Investing 101: What is Private Equity Investment?

May 27, 2020 Posted by : Jorge Cardozo
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Every time we think about investments, we are biased to think immediately about the stock market. And for many people around the world, this is the only way to have access to a company's ownership. What if I tell you that there is a vast world of investments in non-listed-in-stock-market companies? This parallel universe of investments is known as Private Equity.

 What is Private Equity Investment?

This type of investment comes under Alternative Assets. Think of it this way: imagine you are a farmer. You do your work, and you have not realized your properties potential or your reach. But someone else has. This person will come to you and help you better develop the land, teach you new and better techniques to harvest. All of this support comes at a cost; for example part of your income, the decision on the type of products you harvest, etc. This is essentially what private equity investment firms do. 

Definition of Private Equity

Private Equity is defined as “an alternative investment class and consists of capital that is not listed on a public exchange. Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity. Institutional and retail investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet”

There are two main characters in the Private Equity world: Limited Partners (LP) are the ones that invest the money, and General Partners (GP) are dedicated to executing and managing the investments. Execution can be interpreted as the timing for investing the money autonomously (according to established guidelines), and management means that they act independently and in the name of the LPs, seeking for the investment strategy that they consider would work best.

Types of Private Equity

As it is the case in the public market, there are many forms and types of Private Equity in both Equity and Debt, and most of the time the type used will be dependent on the stage the company is in. The most common forms of Private Equity (PE) are:

Venture Capital: Investors (sometimes also known as Angel Investors) provide capital to entrepreneurs that have the potential to escalate the business. This can be delivered merely by capital/equity or debt. 

Buyouts: This way of PE usually comes on the growth stage. It is used to buy an entire company or one of its divisions and make improvements to make it better operationally and economically.

Mezzanine: A type of debt that could be structured with different maturity dates. 

Fund of funds: A diversified portfolio of different forms of private equity investments. 

Characteristics: It is clear now that Private Equity gives you access to non-listed companies. But how different is it from public investments? 

  • Time: PE usually has a longer perspective than traditional assets (stocks and bonds). For buyouts, the average cycle is 8-10 years. It does not mean that you will see returns in 8 years, but the last cent of your invested money will be given back to you in that period. Usually after the first 3-4 years you will have gains (in the form of cash flows) after the strategy starts having exits (selling companies after hitting the proposed targets). The time for Mezzanine could vary between 3-6 years. 
  • Returns: Typically higher than public investments. Of course, returns will depend on the GP (management) and the ability to exit positions. You will have two ways of measuring returns in private equity: IRR (Internal Return Rate) and Multiples (a generic term for a class of different indicators that can be used to value a stock).
  • Exits: Although it is not ideal, and investors are always warned about doing it, let's imagine you want to sell your investment in private equity. You will be “penalized”, meaning that the only way you could exit your position is reducing the market value. Many private equity fund managers or investment managers are looking for these exits, and they are called “secondary funds”, which arbitrage, trade and have profit on the purchase/sell price. 
  • Costs: This is probably one of the most debatable issues in private equity. Management and operational costs sometimes are too high. However, in the last 10 years, with more offers of private equity investment firms, we have seen a slight decrease in the costs.
  • J curve: When investing in private equity, you will invest when you are told to do so. Unlike the public market that you invest all at once, in private equity you have a “commitment” that you will deliver as the GP requires it. In this period, you will have to carry the costs and other expenses of the fund, meaning that before having any profit you will have some “losses”. This is known as the J curve. 
  • Ticket Size: Private equity has always been a strategy reserved for institutions and qualified investors. The minimum ticket size is around $100,000, in most of the cases. However, changes are being promoted so that regular/retail investors to have an opportunity to populate the landscape of private equity investors. 

As it is the case for other asset classes, investments in private equity require an exhaustive and rigorous due diligence. I still ignore the time when retail investors can access this category, but regulation is moving fast in this direction. I encourage all people to start reading and understanding about this matter because investment opportunities will arise massively once all is ready.

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About Author

Jorge Cardozo
Jorge Cardozo

Jorge has over eight years of experience in wealth management and economic research, managing more than 600 million USD. He has invested in all types of securities, ranging from traditional assets (fixed income securities and funds, global equity) to alternative assets (real estate, hedge funds, and private equity). Jorge holds an MBA from a top global program.

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