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What is private equity?

By Aria Krumwiede on September 3, 2021
Categories: INVESTING

High net worth individuals and institutional investors directly invest in private companies with the hopes of earning higher returns than they otherwise would in public markets. However, it’s not without taking on a significant amount of risk. Whether you are interested in investing in private equity or are simply curious about what it is, you’ve come to the right place. Find out what it means to invest in private equity, who is eligible to invest, and what types of risks are involved here.

What is private equity?

Private equity refers to investments made in companies not listed on the public stock market. The target company is usually an established and mature business in a traditional industry. Private equity firms raise capital from external investors and focus on using that capital to buy a controlling portion of a private company. They look to acquire a majority stake to play an active role in creating operational efficiencies, growing the business, and ultimately selling the business (or an ownership stake) for a profit. At times, the private equity firm might also use leverage, through what’s called a leveraged buyout, to complete a deal.

Who is eligible to invest in private equity?

Not everyone is eligible to invest in private equity. Investors must fall into one of two categories: accredited investors or qualified clients. To qualify as an accredited investor, you must meet one of these three requirements:

  • Earned income above $200,000 (or $300,000 with spouse or partner)
  • Minimum $1 million net worth (individually or combined with spouse or partner); this does not include the value of primary residence
  • Holds a Series 7, 65, or 82 license and is in good standing

Certain trusts and entities meeting certain asset requirements may also qualify as accredited investors.

A qualified client is a person with at least $1 million under the management of an investment advisor and has a minimum net worth of $2.2 million.

Minimum investments in private equity funds typically begin around $250,000.

Structure of private equity

In the context of private equity, the structure includes the general partner (which is the private equity firm) and limited partners (which are the external investors). Investors must sign a limited partnership agreement that outlines facts such as the fund’s time horizon, how much risk each party is subject to, and the applicable fees.

Each type of partner has its own financial risk and responsibility. Limited partners are liable for however much they invest. General partners are liable for much more. For example, in case of a failure, the general partners can be responsible for repaying any debts owed by the fund.

Key Risks

There are many risks associated with private equity investments, including the following:

Illiquidity

Private equity funds are typically tied up over a long time horizon, often as long as 10 years. Further, there are strict limitations on withdrawing funds before the investment fund matures. That’s why those who do choose to invest in private equity are mindful of the bite size it represents as it relates to their overall investment portfolio.

High fees and expenses

It’s important to be aware of all fees and expenses charged by a private equity firm. Investors should first read the fund’s offering documents to examine listed fees and expenses. However, there have been instances reported by the SEC where investors have been charged fees without being notified or agreeing to them in advance. Investors must be diligent in continuing to analyze the fund’s financials to make sure they’re not being charged for undisclosed fees.

Lack of transparency

While individual advisors are required to register with the SEC, private equity firms are required to file an exemption to registration which contains a limited amount of reportable information. . As a result, there could be a limitation to the amount of due diligence potential investors can perform. Additionally, after an investment is made, valuations on portfolio companies are infrequent. At times, the private equity firm may oversee the valuation process as well (which poses a potential conflict of interest). Unlike publicly traded investments, you may not know the true value of your private equity investments.

Bottom line

There are key considerations of risk when it comes to investing in private equity. Speak with your financial advisor to further evaluate private equity as an investment vehicle. Ready for some professional guidance on private equity? Contact Dowling & Yahnke today.

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