— 10 min read

Let’s start with the basics: How does private equity work?

Private equity is an alternative asset class that consists of financial investments in private companies or start-ups.

Private equity firms typically invest with the intention of receiving a return on their money through capital appreciation and dividends, and they realize that return by selling their stake in the company once the value is higher.

Historically, the private equity market was viewed as opaque and exclusive. However, today's competitive landscape is drawing in both businesses and investors who are eager to get a piece of the pie.

Based on data, private equity deal value reached $819 billion in the first three quarters of 2022, a figure that’s already higher than any previous annual amount on record except for 2021. Based on historical performance, private equity investing is one of most consistently profitable investment vehicles, even during economic downturns.

What Is Private Equity, And How Does It Perform?

In short, private equity (PE) funds are investment vehicles that provide capital to private companies not listed on a public stock exchange.

Private equity funds may also buy out public companies, take them private, and then restructure them for growth potential, which can result in higher returns for the investors.

To get these results, PE funds leverage unique knowledge and opportunities they can bring to the table. For example, they can help the company access new markets, or they may be willing to make more radical changes compared to the original management.

According to Cambridge Associates, LLC, private equity produced average annual returns of 14.79% over the 20-year period ending on June 30, 2022. During that same time frame, the Russell 2000 Index, a performance tracking metric for small companies, averaged 8.57% per year.

One main issue with private equity investments is that they are typically long-term and illiquid, as funds may take 3–5 years to realize returns and require commitments of 10–15 years.

This is why private equity investing is usually limited to funds and high-net-worth individuals.

When it comes to their risk level, PE investments are typically high-risk but can generate higher returns than their counterparts.

Private equity (PE) itself can be defined as the process where public or private companies receive investments from a PE fund. More often than not, private equity firms invest in established businesses within industries that are seen as more reliable in return for owning a share of the company.

Who Can Invest In Private Equity?

Generally, private equity investors are high-net-worth individuals (accredited investors), family offices, and other institutions such as pension funds or endowments who have access to large amounts of capital and the expertise to evaluate potential investments.

Accredited investors are those who the SEC has determined have the financial know-how to understand more complex investments and the funds available to weather any potential losses.

To become an accredited investor, you must pass several requirements like having a set income, being worth a specific amount, and holding certain professional certifications.

One of the main reasons that private equity investments are so appealing to investors is that it’s a solid strategy for long-term and recession-resistant investing.

This economic downturn presents itself as an opportunity for the middle market, especially for thematic investors. This recession seems a lot different than 2008, and our prediction is that lower middle market deals will bounce back quickly from this dealmaking downturn.

To also see things from the target company’s perspective, it’s often hard to raise funds for your business, especially if it is not listed.

To raise money you may need to take out loans, issue stock, or sell bonds - and issuing stock is not an option for unlisted companies. That is where PE comes in - in fact, these firms became popular in the 1970s and 1980s as an alternative source of funding for struggling businesses.

Private equity provides a unique solution to the rigidities of more standard means of gathering funds. For unlisted companies, the main way for raising capital is taking out a loan - which may be a valid option, but it also adds a lot of risk for the company, along with a significant negative cash flow.

Private equity investors, on the other hand, provide a lot of value to the company, along with the funds themselves. They bring in their own network and expertise to help the company grow, and plan together an exit strategy for the business, either through selling the business or through an IPO.

What Is A Private Equity Firm?

So what do private equity firms do? Private equity firms typically provide capital to companies in exchange for ownership interests, or “equity.”

These firms have a team of professionals who work with the company to identify and implement strategies to improve its performance and increase its value over time.

This may include taking a troubled business and revamping it by improving operations, replacing management, or restructuring the organization. Alternatively, it may include investing in a young business to help it scale and grow.

