The Ultimate Guide to Investing In Private Equity

Private equity refers to investing in private companies that are not traded on public stock exchanges. By providing capital and expertise, private equity firms aim to increase the value of these companies before eventually exiting through an IPO or sale. Private equity investing offers higher potential returns than public markets but also comes with unique risks and requirements.

Key Takeaways:

Benefit	Risk
Higher return potential	Illiquidity and lock-ups
Diversification from public markets	High fees impacting returns
Ability to influence companies	Lack of transparency & regulation
Access to top-performing sectors	Concentrated holdings & leverage

What is Private Equity Investing?

Private equity (PE) firms raise capital from investors like pensions, endowments, and wealthy individuals to form investment funds. These funds then acquire ownership stakes in private companies, often using leverage (debt) to increase their investment.

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The goal is to help these companies grow faster and become more profitable during a 3-7-year holding period before exiting via an IPO or sale to another firm. PE firms take an active role in the companies, providing operational expertise and governance.

Key Benefits and Risks of Private Equity Investing

There are several key private equity investment strategies:

• Leveraged Buyouts (LBOs): Acquiring a controlling stake in a mature company using debt financing. PE firms aim to improve operations and cut costs before exiting.

• Venture Capital (VC): Investing in young, high-growth startups and small businesses with strong upside potential. VCs provide capital and mentorship in exchange for equity.

• Growth Equity: Minority investments in more established companies seeking capital for growth, expansion, acquisitions, or restructuring.

During the typical lifecycle of a PE investment, the fund will acquire companies, actively work to create value through strategic changes and efficiency improvements, and then eventually exit via an IPO or selling to another investor.

Key Players in Private Equity

There are two main groups involved in private equity investing:

• General Partners (GPs) are the investment professionals at firms like Blackstone, KKR, and Carlyle who evaluate deals, deploy capital, oversee portfolio companies, and manage the fund’s operations. They receive a yearly management fee (typically 2% of committed capital) and keep 20% of the fund’s profits as compensation, known as “carried interest” or “carry.”

• Limited Partners (LPs) are the investors who contribute the bulk of the capital to PE funds. Pensions, endowments, sovereign wealth funds, and high-net-worth individuals are common LPs. They aim to generate high risk-adjusted returns from PE in their overall investment portfolios.

Also, See: What is Private Equity? A Thorough Guide to Understanding This Alternative Investment

Evaluating Private Equity Funds

For limited partners considering investing in a private equity fund, thorough due diligence is critical. Key factors to evaluate include:

• Investment Team: Experience, track record, and expertise of the GPs leading the fund
• Strategy Fit: Ensure the fund’s strategy matches your goals and existing portfolio gaps
• Differentiated Thesis: The fund’s unique approach that will drive outperformance
• Deal Sourcing: The GPs’ proprietary channels to find attractive investment opportunities
• Portfolio Fit: How the new fund complements your existing PE investments by strategy/sector
• Terms and Fees: Negotiating the best management fees and carried interest percentages

During meetings with PE firms, LPs should ask probing questions about past performance, future plans, personnel turnover, valuation methods, and other due diligence queries.

Varieties of Private Equity Funds

Sample Private Equity Fund Strategies

Strategy	Description	Target Investment	Example Firms
Buyout Funds	Acquire controlling stakes in mature companies, often using debt financing (LBOs).	Large, established companies	Blackstone, Apollo Global Management, TPG
Venture Capital Funds	Invest in young, high-growth startups and small businesses with strong upside potential.	Early-stage, high-growth companies	Sequoia Capital, Andreessen Horowitz, Founders Fund
Growth Equity Funds	Invest minority stakes in more established companies seeking capital for growth initiatives (expansion, acquisitions, restructuring).	Mid-stage companies with proven business models	General Atlantic, Summit Partners, Thoma Bravo

While all private equity funds invest in private companies, there are several sub-strategies to be aware of:

• Buyout Funds: Among the largest PE funds focused on acquiring control of mature companies, often using leverage (LBOs). Examples: Blackstone, Apollo, TPG.

• Venture Capital Funds: Targeting early-stage, high-growth startups and tech companies. Examples: Sequoia, Andreessen Horowitz, Founders Fund.

• Growth Equity Funds: Investing minority stakes in more established companies seeking capital for growth initiatives. Examples: General Atlantic, Summit Partners.

PE funds may also be differentiated by target industry sectors like healthcare, energy, consumer, or financial services, as well as by geographic regions around the world.

The Risks of Private Equity

While private equity offers compelling potential returns, investors need to be aware of and comfortable with the unique risks:

1. Illiquidity and Lock-ups: PE fund investments are illiquid with long lock-up periods of 10+ years, limiting your ability to access capital.
2. High Fees: The 2/20 model of PE fees – 2% annual management fees plus 20% carried interest – substantially reduces investor returns over time.
3. Lack of Transparency: PE firms are not required to publicly disclose information, creating uncertainty around holdings and valuations.
4. Concentration Risks: PE funds hold concentrated portfolios of companies, creating outsize positive or negative impacts from a few investments.
5. Leverage Risks: The excessive use of debt financing in buyouts amplifies downside risks during challenging economic environments.

