Should You Invest in Private Equity Firms?

Physician's Money Digest, October 2007, Volume 14, Issue 10

More and more when you read financial publications you come across the term private equity. But what exactly does this term mean?

By definition, private equity is a pretty broad term referring to any type of equity investment in an asset that is not freely tradable in the public marketplace on one of the stock exchanges. It also refers to the manner in which monies have been raised, ie, privately. Private equity firms were commonly misunderstood to invest only in assets that were not in the public market. However, this is not necessarily the case as larger private equity firms invest in companies listed on public exchanges and then take them private. Some of the categories of private equity investment include leveraged buyouts and venture capital. Private equity firms typically control the management of the companies in which they invest, and oftentimes bring in new management teams whose focus is to increase that company’s value.

Most private equity firms are not listed on a stock exchange; therefore, to own such securities the firms must find a buyer. The "exit" or "selling out" strategy is often achieved by way of an initial public offering (IPO), which is floating a company's stock on the stock exchange or maybe even selling the company to another private equity firm.

Raising Capital

Private equity firms raise capital by creating what are known as private equity funds that are pools of capital invested by the private equity firm. Although other structures exist, private equity funds are generally organized as either a limited partnership or limited liability company where the private equity firm acts as the general partner. The limited partnership is often called the fund, and the general partners are sometimes designated as the management company. The fund obtains capital commitments from what are known as qualified investors that include pension funds, financial institutions, and wealthy individuals. These investors become the passive limited partners in the fund partnership. All investment decisions are made by the general partner who also manages the fund’s investments, which are commonly referred to as the investment portfolio.

For managing this private equity fund, the general partner(s) is/are typically compensated in the form of an annual management fee of 1% to 2% of committed capital and up to 20% of profits realized above a targeted rate of return. These partnership interests are not freely tradable like mutual funds.

How do these private equity firms generally realize a return on their investment? Usually it is done through an IPO, the sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company commonly referred to as a private placement offering or to a private equity fund, which pools contributions from smaller investors to create a capital pool.

Investment Considerations

If you are intrigued with the thought of investing in a private equity fund, consider the following:

  • There are substantial entry costs usually upwards of $100,000, and further investment may be required for the first few years of the fund;
  • These investments are illiquid, and as such, should earn a premium over traditional securities. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments, which can last for a number of years. Distributions are made only as investments are converted to cash;
  • You can lose all your money if the private equity fund invests in failing companies; and
  • Because of the risky nature of such investments, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example, in the United States, most funds call for potential investors to qualify as accredited investors, which requires at least a $1 million net worth, annual income of no less than $200,000 or $300,000 of joint income for 2 documented years, and an expectation that such an income level will continue.

The bottom line is that a private equity fund investment is for those who can afford to have their capital locked up for long periods of time and who are able to risk losing significant amounts of money. This higher risk is offset by the potential rewards in the form of higher annual returns. Thomas R. Kosky and his partner, Harris L. Kerker, are principals of the Asset Planning, Group, Inc, in Miami, Florida. The company specializes in investment, retirement, and estate planning. Mr. Kosky also teaches corporate finance in the Saturday Executive and Health Care Executive MBA Programs at the University of Miami in Coral Gables, Florida. Mr. Kosky and Mr. Kerker welcome questions or comments at 800-953-5508, or e-mail Mr. Kosky directly at ProfessorKosky@aol.com.