Private equity funds are investment vehicles that pool together capital from several investors to invest in private companies or assets. Private equity funds are typically managed by a private equity firm and are structured as limited partnerships. The private equity firm acts as the general partner and makes investment decisions, while the investors act as limited partners and provide the capital for the investments. Private equity is a type of alternative investment.
Private equity funds have a defined investment strategy, which may include a focus on specific industries, stages of company development, or types of investments (such as leveraged buyouts or growth equity investments). The fund typically has a limited lifespan, usually 5 to 10 years, after which it is dissolved, and the proceeds are distributed back to the investors.
Private equity funds typically aim to generate high returns for their investors through debt financing and equity ownership of the companies or assets in which they invest. They may also seek to add value to the companies they invest in through operational improvements, strategic planning, and other measures. However, private equity investing also involves a higher risk than traditional investments, such as stocks or bonds, as the underlying assets are not publicly traded and may be less transparent.
Private equity firms typically look to invest in mature companies that have a proven track record of success and that they believe have significant potential for growth. Private equity investments aim to generate a return on investment through revenue growth, operational improvements, and ultimately, a sale or initial public offering (IPO) of the company.
Private equity is typically open to accredited investors, meaning individuals with high-net-worth, and institutions, and usually requires a large minimum investment. Hence they are generally exempt from many disclosure and reporting requirements that apply to mutual funds and ETFs. They have a high-risk, high-return profile. They may not be suitable for all investors, and it is essential to carefully consider one’s investment goals, risk tolerance, and investment time horizon before deciding to invest.
Different investment strategies of private equity
- Leveraged Buyouts (LBOs): This strategy involves acquiring mature companies using significant debt financing. The goal is to improve the company’s financial performance and generate returns for investors.
- Growth Capital: This strategy involves investing in companies that are already established and looking to grow their operations and market share. Private equity firms provide capital to these companies to fund their growth plans.
- Turnaround Investing: This strategy involves investing in companies facing financial difficulties, such as bankruptcy or restructuring. The goal is to generate returns by restructuring the company and improving its financial performance.
- Distressed Debt Investing: This strategy involves investing in debt securities of companies facing financial difficulties. The goal is to generate returns by restructuring the company and improving its financial performance.
- Real Estate Investing: This strategy involves investing in commercial and residential real estate properties directly or through acquiring real estate companies.
- Mezzanine Investing: This strategy involves providing debt financing to companies in the later stages of development with a proven track record of success. The goal is to generate returns by financing companies not qualifying for traditional bank loans.
- Secondary Investing: This strategy involves investing in existing private equity partnerships, providing liquidity to existing limited partners and allowing them to realise their investment returns.
These strategies can help generate returns uncorrelated with traditional investments, such as stocks and bonds.
History of private equity
The history of private equity funds goes back to the early 20th century when a small group of wealthy individuals and families began investing in privately held companies. Over time, these early forms of private equity investing evolved into more formalised investment vehicles, such as private equity funds and venture capital funds.
The modern private equity industry began to take shape in the 1970s and 1980s, with the growth of larger financial institutions and the increased availability of debt financing. During this period, private equity firms began to use leveraged buyouts (LBOs) to acquire and restructure mature companies. In an LBO, a private equity firm acquires a company using a combination of debt financing and equity capital, intending to improve the company’s operations and financial performance.
The private equity industry continued to grow and evolve over the next several decades, with the rise of private equity funds and the growth of the alternative investment industry. Today, private equity funds manage trillions of dollars in assets and play a significant role in the global financial landscape.
While the history of private equity has been marked by both growth and controversy, the industry has remained a popular investment choice for institutional and individual investors seeking to generate high returns and access to private markets. However, the industry has also faced criticism for its practices, including the use of debt financing, the high fees charged to investors, and the impact on the companies in which private equity firms invest.
More academic studies on private equity have started to take place. For example, the book “Advanced Introduction to Private Equity” written by Steven Kaplan and Paul Gompers, was released in 2022.
Number of private equity funds
It is difficult to determine the exact number of private equity funds in the world, as the private equity industry is evolving, and new funds are always being created. In addition, some private equity firms may have multiple funds, each with a different focus or investment strategy.
Estimates suggest tens of thousands of private equity funds globally, with a significant concentration in the United States. Estimates suggest several thousand private equity funds in the U.S., ranging in size from small boutique firms to multinational private equity giants.
Estimates suggest several hundred private equity funds in Australia. The Australian private equity industry has grown in recent years, attracting increased interest from local and international investors.
Investment performance of private equity funds
Knowing the usual returns of leading private equity funds is challenging, as private equity firms do not typically disclose their funds’ returns publicly. In addition, the industry is highly fragmented, with a wide range of fund sizes, investment strategies, and geographic focuses.
Private equity funds typically aim to achieve 15% to 20% or higher returns, although actual returns can vary widely depending on the specific fund, investment strategy, and market conditions.
