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Private equity is a type of alternative investment that pools money to make investments. A common private equity strategy may involve buying part or all of a company, restructuring and repositioning it, and eventually selling it for a profit, often back into the public market. Private equity funds can generate good returns but carry a certain level of risk, and are generally not regulated by the Securities and Exchange Commission.

Here’s how private equity works, the potential rewards and risks associated with it and the types of investors that typically participate.

How does private equity work?

Private equity, or PE, refers to investments made by a select group of investors, as opposed to public equity such as publicly traded stocks, where anyone may own a stake in the company. Private equity investments are organized by private equity firms, which source deals and solicit capital from accredited, high-net-worth investors and others to participate in the PE fund.

PE firms often buy established or publicly traded businesses with the goal of increasing their value over time and then selling them profitably, often back to the public stock market. PE firms typically use substantial debt financing to acquire companies, a factor that often makes the companies riskier. They’re well-known for rapidly and ruthlessly cutting costs at acquired companies in order to make them more profitable.

Investments in PE funds are typically not easily accessible to individuals, and potential investors must show that they’re accredited, having substantial financial resources to withstand a loss. PE funds typically lock up investors’ capital for years before they can access it, meaning investors often have to wait for a company to be re-sold to another firm or floated on the public market.

PE firms are typically responsible for sourcing deals, executing transactions and raising capital. While private equity funds are not registered with the SEC, the fund’s advisor may be. For these services, private equity firms are paid substantial fees from the fund’s investors.

The types of private equity strategies include:

  • Venture capital: Venture capital involves investing in early-stage companies that may be unprofitable and lack a proven track record. These funds generally take on more risk than other types of private equity.
  • Growth equity: This is when a fund invests in established companies that need funding for expansion.
  • Leveraged buyouts: Leveraged buyouts, or LBOs, target mature companies that can generate cash flow from day one. LBOs buy a company using a combination of debt and equity. The debt is used to increase returns to equity investors.

What is a private equity fund?

Private equity funds are investment pools managed by private equity firms. As previously mentioned, private equity firms use money from accredited and institutional investors to create funds to purchase companies, restructure them, and later sell them to generate a profit. Private equity funds are not available on the public market and generally have a long investment horizon, often three to seven years or more.

While private equity is a major component of endowments or other large institutional portfolios, these funds are not suited — or often, even available — to most individual investors. Information about the holdings may be opaque and infrequently updated, and money can not be quickly accessed the way it can with publicly traded investments. — Greg McBride, CFA | Bankrate chief financial analyst

How to evaluate a private equity investment

Potential investors should assess the target company’s financial health, including its historical performance and growth prospects. This could include analyzing the company’s business model, its competitive advantage and any relevant industry trends. Additionally, evaluating the management team’s expertise and track record is crucial, as they can impact the company’s success.

Investors will also want to understand the investment structure, terms and potential risks. Many PE investments take on substantial debt, and many investments end up in bankruptcy due in part to high debt levels. So it’s important to carefully analyze the investment, estimate the potential return, and consider how it aligns with your risk tolerance and investment goals.

Other considerations include the often substantial fees and whether you’re able to lock up your money for years in the fund. If ESG investing is important to you, add that to your list, too.

Consider all these factors as you make an informed decision about investing in a PE fund.

Who can invest in private equity?

Because private equity is by definition, “private,” it’s not regulated by the SEC. Private equity is not publicly traded, therefore it doesn’t fall under SEC purview. PE is also considered a sophisticated investment, meaning investors will need to show that they have enough money to participate.

In general, an investment in a private equity fund is usually restricted to institutional and accredited investors. Institutional investors include banks, insurance companies, university endowments, and pension funds, among others. Individual investors typically must meet the accredited investor criteria, which could mean earning an income of over $200,000, or $300,000 with a spouse, having a net worth over $1 million, holding certain professional credentials or being a knowledgeable employee of a private fund. The SEC outlines the specific requirements for accredited investors. Additionally, in certain cases, there is a higher threshold to invest in PE fund structures. In these, a qualified purchase would be the minimum requirement which is generally having $5 million or more of assets.

It’s important to note that while retail investors may be excluded from directly investing in private equity, indirect investment is possible through pension plans and insurance companies that may have private equity funds within their portfolios.

Drawbacks and risks of private equity

Before making any investing moves, you’ll want to consider the disadvantages of investing in private equity, including:

  • Lack of liquidity. Private equity investments are illiquid, meaning they’re not easily convertible to cash, and investors may need to wait at least several years to realize any returns.
  • Fees and expenses. Private equity firms may charge substantial fees for managing the fund, in addition to other expenses that are associated with the fund. Investors should review the contract for such fees and expenses to avoid any surprises later on. Additionally, phantom income, which is an investment gain that has not yet been realized, may result in an increase in annual tax liability, depending on the structure.
  • Not SEC-registered. Because private equity funds are not registered with the SEC, they are not required to provide public disclosures and other documentation that could help with an investment’s transparency.
  • Conflicts of interest. Conflicts may arise between the private equity firm and the fund. Some of these potential sources of conflict include the power of the fund’s management team to decide when the fund can exit its investments, the fund’s ability to purchase assets that the management company already owns, and the fees and their timing. Investors should ensure that the private equity firm is transparent about these potential conflicts of interest.
  • Debt burden. Many PE firms load enormous amounts of debt onto their acquired companies in order to increase the returns to investors. However, this heavy debt load increases the riskiness of the investment, and many PE firms fail when they encounter even modestly worse business conditions. The fund’s investors bear the brunt of this loss rather than the PE firm, which has already extracted lots of fees along the way.

Bottom line

Private equity can be a lucrative investment option, but it comes with a variety of risks and considerations, not least of which is that you’ll need significant financial resources to participate. That said, with the right research and opportunities, private equity could be a way to diversify your portfolio and potentially increase your returns.