It’s likely that most investors rarely thin about the world of private equity, even though private equity funds control billions of dollars in assets. In the best cases, they reap enormous returns for their investors and help launch some dynamic companies. These funds are not for casual investors, but it can be helpful to learn how they operate and ways you can directly or indirectly invest in them. We’ll cover the private equity fund basics here, but if you have large assets to invest, consider working with a financial advisor who can explain how specific funds work.
What Makes Private Equity Funds Distinctive?
Like hedge funds and mutual funds, private equity funds pool resources from multiple investors to spread risk and increase buying power. It’s what they invest in that sets them apart. Hedge funds and mutual funds may invest in stocks, bonds, money markets and other financial products, and they can generate profit quickly. In contrast, private equity funds’ investments are narrower and longer term. They mostly target companies in a promising startup phase or companies in trouble that need restructuring or new management. These investments often can take years to pay off. 10-year time horizons are not unusual.
Beginner investors typically don’t start with private equity funds for several key reasons. Institutional investors, such as pension funds, insurance companies and foundations, make up the majority these funds’ participants. Individual investors generally come with deep pockets and lots of experience. To just get started, most funds require hundreds of thousands or millions of dollars in initial investments. They also will charge annual maintenance fees, and also performance fees when they generate returns.
What’s more, these funds are not regulated as tightly as public investment vehicles like mutual funds. And since private equity focuses on companies with little immediate value, there is substantial risk of failure. Success may depend on talented fund partners who can help make the companies viable and attractive to buyers, For this reason, it may be critical for investors to understand key details about the fund and private equity firm that controls it before joining one.
Types of Private Equity Funds
Generally, private equity funds use one of two methods of investing: venture capital and buyout, or leveraged buyout. Venture capital funds look for startups that need capital but don’t want to assume lots of debt. Since these companies initially have little value, funds are betting on the quality of the companies’ talent and ideas.
Buyout or leveraged buyout firms invest in established businesses and may take controlling stake of the organization or buy it outright. Private equity funds that pursue leveraged buyouts may take on considerable debt to gain control of these companies. They also may take an active role in restructuring and managing the company to bring it back to profitability. Generally, buyout funds tend to be larger than venture capital funds.
How Do Private Equity Funds Work?
Most private equity funds are limited partnerships. With this structure, there are two classifications of participation: general partners and limited partners. The general partners select the investments and manage the fund. Generally, the talent and track records of general partners are major selling points that attract limited partners.
Limited partners may be institutions or individuals. Once invested in the fund, they have no input on investment selections or decisions. When the firm collects funds for the investments, limited investors may not know exactly what they are about to invest in. What they must do is commit assets for a specific amount of time, usually a period of years. So if a limited partner is unsatisfied with the investment selections or fund performance, they have limited recourse until they’ve fulfilled the time commitment.
Private equity funds usually seek a blend of investments that includes low and high risk companies. Limited partner agreements outline risk exposure in investment classifications. But in the event of major losses in a leveraged buyout, limited partners risk only the money they invested. In contrast, general partners are responsible for all debt obligations, even when they exceed their original investments.
Duration of the Private Equity Funds and Exit Structure
While the general partners exercise most of the power, limited partner agreements do outline restrictions around the types of investments the fund can undertake. A limited partnership agreement also designates the expected return on investment and the details of the fund’s lifecycle.
The lifecycle stages can vary from fund to fund, but most will follow this general pattern:
- The organization and formation of the fund. during which the fund builds its management team and raises money. This often takes about two years.
- A multi-year period of sourcing and investing. This is the time when the firm pulls in high-value investors and makes acquisitions.
- The portfolio management period. During this period, the fund must prove its bona fides by increasing the value of its acquisitions and investments. This is critical to the ultimate exit and sale of the assets or positions, since any buyer will look at the entire history of the fund’s performance to determine its value.
- Exiting of the fund, which may occur through IPOs, secondary markets or trade sales. The length of this stage varies widely. If an acquisition builds value quickly, the exit can happen in a year or less. Six or seven years commitment is not unusual, however. Most private equity funds specify a fund exit date, but factors such as a market downturn may require changes.
Private Equity Fund Fees
Many funds charge annual management fees, which often range between 1% and 2% of the capital under management. This fee covers firm salaries, legal and sourcing services, research and analysis, marketing and additional operations costs.
Private equity funds also come with a carry or performance fee. Typically it amounts to about 20% of the fund’s profit. This may seem steep, but if a private equity firm has a reputation for turning high profits, many qualified, discriminating investors are happy to pay, as returns more than justify the expense.
How to Invest in Private Equity Funds
Typically, only accredited investors or qualified clients can buy into private equity funds. However, even if you don’t qualify for direct investment in a private equity fund, you may be able to invest indirectly. If you’re a part of a pension plan or have an insurance policy, some private equity fund investments may be included in the portfolio. There also are some exchange traded funds that include private equity funds in their investment portfolios.
Generally, private equity funds appeal to experienced investors. They require a lot of money up front and can carry substantial risk. This is why private equity funds spread their capital across many investment opportunities. If you have the means to invest in a private equity fund, keep in mind it doesn’t always pay off. However, if successful it can yield large returns that are difficult to attain through stock market investing.
Tips for Investors
- All investing should involve homework. With private equity funds, the most important research may be into the firm that runs the fund. Since investors must count on the expertise of general partners, learning all you can about how the firm’s track record is a good place to start.
- Understanding your risk tolerance and investing goals can get easier when you engage a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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