Home Business What Is a Private Equity Investment and How Does It Work?

What Is a Private Equity Investment and How Does It Work?

What Is a Private Equity Investment and How Does It Work?

Private equity, in the traditional sense, is reserved for accredited investors. While this is true, there are other ways you can start investing in this type of alternative asset.

Making a private equity investment occurs beyond the public stock market. When this investment is made, the investor is gaining an ownership share in a private company.

These investments are considered alternative assets, and private equity allows institutional investment firms and accredited investors to diversify their portfolios. They also can acquire more risk, all in exchange for the possibility of earning higher returns than if they were to invest in a public company.

Getting to Know the Private Equity Market

When it comes to understanding a private equity investment, the best way to learn is with a hypothetical example.

For example, you invest $1 million by way of a private equity firm (keep in mind, higher minimum requirements are required for this type of investment). The firm then takes your money and puts it in the private equity fund with other investors’ money.

Once pooled together, the money is put into different instruments, such as venture capital or buyouts.

In addition to being able to meet the investment requirements, you must also be an accredited investor. This means that your net worth is more than $1 million and that your income for the past two years was more than $200,000.

Creating a Limited Partnership

If you decide to invest in a private equity fund, you can view yourself as a type of secondary investor. Officially, you are a limited partner.

Your role was to provide a portion of the capital that made it possible to make an investment. While this is true, you are in no way responsible for managing the purchase made, making improvements, or handling the public offering or sale. The firm handles all of this.

As a limited partner, you will receive a return on the investment you make when the company that was purchased is sold. Usually, the private equity firm will retain 20% of the total profits. The remaining profits are split to each limited partner based on their initial contribution.

As a limited partner, you also have limited liability. What this means is that the most that you can lose is the amount you originally invested.

Understanding Private Equity Investment Types

After you have made a private equity investment contribution, the firm will use your money in several ways to generate a profit. The investments made depend on the firm you choose. Some of the most common options for these investments are found here.

Buyout Funds

With buyout funds, the investment is made to receive a controlling stake for a particular company. Sometimes, these investments provide strategic or operational support, which can be used for restructuring.

A buyout fund makes money by providing more value or by unlocking the company’s hidden value. Once discovered, the company is sold at a higher valuation a few years down the road.

The investment firm may decide to take the company public or sell it to another interested investor.

Venture Capital Funds

With these funds, the firm will invest in a start-up company that has promising growth potential.

Sometimes, the funds are used to assist start-up companies in structuring the operations and getting the business “up and going.”

One of the main advantages of investing in a start-up company is that they are offered at lower valuations. While this is true, the lock-in period for the investment that you make is much longer.

There is also the risk that the company could fail, which is important to understand.

Growth Funds

A growth fund is also used for investing in companies that have significant growth potential.

The difference from a venture capital firm is that this type of investment will be made in companies with an established and proven business model. Usually, the investment is needed to enter a new location, launch an all-new product, or begin a new plant.

The growth equity fund can make money by growing the business invested in. This is done by helping the business achieve the full market potential it has and then selling the share purchased for a much higher valuation.

The funds could also be used for investing in a certain sector (i.e., healthcare) or geography (i.e., Asia). In the past few years, there has also been a surge in the availability of investment firms that focus exclusively on social sector enterprises.

The Top Reasons to Make a Private Equity Investment

Many investors opt for private equity to diversify their portfolios and achieve higher returns than what the public market can provide. While a private equity fund investment may come with a much higher risk (from a historical standpoint), they also offer higher returns.

If you want to make a direct investment in private equity, it is required that you work with a private equity firm. Each firm has set investment minimums, certain industry expertise, specific fundraising schedules, and unique exit strategies. You must research the options to find one that meets your needs and risk tolerance.

As an average investor, there is a way for you to take part in private equity investments without going through a firm. This is done through an exchange-traded fund or ETF. It is best to speak with a professional in the investment sector to learn more about this.

Should You Make a Private Equity Investment?

As you can see from the information here, a private equity investment offers several options and benefits. While this is true, there is also more risk than other investments pose. As a result, it is up to you to decide if you want to do this.

If you found the information here helpful and are looking for additional resources, be sure to check out some of our other blogs.


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