What Is Private Equity?

Private equity is one of the largest areas of the financial sector but remains largely a mystery to most. Since the average retail investor generally doesn’t have direct access to private equity funds, they become a black box. So, what is private equity, and how can it affect you and your finances?

Unless you’re a long-term professional or institutional investor, you most likely won’t interact directly with a private equity firm in your financial dealings. However, these firms are major players in the financial world and may still impact your investment portfolio in a handful of ways.

Let’s dive into private equity to see what it is, how it works, and its different effects on investors and the economy.

What Is Private Equity?

Private equity is a channel of business and investing that exists as an alternative to dealing directly in publicly traded securities, such as buying stocks and bonds on a public exchange. It usually involves buying ownership stakes in non-publicly-traded companies or buying public companies and taking them private.

A private equity fund is typically an investment partnership between a private equity firm and a group of limited partners. These limited partners may include insurance companies, foundations, endowments, or other institutional or high-net-worth investors.

Private equity funds are highly illiquid investments focused on long-term growth. Partners in a fund should expect to face limitations on withdrawing their investment before a requisite time window (usually several years) has passed.

As privately orchestrated arrangements, these opportunities are generally unavailable to everyday retail investors. However, ordinary investors may be exposed to private equity through employer-sponsored retirement plans like a 401(k) or 403(b).

Private Equity Firms Explained

Private equity firms operate on the primary goal of acquiring companies and using them to turn a profit, both for investment partners and for the firm itself.

Typically, a private equity firm invests in established companies with potential but facing some form of financial distress or mismanagement. The firm usually aims to buy a majority or controlling stake in one of its portfolio companies and uses that control to make significant changes to the business.

With its management influence, a private equity firm may change personnel, operations, or many other areas of a company. These adjustments aim to grow the portfolio company, improve its profitability, or both.

After managing the business for typically a few years, the firm aims to sell or “exit” it for a profit. An exit may entail selling the company to another investor or firm or taking the company public through an initial public offering.

Private Equity Firm vs. Private Equity Fund

The terminology here can get a bit messy, so it’s essential to clearly distinguish between a private equity firm and a private equity fund.

A private equity firm is an organization that pools together assets (primarily companies) to create investment opportunities for both the firm and its partners. One such pool is a private equity fund, into which the firm and limited partners invest.

Each firm may, and likely will, operate multiple funds at any given time.

The distinction becomes much simpler when using the more familiar concept of mutual funds as an analogy. A private equity firm is similar to a mutual fund issuer like Vanguard or Fidelity. In that analogy, each private equity fund the firm issues is equivalent to a mutual fund or ETF. The limited partners are the investors in that fund, and rather than publicly traded securities, the fund invests privately in its portfolio companies.

However, there are significant differences between private equity and mutual funds, and the distinction is more complex than the type of assets within the fund.

For instance, the active role of private equity firms in managing their portfolio companies would fall far out of the purview of your typical index fund. Private equity swaps the buy-and-hold approach to investing for a hands-on approach to turning companies profitable.

Private Equity vs. Venture Capital

Like private equity, venture capital (VC) is a phrase most investors have heard but few have access to. As such, it can fall into a similar shroud of mystery and ambiguity. Since the two are pretty similar and have a great deal of overlap, it’s well worth taking a moment to distinguish between the two.

By a broad definition, VC is a type of private equity. Although, as a large industry, it often gets its own space in the conversation, separate from what one would typically call private equity funds.

Venture capital has most of the traits of private equity that we’ve discussed so far. It is a channel where professional and institutional investors pool their assets to privately invest in companies intending to grow and profit from them. It is a long-term strategy with limited liquidity and little availability to retail investors. Additionally, VC usually relies on having a management stake in a company to influence its growth and profitability directly.

One of the primary differences between VC and private equity is the size of their portfolio companies. Private equity firms tend to target larger, established portfolio companies. These companies often have a strong history or future potential but present issues where the firm can improve profitability. Conversely, VCs usually pursue smaller companies or startups with high potential for expansion and growth.

How a Private Equity Fund Makes Money

In an ideal scenario, private equity makes money for three primary groups of stakeholders: the issuing firm, the limited partners, and the portfolio companies. Each of these stakeholders has different goals and prospects in this arrangement. Each party’s returns come from separate sources; what benefits one party may not necessarily mean a payout for all. Let’s take a look at each individually below.

Investors (Partners)

The investors, or limited partners in a private equity fund, have the most straightforward financial arrangement. At a high level, they put money into the initial pool to establish the fund, and they hope to profit from that investment through a mix of growth and income.

Calling back to the mutual fund analogy above, the role of investors here is very similar to those buying into a mutual fund. They contribute to the asset pool and wait for it to yield a return.

While many investors in private equity funds are large institutions, it’s becoming easier to find a financial advisor who can offer their clients access to private equity funds. While the costs may be higher and choices more limited than the opportunities available to large institutions, the potential diversification benefits could make an allocation to private equity worth considering.

Private Equity Firms

The way private equity firms profit from their funds is a little more complex but usually comes from a mix of two sources: management fees and performance fees.

Management fees are a recurring charge for the firm’s involvement in managing its companies. It usually derives from a percentage of assets under management (AUM). Performance fees are the firm’s cut of the profits from the portfolio company.

The most common scheme is a 2% management fee and a 20% performance fee, also known as the 2-and-20 rule.

Portfolio Companies

Ostensibly, portfolio companies owned by a private equity fund also stand to profit. By injecting investor capital and getting involved in the company’s management, firms offer the possibility of growing these companies in size and profitability.

However, this doesn’t always turn out to be the case. Often, a mix of corporate raiding and immense debt yields a significant profit for private equity firms and their investors but leaves companies holding the bag. We’ll cover these issues in more depth in the next section.

Criticism of Private Equity

The private equity sector can be profitable to its investors but has faced much criticism over the years. Critics uphold private equity is often harmful to businesses, industries, and even the economy as a whole.

One of the foremost critiques of this industry is private equity firms serve only their own (and their investors’) profits while often significantly harming the businesses in which they invest, sometimes irreparably so. Some standard practices, such as the downsizing and selling of business assets, leave businesses much worse for wear after extracting value from the companies for investors’ sake.

In addition to raiding corporate assets, private equity is often under fire for using leveraged buyouts (LBOs), one of the most common methods by which firms acquire companies. LBOs saddle portfolio companies with an often insurmountable debt burden on behalf of the private equity firm, which can later walk away scot-free.

The carried interest loophole, a mechanism by which private equity managers and executives can slash the tax bill on their compensation, is also a target of frequent rebuke.

Growth and Profits With Private Equity

Private equity is not a core component of the average investor’s portfolio, so it remains shrouded in mystery to most. Despite being a common phrase to hear in business and investing news, it is not usually something everyday investors deal with, at least not directly. However, private equity plays a massive impact on the financial sector and the economy, and it even indirectly plays a role in many people’s retirement savings.

Given the outsized role of private equity in shaping and reshaping the markets, it is wise to familiarize oneself with how this investing channel works and who the key players are. Even if you’re not considering buying into a private equity fund next week, familiarizing yourself with the concepts and mechanics of this world is an investment in your prospects and preparedness.

This article originally appeared on Wealth of Geeks.