An Introduction to Private Equity

What Is Private Equity and How Does It Work?

Private equity is the broad term for investing in a privately owned company rather than owning shares in a public company that can be traded on an exchange. Private equity is now the largest alternative asset class and among the faster growing: Assets under management reached over $5 trillion by the end of 2021 and could hit $11 trillion by 2026 (Exhibit 1).

Source: Preqin Forecasts, as of Q3 2021, 2021 figure is annualized based on data to March, 2022-2026 are Preqin's forecasted figures.

One of the reasons for the growth of private equity is its potential to offer higher returns than both public equities and some other alternative investments over the long term.¹ The potential for higher returns comes at the expense of liquidity: unlike public equities and traditional equity investment vehicles, such as mutual funds or ETFs, private equity is not traded on an exchange or offered in a regulated vehicle with daily liquidity. Instead, private equity funds tend to be relatively illiquid because they require investor capital to be locked up for several years to allow time for the investment to increase in value through growth, maturity or business improvement.  

While some investors may allocate to private equity seeking to improve the return potential of their portfolio, obthers may be interested in the possibility to diversify traditional equity and bond holdings (Exhibit 2).

Source: Preqin Investor Survey, November 2021.

A vehicle utilized for many private equity investments is a fund structured as a limited partnership, where the general partners (GPs) oversee the investment of the fund’s assets and manage the day-to-day operations of the fund. The limited partners (LPs) are the investors that supply capital and are otherwise passive partners.

The private equity life cycle tends to have three stages, which can sometimes overlap. These include fundraising, when capital is being raised for a new fund; investing, when capital is deployed into new investments; and harvesting, when a mature investment is prepared for an exit strategy, such as an initial public offering (IPO) or sale to another company.

What Are Some Common Types of Private Equity Investments?

There are a number of categories and sub-categories of private equity strategies, which display a range of risk and return profiles (Exhibit 3).

• Buyout is the largest category of private equity. Buyout funds typically seek to gain controlling or majority ownership of an existing private company or a public company that can be taken private, with the goal of creating value by improving the operations of the company. The fund then seeks to sell or take the company public at a higher valuation.

• Growth equity investments tend to be in more established businesses than venture capital but may still offer strong potential for growth because they are typically at an earlier stage of development than broader buyout investments.²

• Secondary investments are typically made by buying the LP interest of an existing private equity fund from another investor. They may often be purchased at a discount to the net asset value due to the illiquidity of the investment, though sometimes a premium is warranted.³

• Funds of funds seek to combine investments in a variety of private equity funds in an effort to diversify private equity exposure by strategy, manager or vintage year.

Additional Sub-Categories:

• Distressed funds typically invest in companies or situations that are financially or operationally challenged and can usually invest across the capital structure. The GP tends to seek operational and financial support to turn the company around through restructuring or other changes. These assets may sometimes be considered a subset of buyout strategies.

• Venture capital investments are generally made in new and disruptive companies across industries, such as technology or health care. They may sometimes be considered part of the growth equity category. Venture investments are often further categorized as angel, seed, early-stage, late-stage and pre-IPO, with each stage typically offering a different risk and return profile. Venture is considered to be one of the higher risk/higher return areas within private equity.⁴

• Infrastructure & energy investments can vary in terms of the risk and return profile, with riskier opportunistic investments as well as lower-risk core-type assets that may have more predictable cash flows and are not dependent on exiting at a higher valuation. These assets can sometimes be categorized as real asset investments.

Considerations When Investing in Private Equity

• Manager Selection and Access: Private equity returns can be somewhat dependent on access to deals with strong potential and the ability of a manager to add value. This can make due diligence when selecting managers—in terms of their track record, experience and access to deal flow—an important part of the private equity investment process; it also can create significant investor demand for the top-performing managers.

• J-Curve: Private equity investments tend to follow a pattern called the J-curve, where they will produce negative cash flows in the early years, due to capital calls and management fees paid before there is a chance for the investment to generate returns.⁵ It may take several years until underlying investments are marked up to their current value or gains realized through exit transactions.

• Liquidity and Volatility: Private equity tends to be a long-term, relatively illiquid investment because a strategy can take years to play out, requiring capital to be locked up for long periods of time. The GP controls the investment decisions, and an LP may only be able to exit the partnership in a secondary market that may have limited buyers, if any, or at a discount to the stated value. Private equity investments tend to be valued only periodically by the owners of the company, as opposed to public equity investments which are valued daily or in real time. This can make private equity investments appear less volatile in a portfolio but should not be confused with potential underlying volatility in the real value of the asset.

• Business Risk: All stages of private equity investments come with some level of business risk. For example, a business at the venture capital stage may not prove to be viable or competitive; in buyout or distressed transactions the company may not be able to successfully restructure to add value.

Private equity is one of the more established alternative asset classes and appears likely to remain a popular allocation going forward.