When evaluating private equity funds, investors must focus on the specific fund’s track record, investment strategy, and the experience and expertise of the private equity firm managing the fund rather than simply looking for the highest returns.
It’s worth noting that even the best-performing private equity funds have experienced periods of weak performance, and investment in private equity funds is not without risk. As with any investment, it’s essential to carefully consider the risks and potential rewards before investing in private equity.
Size of private equity funds
Private equity funds are generally characterised by their large size, as they are designed to pool capital from a large number of investors to make significant investments in private companies or other assets.
The size of private equity funds can range from a few hundred million to several billion dollars, with many of the largest private equity funds having assets under management of $10 billion or more. In addition, big private equity funds are often managed by some of the largest and most established private equity firms, which have extensive networks, expertise, and resources for identifying and evaluating investment opportunities and managing portfolio companies.
It’s important to remember the size of a private equity fund is not necessarily an indicator of its performance or suitability for investors, and investors should carefully evaluate the investment strategy, track record, and risk profile of any private equity fund before making an investment decision.
Net worth of an individual to access private equity funds
The net worth required to access private equity funds varies depending on the specific private equity fund.
Private equity funds typically have a minimum investment requirement for investors, ranging from hundreds of thousands to millions of dollars. They generally are only available to institutional investors, high-net-worth individuals, and other accredited investors.
The high minimum investment requirements for private equity funds are designed to limit the number of investors in the fund to a relatively small group of institutional investors, high-net-worth individuals, and other accredited investors who can meet the financial requirements of the fund.
Private equity funds often have access to investment opportunities not available to retail investors. Generally, the higher the minimum investment requirement for a private equity fund, the more exclusive and less accessible the investment will likely be. High-net-worth individuals and institutional investors are typically the primary target market for private equity funds because they tend to have the financial resources and risk tolerance necessary to invest in these assets.
Proportion of portfolio in private equity funds
Some high-net-worth individuals allocate a portion of their portfolios to private equity investments to diversify their holdings and potentially generate higher returns.
Many financial advisers suggest that a well-diversified portfolio of a high-net-worth individual should have between 5% and 10% invested in private equity funds. However, this is just a rough estimate, and the exact portfolio mix will depend on an individual’s specific financial circumstances and investment goals.
Private equity investments and play money
Whether all investments in private equity funds are considered play money depends on the nature of those specific private equity funds. Usually, a sizeable section of private equity investments of an investor is considered part of her play money.
Private equity as part of the satellite portion of core-satellite investing
Private equity funds are typically not considered part of the core portion of a core-satellite portfolio, as they are generally considered high-risk, illiquid investments that are more suitable for the satellite portion of a portfolio. The satellite portion of a core-satellite portfolio can contain private equity funds.
Private equity funds and long-term investing approach
Private equity funds can be either long-term or short-term investors, depending on the investment strategy of the fund and the goals of its investors.
Long-term private equity funds typically take a more patient, strategic approach to investing, focusing on acquiring controlling stakes in companies and working to improve their operations over several years. These funds typically aim to hold their investments for 5-7 years or longer and to exit through a sale of the company or an initial public offering (IPO).
Short-term private equity funds, on the other hand, typically focus on more opportunistic, shorter-term investments, such as distressed debt or special situations. These funds may hold investments for a period of just a few months or a few years and may exit through a sale of the company or a financial restructuring.
It’s worth noting that the distinction between long-term and short-term private equity investing is not always clear-cut, and some funds may employ a combination of long-term and short-term strategies. Therefore, when evaluating private equity funds, investors need to understand the fund’s investment strategy and its expected hold period for investments.
Private equity and liquidity
Private equity funds are generally considered to be illiquid assets.
Unlike publicly traded stocks or bonds, which can be bought and sold on an exchange daily, private equity investments are often made in privately held companies and can be challenging to sell or redeem. Private equity funds typically have a long-term investment horizon, with a typical hold period of 5-7 years or longer. Investors in private equity funds usually must be prepared to keep their capital committed for the fund’s life.
In addition, private equity funds are often structured as limited partnerships, meaning that investors may have limited rights to access their capital before the fund’s termination. The terms of the fund, including the redemption rights of investors, are typically outlined in the fund’s limited partnership agreement.
Some private equity funds may offer more flexible redemption terms, such as periodic redemptions or the ability to sell interests in the fund on a secondary market. Still, these structures are less common and may also be subject to restrictions or fees.
As a result of these factors, private equity funds are generally considered less liquid than other investment products, such as stocks or bonds. Therefore, when evaluating private equity investments, it’s crucial for investors to assess their liquidity needs and to carefully review the terms of the fund, including the redemption rights and the expected hold period for investments.
Private equity fund and mark-to-market
The frequency with which the underlying assets of a private equity fund are marked-to-market depends on the specific fund and the accounting standards that apply to the fund.
