What is private equity?

Private equity (PE) describes investments that represent an equity interest in a privately held company. 

Any business that is not a public company is part of the substantial private company universe, which includes millions of US businesses compared with the few thousand that are public companies. That also means a large part of the private universe is startups and small businesses, along with some more established companies that have not yet gone public or choose to remain private. 

While similar in concept to equity securities in publicly held companies, private equity investments have sufficiently unique form and characteristics to consider them a separate asset class. Primary among these characteristics are high risk, illiquidity, and finite durations.

Private equity shares can be acquired directly from an issuing company, though because they have high risk and are not liquid, it is more common to acquire private equity through funds for diversification and professional management. 

Investing in private equity means understanding the uniqueness of the asset class and its various subclasses, the mechanics of a private equity fund, and the risks and returns of the investment.

Private equity fund structure

Investments in private companies can be in the form of primary investments made directly with the target company or secondary transactions which are made by acquiring shares from existing investors. For diversification purposes, both primary and secondary PE investments are made primarily through a fund that is set up as a limited partnership.

PE funds involve the following entities:

General Partner (GP) – The General Partner initiates and administers the fund, selects and manages the investments, collects money from investors, and distributes money back to investors when investments are sold. General Partners are usually a specialized Private Equity Firms.

Limited Partners (LP) – The investors in the fund are the limited partners.

Target companies – The private companies in which the fund invests are the target companies.

The typical structure of a Private Equity fund is shown below.

A PE firm initiates a fund and issues a call for investors to contribute to a pool of capital with a predetermined investment strategy that will purchase private equity investments. By contributing, investors become ‘Limited Partners’ of the fund. The private equity firm serves as the ‘General Partner’ of the fund and is responsible for acquiring and managing the investments as well as administering the fund on behalf of the investors.

The overall goal of a private equity fund is almost always to realise appreciation in the pool of private assets acquired within a time frame of generally 10-12 years. Fund strategies and the type of assets held will vary in accordance with the fund’s stated objectives. The different strategies used describe subclasses of private equity such as venture capital investing or buyouts.

Characteristics of private equity

Private equity characteristics - Fund perspective

• Leverage

Private equity funds may sometimes use debt to ‘leverage’ their PE investments. In particular, certain funds focus their investment on a single public company, buying the entire entity and effectively turning the company back into a privately owned business as a result of the transaction. Since purchasing all of a publicly held company requires a substantial amount of capital, PE funds engaged in such strategies will frequently leverage the purchase with debt, servicing the debt with revenue from the business, and eventually paying it off by selling assets of the company. The strategy is referred to as a “leveraged buyout” and is deployed for distressed public companies that investors can restructure and make healthy again without the pressure of public shareholders or regulatory requirements. The practice allows for the PE fund to magnify its investment gains if it succeeds, but of course, the reverse is also true: if the investment fails, there is additional downside risk.

• Value-add operations

Since the goal of private equity investment is to eventually sell the stake in the company, there is a strong motivation to add value. Most modern-day private equity firms have clear value-creation methodologies and often dedicated value-creation teams within the firm. Value-creation initiatives may include reorganisation, cost reduction, technological improvements or introduction of ESG frameworks, all of which will be thoroughly planned out before any investment is made.

• Higher risk / higher reward

Investing in private markets gives private equity firms access to companies that are untested, without the strict reporting that public companies offer. To manage this risk, firms operate large research and due diligence operations, closely examining the data rooms that potential companies make available to them. Firms often illustrate the rigour of their due diligence process by comparing the number of closed deals to the number of companies entering their pipeline. For example, a large manager might show that over a thousand companies are screened in a year but fewer than ten deals are closed.

Private equity characteristics - Company perspective

• Alternative funding access

Startups and small privately held companies can find it highly challenging to raise working capital as many do not yet have assets or revenue against which to borrow from banks. As such, offering equity to private equity investors provides an alternative route to raising capital as well as connecting them with professionals that have expertise in their industry and with the special needs of young, private companies.

