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Private equity

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Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Passive institutional investors may invest in private equity funds, which are in turn used by private equity firms for investment in target companies. Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.

Private equity securities

Private equity refers to shares in companies that are not listed on a public stock exchange; while technically the opposite of public equity they are broadly equivalent to stocks, though return on investment often takes much longer. As they are not listed on an exchange, a private equity firm owning such securities must find a buyer in the absence of a traditional marketplace such as a stock exchange. In addition, there are many transfer restrictions on private securities. This long term investment area currently has over $710 billion in assets.[citation needed]

Private equity firms generally receive a return on their investment through one of three ways: an initial public offering, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.

Private equity funds

Private equity funds are the pools of capital invested by private equity firms. Although other structures exist, private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10% of the total commitments.

General partners are typically compensated with a management fee, defined as a percentage of the fund's total equity capital. In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will receive an annual management fee of 2% of committed capital and carried interest of 20% of profits above some target rate of return (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year, which in the case of leveraged buyout firms is primarily due to leverage, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not freely tradeable like mutual fund interests.

Considerations for investing in private equity funds relative to other forms of investment include:

  • Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus further investment for the first few years of the fund called a 'drawdown'.
  • Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
  • If the private equity firm can't find good investment opportunities, they may end up returning some of your capital back to you. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
  • Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

For the abovementioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.

Most private equity funds are offered only to institutional investors and individiuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth (exclusive of primary residence), $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.

Size of industry

Nearly $180bn of private equity was invested globally in 2004, up over a half on the previous year as market confidence and trading conditions improved. Funds raised globally increased 40% in 2004 to $112bn. Prior to this, investments and funds raised increased markedly during the 1990s to reach record levels in 2000. The subsequent falls in 2001 and 2002 were due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The decline in fund raising between 2000 and 2003 was also due to a large overhang created by the end of 2000 between funds raised and funds invested.

The regional breakdown of private equity activity shows that in 2004, 66% of global private equity investments (up from 58% in 1998) and 62% of funds raised (down from 72%) were managed in North America. Between 1998 and 2004, Europe increased its share of investments (from 24% to 26%) and funds raised (from 18% to 31%). Asia-Pacific region’s share of investments and of funds raised during this period was virtually unchanged at around 6% while share of the rest of the world fell. The country breakdown for private equity activity shows that private equity firms in the US managed 64% of global investments and 59% of funds raised in 2004. The UK was the second largest private equity centre with 13% of investments and 11% of funds raised.

See also

References

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