How Does Private Equity Work? A Comprehensive Guide
How Does Private Equity Work? Private equity provides exposure to private companies not available in public markets. It involves complex deals and fundraising structures that enable firms to invest capital into private businesses, improve operations, and ultimately sell them for significant profits.
But how exactly does private equity work and generate returns? This comprehensive guide aims to demystify private equity, its structures, investment strategies, and performance.
Key Takeaways
| Term | Definition |
| Private Equity | Investments in private companies that are not publicly traded on stock exchanges |
| General Partners (GPs) | Private equity firms who source deals, raise capital, manage funds |
| Limited Partners (LPs) | Institutional investors who provide capital – pensions funds, endowments etc. |
| Fund Lifecycle | Raise Fund > Source & Close Deals > Improve Operations > Exit for Returns |
| Carried Interest | Profit share that general partners receive if certain return hurdles are met |
What is Private Equity and How is it Different from Public Markets?
Private equity refers to capital that is invested in private companies that are not publicly traded on major stock exchanges. Some key differences versus public market investing include:
- Less Regulation – Private equity operates outside of public markets and thus has less regulatory oversight from bodies like the SEC.
- Illiquidity – Investor capital is tied up for years given the long fund lifecycles. Liquidity only occurs when investments are exited.
- Available Deals – Certain deals, investments, and opportunities are only accessible in private markets.
This means private equity funds can flexibly structure more complex, risky, and potentially more profitable investments compared to average public market investors.
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Average investors also cannot access private equity directly. Investors must meet SEC-accredited investor requirements and minimums that often start from $5 million+.
| Factor | Private Equity | Public Markets |
|---|---|---|
| Regulation | Less regulation | Higher regulation |
| Liquidity | Low liquidity | Higher liquidity |
| Availability | Exclusive deals | Accessible to average investors |
| Fees | Higher management fees, carry | Lower expense ratios |
| Returns Potential | Higher | Lower |
| Risk | Higher | Lower |
Who Invests in Private Equity and What Do They Invest In?
The two main players in private equity are:
- General Partners (GPs) – Private equity firms who raise capital, source deals, manage companies
- Limited Partners (LPs) – Institutional investors who supply the investment capital
Prominent LPs include pension funds like CALPERS, university endowments like Yale’s, and high-net-worth individuals.
Well-known private equity GPs include firms like:
- The Carlyle Group
- KKR
- Blackstone
- TPG
These firms raise funds and then invest in various private companies and assets like:
- Mature private companies
- Leveraged buyouts
- Distressed companies
- Venture capital deals
The deal prospects must demonstrate upside potential and the ability to drive improved growth and returns when managed effectively.
Understanding the Private Equity Structure and Fund Cycle
Private equity firms raise dedicated investment funds to finance purchases of companies and assets. A typical private equity fund structure and lifecycle includes:
Raising Capital
- Firms first raise a dedicated pool of capital for a fund with a 10-year lifespan
- Capital raised from LPs under agreed partnership terms
- Fund target size can be anywhere from $100M to $100B+
Making Investments
- Once the fund closes, the investment period starts, usually 3-5 years
- GPs analyze deals, execute purchases, and begin implementing improvements
Managing Assets
- After the deal, GPs actively manage assets over 3-5 years on average
- The focus is on driving growth and operational efficiency to build value
Existing Investments
- The end goal is to exit the investment for maximum returns at the right time
- Typical exit paths are IPO, sales to strategic, secondary sales
This overall fund performance then dictates success and the ability to raise follow-on funds down the line.
Top GPs have a disciplined and established fund management process. For example, Apollo Global Management oversees over $500B in assets under management across various funds and investment vehicles.
| Term | Definition | Duration |
|---|---|---|
| Fund Size | Total capital raised from LPs | $100M+ |
| Fund Lifespan | Total duration before ending | 10-12 years |
| Investment Period | Phase II – Investing capital | 3-5 years |
| Lock Up Period | Liquidity restrictions | 5-7 years |
How Do Private Equity Firms Make Money? Fees and Carried Interest
Private equity firms utilize a unique fee structure and compensation model for themselves and their institutional investors:
Management Fees
- An annual ~2% fee on assets under management
- Much higher than traditional mutual funds
- Pays for firm operations and talent
Carried Interest
- GPs earn a ~20% cut of realized fund profits
- It is also called carry or promote
- Subject to return hurdles for LPs
This means GPs potentially earn substantial payouts if their deals perform well. However, they may earn nothing if returns fall below hurdle rates.
The exact details behind waterfalls and distribution schedules get more complex with preferred returns and catch-ups affecting GP payout timing. However, the concept drives alignment between private equity fund managers and their underlying investors.
What is the Due Diligence and Deal Execution Process?
For private equity funds to deploy capital, they first have to source and execute deals:
Deal Sourcing
- Proactive outreach to potentially sell
- Inbound inquiries looking for capital
- Networking and past relationships
Due Diligence
- Thorough legal, financial, and operational analysis
- Validating investment thesis and pricing
Deal Execution
- Negotiating terms acceptable to both parties
- Securing financing and legal approvals
Top private equity firms have dedicated in-house teams specializing in areas like leveraged buyouts (LBOs) and complex financial structuring. Others partner with investment banks or outside consultants.
