What Is Private Equity and How Does It Work? A Complete Guide
In this post, I am going to explain what is private equity and how does it work?
Let's say; I own a company. And it needs funds.
And, you are an investor on the lookout for an alternative source of investment that will earn a good return.
As an investor, how will you know that my company needs funds?
And, even if you do manage to find out, how can you trust that my company is the best possible investment for your money?
That's where the private equity firm comes in.
It helps the money flow to where it is most required and manages to earn a sweet return in the bargain.
So how exactly does the private equity firm do that? What is private equity, and how does it work? Let's take a closer look.
What Is Private Equity and How Does It Work?
A private equity firm is formed of a group of professional investment managers who invest private companies that they think will yield a high return.
The money for the private equity investment comes from the private equity fund that I will tell you in more detail about in the next section.
The private equity firm typically invests only in privately-owned companies by acquiring a majority or minority stake in the company.
Investments can either be active or passive.
In an active private equity investment, private equity managers will play a significant role in the day to day operations of the company.
In a passive investment, the company management runs the day to day operations of the company and takes the major decisions.
The private equity managers may play an advisory role at most.
What Is a Private Equity Fund?
A private equity fund is formed when partners at a private equity firm collect money from a bunch of investors and pool it together to form a fund. Investors can be large institutions like banks, insurance companies, pension funds or they can also be high net worth individual investors.
So why would someone want to invest in private equity when there are so many other investment options around?
Private equity offers some of the highest returns in the market, outperforming stock market returns consistently.
Investors in the private equity fund are the Limited Partners of the firm. Their liability is limited to the amount they have invested. Investment managers are the General Partners of the firm.
They have an immense responsibility, which means that their assets can be seized if the firm is unable to meet its financial obligation.
Have You Ever Thought of Becoming a Private Equity Investor?
To become an investor in a private equity fund, some amount of minimum investment is required.
Minimum investment amounts vary widely from fund to fund but are usually in millions.
Until recently, it was almost impossible for the Average Joe to think of investing in private equity.
But things have changed a bit now.
In the last few years of global economic gloom, many private equity firms have been struggling to raise enough money and have been forced to lower the investment bar.
These days, for as little as $50,000, some people can invest in a Carlyle Group buyout fund.
Now that you have a good understanding of what a private equity fund is let's look at the different types of private equity funds. Here are three of the most common ones:
1. Buyout Funds
Buyout funds typically acquire a controlling stake in a company.
They may also provide operational and strategic support to the company or restructure it.
Buyout funds make their money by adding additional value or unlocking the hidden value in a company and then selling it off at a much higher valuation a couple of years later.
They may either sell the company to another investor or take it public.
2. Venture Capital Funds
These funds invest in start-up companies with high growth potential.
The funds might also help start-up companies structure their operations and generally get their business going.
The advantage of investing in start-up companies is that they come at relatively cheap valuations, but the lock-in period for the investment is long. There is also a risk that the company might fail.
3. Growth Funds
Growth funds also invest in companies with high growth potential.
However, unlike venture capital firms, they invest in companies with established business models.
Such companies might need investment to start a new plant, launch a new product, enter unique geography, etc.
Growth equity funds make their money by growing the business, helping it realize its full market potential, and then selling off their share at a higher valuation.
Funds might also be formed to invest in a particular geography (like Asia) or a specific sector (like healthcare).
The last few years have also seen the rise of private equity firms like the Acumen Fund that invest only in social sector enterprises.
What's It Like to Work in Private Equity?
Working as a private equity analyst is not easy, the hours are long, and the pressures are many.
Private equity firms hire only the best and brightest of the private equity industry, but if you are employed, then the opportunities to learn are endless.
Since private equity firms have a relatively flat hierarchical structure, even as an associate or analyst, you will have the opportunity to interact regularly with Vice Presidents and Partners in the firm.
Many aspiring associates and analysts want to know what exactly their job responsibilities will be.
The four primary functions of private equity professionals are finding investors, finding companies to invest in, managing portfolio companies, and thinking of lucrative exit options for existing investments.
As an associate or analyst, you might be involved in one or all of them, which will depend on the firm you work at.
Typically, fundraising is handled by the most senior employees, while analysts and associates play a more significant role in finding potential investments and coming up with an investment rationale.
Associates with previous experience in strategy consulting might also be involved in the management of portfolio companies, helping to make operations of the company more efficient and profitable.
In the last few decades, private equity has contributed immensely to global development by providing monetary and operational support to firms at their most crucial early stages.
Many firms that are household names today (like FedEx) might not have been around if it wasn't for private equity.
I hope this article has helped you understand clearly what a private equity firm is and what the professionals do in private equity jobs.
It's Private 😉
If you've ever wondered how private equity firms work, you may have your answer. If you want to work in Leveraged Buyout (LBO) projects or private equity investment, this career is for you.
How many efforts do you put in gaining more skills in private equity? Are there any other ways to get into private equity that I didn't mention here?