• Less scrutiny

Many innovative companies operate progressive growth strategies that may be too radical to pass the approval of wary public investors. For example, tech startups over the past two decades have been at the forefront of growth hacking techniques that are only taken on by more conservative companies once they are tried-and-tested. A private equity firm is more likely to accept the risks involved in a new strategy, especially in venture capital, where decisions to invest are often based on the vision and abilities of the founding team.

On top of that, public companies adhere to tight reporting regulations, while private companies don’t have the same requirements. By accessing capital through private equity - or taking the step to move from public to private - companies can pursue more innovative growth strategies without the pressures imposed by quarterly reporting and shareholder scrutiny.

• Longer strategic horizon

When a PE fund invests in a portfolio of private companies, the goal is to increase value for the limited partners by helping those companies grow their businesses. This means providing funding for target companies to hire more employees, develop their products, and expand their markets. The holding period for individual companies in the portfolio may range from three to five years. Added to that is an initial acquisition period of one to three years wherein the General Partner identifies and acquires the shares of target companies, and a harvesting period later to arrange for assets to be sold to other investors, acquired by other companies, or taken public through an IPO. All in all, the total investment process typically spans a period of ten years or more for most PE funds. 

This contrasts with public equity investments where gains are pegged more to quarterly improvements in earnings and where the acquisition and harvesting periods are dramatically shorter due to high liquidity. Private equity thus focuses on long-term value creation with high growth opportunities rather than short-term incremental improvements to existing operations.

• Unique risk-return profile

Private equity funds offer the potential for higher returns that are less correlated to public markets. See Why invest in private equity for more on how private equity returns compare to other asset classes and how including private equity in a portfolio affects the risk-return profile.

• Fees and carry

Private equity funds are actively managed, meaning that the General Partner is usually heavily involved with both the strategic goals of the company and its day-to-day operations. The result is that private equity fees tend to be higher than those for a managed portfolio of public equity. The most common structure in private equity is “2 and 20”, where the General Partner receives a 2% annual fee, as well as 20% ‘carry’ of profits above a predefined performance threshold. Many funds operate other structures, with lower fees to incentivise investment, or higher carry to ensure the General Partner is motivated to increase the value of the company - commonly referred to as “skin in the game”.

• Low liquidity

Limited Partner stakes are considered illiquid since there are no formal exchanges or secondary markets for stakes in PE fund shares. In addition, Limited Partners may be subject to a ‘lock-up period’ during which the General Partner will deploy the committed capital to make strategic changes to target companies within the portfolio. Lock-ups mean that investors cannot liquidate their position until the end of the fund’s term, usually up to ten years or more. 

This makes private equity investments far less liquid than public market assets, resulting in the expectation by PE investors that their long-term returns will be enhanced by a liquidity premium, which compensates investors for the lack of liquidity in their holdings. Additionally, if investors want - or need - to liquidate their positions before the end of the fund’s term, limited secondary market opportunities are now becoming available to provide a solution (see below).

• High minimums

Traditionally, an investor must put forward a relatively larger amount of capital to become a Limited Partner of a fund when compared to investing in traditional public market vehicles. Depending on the fund, investment minimums can run into the millions, though a minority of funds require ‘only’ minimums in the hundreds of thousands. Until recently - with platforms like Moonfare opening the private equity market to individual investors with accessible minimums - access to private equity had been largely limited to institutional investors.

• Delayed cash flows

Private equity investors commit capital at the opening of the fund and the General Partner calls this capital periodically as investments are made. Limited Partners cannot expect to receive cash flows in return until late in the fund’s life. 

The unique characteristics of private equity can make it a beneficial addition to a well-managed portfolio. The advantages of private equity will be explored further in the article Why invest in private equity?.

Private equity secondary market

¹The delayed cash flows and illiquid nature of private equity have historically reduced the level of control investors have over their portfolios. Increasingly, though, investors who need to rebalance their portfolio or seek urgent liquidity now have secondary market opportunities to accomplish that.

The private equity secondary market allows investors to liquidate their fund interests before the end of the fund’s term. Among other characteristics, trading on the secondary market alters the cash flow profile, provides urgent liquidity and lowers private equity blind pool risk for buyers. These aspects have led to the secondary market growing rapidly as an alternative option for investors and equity fund managers alike.

Find out more about the secondary market or continue reading to learn more about how private equity works.

‍Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. This is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.