non-tradable investments to earn an additional premium. However, there are other potential sources of excess returns.
First, private ownership means fewer stakeholders, so management and decision-making can be more efficient and flexible. With active balance sheet leverage, cash flow and margins can be focused. Additionally, private equity often invests in smaller companies with significant growth potential.
It is important to note that private equity managers pursue a buy-to-sell strategy, which differs from traditional business management. They seek out companies that are undermanaged or undervalued, where they can raise the value of a company and then sell it at a higher price.
Tips on Investing in Private Equity
Investing in private equity can be challenging because of all the nuances. The following tips will help everyday investors incorporate private equity investments into their portfolios while balancing returns with risk:
Plan a comprehensive financial strategy
Defining your financial goals is crucial before making any investment decisions. A financial plan should include budget management, cash flow, expenses, and essential recordkeeping. All these factors contribute to achieving financial goals.
Identify potential opportunities through research
Before selecting a deal, consider factors such as profitability trends, competitive landscapes, management teams’ abilities, and track records of success. You should also consider exit strategies.
A private equity firm can exit in one of two ways: a total exit or a partial exit. Wholesale exits can include trade sales to other buyers, LBOs by other private equity firms, or share repurchases. A partial exit could involve a private placement in which another investor purchases a piece of the company.
Make sure there is downside protection and liquidity
Retail investors must prioritize downside protection and liquidity in the current late-stage market environment. If short-term cash flow requirements force you to sell assets at a discount due to market downturns, ensure you can hold quality positions through those times.
Prepare an investment policy statement
Your investment policy statement should outline your portfolio allocation, target returns, and rebalancing rules. Ideally, your investment strategy should be based on forecasted returns of 6% to 10% per year. You should avoid taking on unnecessary risks by seeking excessively high returns.
Ask a professional for advice
You can benefit from financial advice and guidance from financial advisors or managers. Management fees may be an issue, but a competent manager offers peace of mind and is worth the expense.
Assess the fees
In private equity, management fees range between 1% to2% annually. Get a sense of what these fees are like compared to other opportunities in this sector, and be aware of how they will affect your net returns.
Continue Learning
Learn about investment strategies and financial planning concepts as part of your financial education. Valuable resources like newsletters that provide financial planning insights can benefit everyday investors by making various concepts more understandable.
By educating yourself and performing due diligence, you can mitigate the risks associated with private equity investing and maximize your chances of seeing significant portfolio gains.
Do your due diligence
Investing in private equity is much more complex than buying public stock; you must conduct your due diligence before committing any funds to a deal. If you are considering investing in a business, look closely at the financials, industry knowledge, and customer base before deciding.
Should You Invest in Private Equity?
Is exposure to private companies and private equity investing worth it? It certainly has its appeal. However, like other asset types, there are challenges.
Investors have repeatedly warned that past performance does not guarantee future results. Despite this, they typically select funds based on their past performance. Private equity’s past performance, however, can be even more misleading. This is because the funds are valued by third parties; thus, the valuation can be highly subjective.
