The key principle of private equity investments is simple: direct or indirect investments in private companies with the objective of streamlining, developing and leading them to an exit point – whether by way of selling to a third party or an IPO. Unlike tradable investments, these types of investments are illiquid and require an investment horizon of several years, but they may constitute a potential source of returns and substantially diversify an investment portfolio. In this review, we focus on the nontradable channel of investing in the equity of private companies, but there are many other nontradable channels (which we will elaborate on in other reviews), such as private debt (providing private credit to companies or nontradable assets), infrastructure, real estate, commodities, etc.
What is a private equity investment?
Private equity investments are usually carried out by designated funds or institutional investors that acquire material holdings or control of private companies. Sometimes at issue are also acquisitions of public companies and privatizing them, a process that includes delisting them from a stock exchange.
In most instances, private equity investments are multi-year investments in which investors are actively involved – whether in financial, operational or strategic aspects – with the objective of improving the company’s performance in preparation for a future sale. This entire field is characterized by sparse regulation, limited liquidity and high reliance on professional, meticulous analyses of the target companies.
Brief background
Private equity investments already emerged during the 19th century, when HNW families financed industrial projects in the United States. Over the years, private equity investments evolved into a more structured professional sector through the establishment of venture capital funds and the limited partnership structure and as a result of major institutions’ entry into the sector. Today, this is a global market of trillions of dollars that is undergoing a constant process of expansion and diversification.
Principal investment strategies
The private equity market offers several principal investment approaches, each of which offers a different risk-return profile:
- Buyouts – acquisition of control over established companies, sometimes using financial leverage, for the purpose of improving value and later selling them.
- Growth capital – investing in the equity of growing companies, usually without acquiring a controlling interest.
- Turnarounds – investing in distressed companies contending with operational or financial challenges with the objective of rehabilitating their operations.
- Venture capital – investing in young companies or startups, usually at an early stage of product or service development.
- Secondaries, and fund of funds – investing indirectly through other private equity funds or acquiring shares in existing investments.
Each strategy depends upon the investor’s profile, desired degree of involvement and investment objectives.
Differences between private equity and venture capital
Although venture capital investments are considered part of the private equity sector, there are significant differences between them, both in terms of the investee companies and the investment strategy.
Buyout private equity investments are usually made in mature companies with proven cash flows and financial data. In contrast, venture capital investments focus on young companies (sometimes at the pre-revenue stage) with significant growth potential but also posing a high degree of uncertainty.
When it comes to the structure of the investment, private equity investors tend to combine equity and leverage (debt) and usually acquire control or material holdings of a company. In contrast, venture capital investors usually invest only in a company’s equity and hold noncontrolling interests.
The mechanism of value creation also differs: in private equity, value creation is based on improving operational and financial efficiency and sometimes, also expanding markets or products; in venture capital, value is created mainly through rapid growth and increasing the company’s value in preparation for additional fundraising or a future exit.
Why do investors choose private equity?
Private equity investments offer qualified investors – that are unconcerned about limited liquidity and long-term commitments – access to sources of value that are unavailable in the public market. The advantages of private equity investments – such as strategic diversification, flexibility in investment management and the ability to operate in an environment that is not subject to daily pricing – have positioned this sector as a differentiated channel in sophisticated investment portfolios. In a private market that is growing in volume and complexity, familiarity with the private equity sector, understanding the types of investments and informed analyses of its advantages and risks constitute integral parts of the decision-making process for both institutional and qualified investors.
