What Is Private Equity?
Private equity is owning a stake in a company not listed on a public stock exchange to gain better returns than public stock markets. It is one of the ways organizations use to raise capital. Other methods include selling bonds, issuing stock, and taking loans. While most private equity investment companies invest in private companies, some buy unlisted public companies.
Private equity funds are not regulated by the Securities and Exchange Commission (SEC), making them better for experienced investors. Funds regulated by the SEC include mutual funds, ETFs (exchange-traded funds), and publicly traded stocks.
An alternative investment option, private equity is similar to hedge funds and venture capital. Investors in such asset classes are required to commit significant sums of money for long periods, typically around 10 years. Therefore, these assets are restricted to high-net-worth individuals (HNWIs) and institutions since only these entities can afford the funds for such investments.
It is important to differentiate between private equity and alternative investment options that work similarly, such as venture capital. First, private equity is investments in established companies, while venture capital supports entrepreneurs and startups. Second, private equity offers funding in exchange for a majority stake in a company, while venture capital aims for a minority stake.
Third, private equity investors actively manage a company’s activities. However, venture capital investors get advice from advisors and other fund managers. Last, private equity realizes returns when a company grows or sells. With venture capital, investors receive returns after a company is acquired or goes public.
A private equity firm is an entity that manages private equity funds. Its work is to buy out struggling companies or major stakes in them. After restructuring such an organization back to profitability, the firm sells the company at a profit.
Most private equity firms specialize in different areas, such as real estate, technology, and healthcare. These entities have two types of partners: Limited partners (LPs) and general partners (GPs). LPs fund the investment and receive shares or an ownership stake in return. They include individual investors, institutional investors, and pension funds.
On the other hand, GPs work with LPs and manage the investment fund. They make the decisions regarding the investments. GPs also receive some shares of the fund. Notably, they take full liability if their decisions don’t result in good returns for the LPs.
Private equity collects funds from investors and then finances activities such as restructuring a company on the brink of collapse. Private equity may also fund a startup or an organization’s initial public offering (IPO) or cover costs in mergers and acquisitions. Once the set time frame elapses, investors get their initial investments back, plus possible profits from IPOs and sales. While most private equity investments payout at the end of the set duration, some, such as real estate limited partnerships, may earn investors regular income throughout the investment’s lifecycle.
Private equity has advantages for both companies and individual investors. For a company, private equity offers an alternative to raise funds without using costly options such as loans or IPOs. Private equity allows companies to focus on overall growth instead of quarterly returns, which may not show a complete picture of the organization’s performance. For investors, private equity offers more freedom than trading in public markets with certain restrictions, and profits are not subject to income tax.