Proper due diligence and diversification across PE fund types/vintages are crucial for managing and mitigating these risks.

How to Get Access to Top PE Funds

Entry requirements for investing in the most elite private equity funds are extremely restrictive:

• High Minimums: Many top funds have minimum investment commitments of $10-25 million or more.
• Existing Relationships: Funds are often oversubscribed and prioritize reinvestments from current LPs and investors in other funds.
• Network and Consultants: Introductions to GPs through an investor’s network or by using placement agents/consultants.
• Funds-of-Funds: Some invest in a portfolio of PE funds to gain diversified exposure while having lower minimums.

Once granted access, the capital commitment process involves reviewing fund materials, completing subscription documents, conducting due diligence, and then wiring investment capital over time as funds make capital calls.

Building a Private Equity Portfolio

For institutional investors and ultra-high net worth individuals, private equity commonly represents a 10-30% allocation within an overall portfolio designed to:

1. Boost Returns: Historically, top PE funds have outperformed public markets over longer periods.
2. Reduce Public Correlation: Private investments act as a diversifier from public stocks and bonds.
3. Access Top Opportunities: Ability to invest in sectors/deals not available in public markets.

To create a prudent private equity program, investors should:

• Determine Target Allocation: Based on risk/return goals and liquidity needs.
• Diversify by Strategy: Mix of buyout, VC, growth equity, credit, secondaries, etc.
• Diversify by Vintage: Invest consistently across recent and upcoming fund vintages to average cycles.
• Diversify by Geography: Exposure across North America, Europe, Asia, and emerging markets.
• Consider Co-Investments: Direct investments in deals alongside funds to boost returns.
• Monitor Pacing: Manage capital calls and distributions to avoid liquidity issues.

Private Equity Performance and Benchmarking

Metric	Description
Internal Rate of Return (IRR)	Annualized returns generated by investment
Multiple on Invested Capital (MOIC)	Total value created versus how much was invested
Public Market Equivalent (PME)	Compares PE returns vs. returns from investing in public index

Measuring and benchmarking private equity performance is more complex than public assets due to factors like:

• The J-Curve Effect: During initial holding years, returns are negative due to fees/costs before investments mature and are exited profitably.
• Irregular Cash Flows: Large cash contributions and distributions create volatility.
• Lack of Pricing Transparency: Private companies require complex valuation methods.

To evaluate fund performance, investors frequently use metrics like:

• Internal Rate of Return (IRR): Annualized returns generated by investment
• Multiple on Invested Capital (MOIC): Total value created versus how much was invested
• Public Market Equivalent (PME): Compares PE returns vs. returns from investing in public index

Benchmarking databases like Cambridge Associates and Burgess provide fund and industry performance data that LPs use to compare GPs and investments against relevant peer groups.

Over the longer term, research shows that top-quartile private equity funds have outperformed public markets. However, PE returns vary significantly between top and bottom-tier managers, highlighting the importance of access and selection.

Expert Tips for Private Equity Investors

For those able to invest in private equity, here are some tips from experienced LPs:

1. Remain Patient: Avoid overreacting to short-term performance swings due to the J-Curve effect. Let investments and strategy play out over the fund’s lifespan.
2. Conduct Thorough Due Diligence: Meet with GPs extensively, contact references and former employees, and scrutinize track records.
3. Negotiate Fees and Terms: For large commitments, push for lower fees and more favorable terms like no management fees on committed but undrawn capital.
4. Focus on Governance and Controls: Ensure a seat on advisory boards to actively oversee investments and influence key decisions. Impose strict reporting requirements.
5. Consider Co-Investments: To boost returns, explore investing directly into deals alongside funds for lower fees. However, do extra homework on individual opportunities.
6. Pay Attention to Team Stability: Excessive personnel turnover at PE firms during a fund’s lifespan raises red flags.
7. Think About the Exit Early: Well before exiting, review positioning and options to maximize returns.

Conclusion

Private equity has become a crucial part of institutional and high-net-worth investment portfolios in pursuit of higher returns and diversification from public markets. However, investing in PE also comes with unique risks around illiquidity, fees, lack of transparency, use of leverage, and high dispersion of returns.

While the potential rewards are substantial for those able to access top-tier funds, generating consistent outperformance requires skill in evaluating fund managers, negotiating terms, building diverse portfolios, and actively overseeing investments over multi-year holding periods.

For investors with the requisite capital, resources, and time horizons – as well as the ability to absorb illiquidity – allocating prudently to this asset class allows participating in the upside of private companies while helping to boost overall portfolio returns.