What Is Private Equity?

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by Advice Chaser
by Advice Chaser

Most investments are public, such as stocks and bonds. However, some investments are private, meaning they aren’t available on a stock exchange, aren’t regulated by the SEC, and aren’t available to everyone. Private equity is one such investment type. 

As with all private investments, only accredited investors, such as institutions or high net worth individuals, can invest in private equity. Generally, private equity consists of a firm which collects investments from others before purchasing assets such as businesses.

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How Private Equity Works

Private equity begins with a firm which raises money from limited partners. These limited partners are high net worth individuals or institutions. Often, these include pension funds, endowments, and insurance company funds—money that an institution needs to invest but doesn’t need to see again right away. Limited partners don’t have decision-making power in the private equity fund—the firm does all the management.

Once the firm has enough money, it invests in various private assets. These are investments which aren’t publicly traded or regulated by the SEC. The usual model is that the private equity firm purchases a majority stake in a business—50% or more of the company. Sometimes, companies sell to a private equity firm because they’re in dire straits already. Other times, they’re hoping the firm will help them grow.

A private equity firm holds its investments for a medium term—about five to ten years. During that time, it may dramatically restructure the business, downsize it, or pivot it to new markets. The idea is that the firm, being an expert in distressed companies, can save the business and make it profitable again. When that happens, the limited partners make a profit on their investment and the firm takes a percentage.

Private Equity and You

Unless you work at a private equity firm, you’re unlikely to have direct contact with one of them. And yet you probably cross paths with private equity all the time. It is possible that your pension is currently invested with one. And you have almost certainly shopped at businesses owned by private equity.

If you own a business, you may be faced with the decision to sell to a private equity firm. These buyers have the money to make an immediate purchase and a plan to turn your company around. They may want to buy your business for a combination of cash and stock. Some of the purchase price may be financed by debt.

The advantage here for you is that you have a buyer eager to put a sale through and experienced at making businesses profitable. Because they invest for a medium term, they won’t be hurting your company’s long-term success for immediate profits, which can be a problem with publicly-traded companies that have to show quarterly profits. At the same time, since they don’t intend to keep the company forever, they will want to act aggressively to make immediate improvements.

There are downsides, however. You will lose control of your company, and the firm is likely to make dramatic changes. Your employees may hate the restructuring. Some might be laid off. Private equity buyers may attempt to pay less than other buyers in the hopes of maximizing their profit. They will also have their own preferred deal structure for the purchase, which might not be what you wanted. You definitely need an expert of your own to help you navigate the process and decide if what they are offering is a good deal for you.

Pros and Cons of Private Equity

The advantage of private equity is that it infuses cash and expertise into struggling businesses. By connecting investors with these businesses, a private equity firm can save companies that would otherwise go under and make a profit for the investors at the same time. This can be useful for institutional investors like pension funds and endowments. If you’re a business owner, selling to private equity can be a way to keep your business alive while remaining a minority owner.

But private equity isn’t without its critics. Companies purchased by private equity firms are more likely to go bankrupt than other companies. It’s too easy for the firm to downsize, profit off the assets, and call it a victory. Since they’re majority owners, they can call the shots, but since the company is still a separate legal entity, they can avoid liability for things that go wrong. Sometimes a purchase saddles the company with unmanageable quantities of debt.

Private equity can also lead to conflicts of interest. With so many middlemen, it can be difficult to detect these conflicts. Tax loopholes also allow private equity firms to pay far less than other investors. Some people would like to see greater SEC regulation for private equity firms.

Why You Need an Expert

When dealing with a private equity firm, you might feel like David facing Goliath. They have money and expertise far beyond yours. That’s why it’s vital to hire a business financial advisor to help you consider your options, whether you’re looking to sell a business or seeking unusual investment opportunities. Make your advisor aware of your priorities, and they’ll help you chart a path that preserves what is most important to you.We can connect you with the right advisor for you when you contact us. Our list contains advisors with expertise in business, investment, taxes, retirement, and more.

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