For example, Bain Capital, a leading private equity firm, hired consulting firm McKinsey & Company to conduct due diligence on one of their biggest toy company investments.
How are Private Equity Deals Exited and Returns Generated?
Realizing returns from private equity investments involves exiting them at the right time and price. This usually happens between 3-7 years after the initial purchase.
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Common exit strategies include:
- IPOs – Taking a portfolio company public
- Sales to Strategics – Selling to corporate acquirers
- Secondary Sales – Selling to other PE funds
According to Bain’s research, over half of the exit value came from sales to corporates rather than IPOs.
Top performing GPs plan years in advance for exits using frameworks like:
- T – Time investment
- O – Operating fixes during ownership
- P – Price Target
- S – Strategic sales process
The exits return capital to LPs and help them realize 2-4x their original investment when things go well. The firms then keep a share of the profits too.
| Exit Type | Description | Timeframe | Returns |
|---|---|---|---|
| IPO | Taking a portfolio company public | Longer Preparation | Variable liquidity events |
| Strategic Sale | Selling to corporate acquirer | Shorter | More certain return of cash |
| Secondary Sale | Selling to another PE fund | Quickest | Moderate return potential |
What are the Returns Like in Private Equity?
In exchange for illiquidity and risk, private equity returns can surpass public market equivalents:
- Higher Returns – Top quartile PE funds historically return ~20% compared to ~10% for the S&P 500
- Risk vs Reward – Higher potential reward offsets higher risk
- Top Quartile – The best funds dramatically outperform mediocre ones
According to McKinsey Research, PE returns beat public benchmarks more than half the time. Of course, past performance never guarantees future results.
Pros and Cons of Investing in Private Equity
Pros
- Exposure to exclusive deals
- Leverage the expertise of top GPs
- Enhanced growth and oversight
- Potential for outsized returns
Cons
- Higher fees than public funds
- Long lock-up periods
- Less oversight and regulation
- Higher complexity and risk
In essence, private equity offers unique access and potential upside but with strings attached.
Investors face a tradeoff between the pros and cons of private equity relative to traditional public market exposure. As with any investment, assessing suitability depends on personal financial situations and risk tolerance levels.
Is Private Equity Right For Me as an Investor?
Gaining direct access to private equity requires meeting SEC accredited investor criteria including:
- $200K+ annual income
- $1 million+ net worth
Even then, investing sufficient capital to meet minimums is crucial. Given the long lock up periods and complexity, only more sophisticated investors can realistically invest directly into private equity.
For those that meet the criteria, weighing factors like risk tolerance and return requirements determines suitability. Most experts recommend allocating only a small portion of the overall portfolio to alternatives like private equity.
Some final considerations include:
Minimum Investment – Typically $5M+ for direct investments in top-tier private equity funds. Newer fund managers or deals on secondary markets allow lower minimums.
Lock Up Periods – Capital tied up between 5-7 years on average for PE funds. Assess liquidity needsbeforeover-allocating.
Diversification – With the complexity and risk in PE, diversifying across multiple funds and GPs reducesvolatility.
Professional Advice – Wealth advisors, investment consultants, and industry experts provide guidance on allocating capital, selecting fund managers, and creating balanced PE exposure.
While not feasible for all, private equity offers compelling opportunities for suitable investors. Conducting due diligence and seeking qualified advice ensures the best chance of realizing outsized returns over the long term.
Frequently Asked Questions
What are the minimum investments for private equity funds?
The minimums vary by fund size and manager but typically start around $5 million for direct private equity funds. Emerging managers and deals on secondary markets can lower the thresholds to low six figures.
How much of a diversified portfolio should private equity represent?
Most advise keeping private equity allocation around 5-10% of total portfolio assets given the heightened risk and illiquidity relative to other assets. Limiting overexposure is key.
What is the difference between venture capital and private equity?
Venture capital focuses more on investing in younger, high-growth startups and taking minority stakes. Private equity typically purchases more mature companies or leverages buyouts to take controlling positions.
What qualifications do I need to invest in private equity?
SEC-accredited investor standards currently include having $200K+ in annual income or $1 million+ in net worth. Separately, sufficient assets to meet minimums and long lock-up periods are key.
What returns have top private equity funds historically achieved?
McKinsey research shows top quartile private equity funds have returned over 20% historically compared to around 10% for the S&P 500 public benchmark over the same periods.
How long does private equity money need to be locked up for?
Given the fund lifecycles, investment periods andlong hold times to exit, typical lock up periods require private equity capital commitments for 5-7 years.
Conclusion and Key Takeaways
Private equity encompasses complex investments in and active management of private companies to drive returns. While only accessible to accredited investors, it remains an attractive opportunity for those meeting qualifications.
Conducting detailed due diligence and portfolio diversification helps mitigate risks inherent in the space. With the right diligence and advice, including private equity as part of a balanced portfolio provides access to a compelling asset class.
Summary of Key Points
- Private equity firms raise funds from institutional investors to acquire private companies and improve operations
- General partners earn management fees and carry while providing expertise
- Returns are realized years later when investments are exited at a profit
- Risk/return tradeoffs, regulation limits, illiquidity represent key considerations
While certainly not a fit for all, hopefully this guide provided helpful context on how private equity works as an asset class. Let me know if you have any other questions!