In general, private equity funds are not required to mark their underlying assets to market regularly, as the assets are typically held for several years, and their value can be challenging to determine in real time. Instead, private equity funds usually value their investments using a method known as “fair value” accounting, which involves estimating the value of the investment based on factors such as current market conditions, the financial performance of the underlying company, and the fund’s exit strategy.
The frequency of fair value accounting can vary from fund to fund but is typically performed quarterly or semi-annually. Some funds may also conduct periodic “impairment testing” to determine if an investment has declined in value to a point where it is no longer considered a viable investment.
It’s worth noting that the lack of regular mark-to-market valuations can make it difficult for investors to assess the performance of private equity funds in real time. As a result, many investors in private equity funds have a long-term investment horizon and are comfortable with the illiquid nature of the investments.
Investor preference between private equity and hedge funds
Refer to the section ‘Investor preference between private equity and hedge funds‘ in the ‘An introduction to hedge funds‘ knowledge resource.
Fee structure of private equity funds to investors
Private equity funds typically charge a management fee and a performance fee, which together are known as the “two and twenty” fee structure.
The management fee is typically a percentage of the total assets under management, generally 1-2% per year. This fee is designed to cover the costs of managing the fund, including salaries, office expenses, and other overhead costs.
The performance fee, also known as the “carried interest,” is typically 20% of any profits earned by the fund. This fee is designed to incentivise the fund managers to generate strong returns for investors, as they only receive a portion of the profits once a certain return threshold has been met. The performance fee is often subject to a “hurdle rate,” a minimum return that must be achieved before the performance fee is paid.
In addition to the management fee and performance fee, investors in private equity funds may also be subject to other fees and expenses, such as legal and administrative expenses, due diligence fees, and transaction fees.
The specific fee structure of a private equity fund can be complex and will depend on the investment strategies used by the fund and the agreements between the private equity firm and the investors.
Fee structure of private equity funds to portfolio companies
- Management fees: Some private equity funds charge management fees to portfolio companies to cover management and operational support costs. These fees are typically a percentage of the portfolio company’s revenue.
- Monitoring fees: Similar to management fees, monitoring fees are charged to cover the costs of monitoring and supporting portfolio companies. These fees may be a fixed amount per year or a percentage of revenue.
- Transaction fees: Private equity funds may charge transaction fees to portfolio companies for services related to mergers and acquisitions, refinancing, or other financial transactions.
- Termination fees: If a portfolio company is sold before a certain period, the private equity fund may charge a termination fee.
- Advisory fees: Some private equity funds provide advisory services to their portfolio companies and charge fees for these services.
- Other fees: Private equity funds may charge additional fees to portfolio companies, such as legal and administrative fees or fees for providing training or support.
The fee structure and amounts charged by private equity funds to their portfolio companies can vary widely depending on the fund’s investment strategy, the size and complexity of the portfolio companies, and other factors. Therefore, it’s essential for portfolio companies to carefully evaluate the fee structure of any private equity fund before accepting an investment and to understand the potential impact of fees on their overall financial performance.
Advantages and disadvantages of private equity funds
- Potential for High Returns: Private equity funds have the potential to generate high returns, especially over the long term. This is due to the private equity firms’ focus on improving the financial performance of the companies they invest in and exiting those investments at a profit.
- Active management in portfolio companies: Private equity firms take an active management approach to the companies they invest in, providing capital, resources, and expertise to help them grow and succeed.
- Diversification: Private equity funds can provide investors with diversification, as they typically invest in a variety of companies across different industries and stages of development.
- Long-Term Investment Horizon: Private equity funds typically have a long-term investment horizon, which allows them to take a patient approach to their investments and focus on building long-term value.
- Lack of Liquidity: Private equity funds are typically illiquid investments, meaning it can get difficult for investors to sell their holdings to access their capital.
- High Fees: Private equity funds often charge high fees, including management fees, performance fees, and transaction fees. These fees can reduce the net returns generated by the fund for investors.
- Risk of Underperforming Public Markets: Private equity funds can underperform public markets, especially over the short term.
- Limited Information: Private equity firms typically operate in private markets and have limited disclosure requirements, making it difficult for investors to obtain information about the performance of their investments.
- Complex Structure: Private equity funds have a complex structure, with multiple limited partners and general partners, making it difficult for investors to understand the investments and risks involved.
- Frequency of mark-to-market: In general, private equity funds are not required to mark their underlying assets to market regularly. Their value can be challenging to determine in real time.
- High minimum investment: Private equity funds typically have a minimum investment requirement for investors. They generally are only available to institutional investors, high-net-worth individuals, and other accredited investors.
Our view at QuietGrowth
To know about our view at QuietGrowth regarding private equity, refer to the ‘Private equity funds‘ section in our Investment Methodology page.
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