Private equity funds invest either in private businesses or in public companies that are proposed to bring back to private. Private equity is an alternative investment vehicle created as a limited liability partnership and the investors are the part owners.
In the conventional model mutual funds can be attributed to private equity firms who allocate resources to publicly traded businesses.
How Private Equity helps:
- Leveraged buyouts are the prevalent mode of private investments which eliminates the fixed cost to the firm. Leverage can be of bank debts or high yield bonds issued by the company at its initial stage. PEs enter to save the firm from the high cost of additional capital.
- Fund of fund is the back door opportunity of investing in a private equity firm. Absolutely the intermediary charges an extra 1% or nearing fee as a management fee.
- Real estate PE invests in commercial properties or Real estate Investment Trusts (REITs). Unlike other PE funds this type of fund requires highly committed investors who contribute extremely high capital investment and longer lock in period by the investors. After the 2008 financial crisis, the funds surged to even out concentrated risks in real assets.
- Private equity managers look for financially distressed companies that are in desperate need of additional capital, which adds to business turnarounds, maximizing asset utilization, selling non-performing assets etc to improve the performance and establish stability on exiting.
Invested capital is the amount of fund that is invested in the company portfolio, which in traditional investments called equity portfolio in case of equity investments. Committed capital is the total amount HNIs, Institutional Investors, Insurance companies, university endowments and other eligible investors commit towards private equity investments.
What private equity firms do is, aiding in financial restructuring, revenue generation, mainly adding a new set of management to improve conducive business interests, at times in the level of turning around the business.
How PE funds make money:
On a consistent basis PE fund charge from 1% to 3% of the committed capital as a management fee. Being said, not all the money is invested in private equity, most of the fund is set aside to fulfil future hunts. The unused funds are invested in the market or in highly liquid investment vehicles. Apart from the management fee PEs charge 20% of the profits after exiting the company, thereby the PE fund investors earn less than 80% of the real profits.
Private Equity vs Venture Capital:
A common misconception is venture capitals are different from private equity, Venture capitals are a subset of private equity, which aids in different tranches of a budding business. Private Equity and Venture capitals both play with privately held equity and promote business pursuits. Venture capital investments are far more riskier than backing a mediocre business because of the involvement with nascent stage businesses that have a high probability to fail.
Advantage of investing in a private equity fund is, high returns which unequivocally come with unbearable amounts of risk. Since the operations are away from the public market PE activities are opaque to the outside world.
Exiting strategies that private equity employs:
- IPO– Making the firm ready for Initial Public Offering at a profitable price, booking profits and exiting.
- Secondary Buyout– Another Private Equity firm substitutes the current valuation and the former entrant exits.
- Liquidation– At the stage of no improvement, other than liquidating the firm PEs cannot exit booking profits and thus profiting from the proceedings.
- Trade Sales– No founder will love to get in the hands of a competitor in the same industry or to sell to a strategic business acquirer to create synergy and improve business dynamics.
PE funds are currently no open for retail investors, the criteria set by the funds can only be fulfilled with QIBs, HNIs and similar capital contributors. Retail investors cannot bare risks as the other professionals do and knowledge about business is thing to be learned playing in the field or have prior experience analysing business conducts.