According to Investopedia and a Private Equity International (PEI) report, the top 10 private equity firms and their total Assets Under Management (AUM) are,

  1. The Blackstone Group Inc. - AUM: $881 billion
  2. KKR & Co. Inc. - AUM: $459 billion
  3. CVC Capital Partners - AUM: $122 billion
  4. The Carlyle Group Inc. - AUM: $293 billion
  5. Thoma Bravo - AUM: $91 billion
  6. EQT - AUM: $81.7 billion
  7. Vista Equity Partners - AUM: $86 billion
  8. TPG Capital - AUM: $109 billion
  9. Warburg Pincus LLC - AUM: $73 billion
  10. Neuberger Berman Group LLC - AUM: $460 billion

Private equity firms generate revenue by assessing management and performance fees from investors. The executive team of a typical PE firm includes:

  • GPs are responsible for the management and operation of the fund, as well as obtaining investment commitments.
  • The primary source of capital for Private Equity (PE) firms comes from Limited Partners (LPs), who are typically institutional or high-net-worth individuals. These investors may include pension funds, endowment funds, retirement plans, insurance companies, and the like.

The GP relationship with the Limited Partners is an important aspect of the success of a private equity firm.

There should always be open and honest communication, based on transparency and clarity. As with every partnership, both sides should be on the same side of the table, and act like it. 

What To Consider Before Investing In Private Equity

Investing in private equity is not for everyone. It requires significant capital and carries more risk than other investments such as stocks, bonds, and mutual funds. The returns can be more rewarding, so investing in private equity can be an attractive option if you have the resources and the risk tolerance.

As discussed earlier, private equity produced average annual returns of 14.79% over the 20-year period ending on June 30, 2022. During that same time frame, the Russell 2000 Index averaged 8.57% per year.

When considering a private equity investment, it’s important to consider goals and objectives. For example, is the goal long-term capital appreciation or shorter-term returns?

Different funds specialize in different strategies and deal types - and thematic investing is going to be even more important in the next few years. Therefore, understanding the PE fund’s objectives before investing is crucial.

Additionally, the costs associated with private equity investments should be taken into account. These can be management fees, placement fees, and carry or performance fees.

Some of the private equity fund specialties include:

  • Growth equity
  • Distressed investing
  • Leveraged Buyouts
  • Sector specialists
  • Carve-outs

How To Invest In Private Equity

There are a few options for investing in private equity.

The most common way is investing in a fund managed by an experienced private equity firm. These firms might focus on certain industries, such as technology or healthcare.

Alternatively, you can invest directly in private companies through angel investing or venture capital. Angel investors are typically high-net-worth individuals who provide capital to start-ups they believe in.

Venture capitalists, on the other hand, invest in companies that have the potential to grow quickly and generate significant returns.

Finally, you can look for private equity investment opportunities through online marketplaces, Grata's engine, or crowdfunding platforms, potentially earning much higher returns than traditional investments.

How Does It Compare To Venture Capital?

While private equity and venture capital (VC) are often used interchangeably, one key difference is the company's size. Venture capital firms invest in early-stage companies, while private equity investors typically invest in more mature companies.

Venture capitalists provide funds to start-ups or high-risk businesses with a lot of potential for growth.

On the other hand, private equity firms look for established businesses that have proven their worth and now need additional funding to expand operations or finance buyouts.

A good classification of the 5 stages of private market investors is:

  1. Angel: Individuals, Friends & Family, Former Colleagues
  2. Seed: 1st institutional check
  3. Growth: Series A - C
  4. Late Stage or Crossover: C through IPO
  5. Buyout: Majority control, Debt

According to CJ Gustafson, CFO at PartsTech, here are some “hard” numbers on what to expect in each of the 5 stages of private equity investing:

IRR stands for “internal rate of return”, which is the percentage of return you’d expect each year.

Angel Stage: PowerPoint to reality

-Check Size: $10K to $250K

-Holding Period: 8 to 10 years

-Target Return: >75% IRR or +10x

Seed Stage: Research & Business Expansion

-Check Size: $250K to $2M

-Holding Period: 6 to 8 years

-Target Return: >60% IRR or +10x

Growth Stage: Exponential Growth

-Check Size: $10M to $50M

-Holding Period: 5 to 7 years

-Target Return: >40% IRR or +7x

Late Stage / Cross Over: New Products Or Markets

-Check Size: $50M - $150M

-Holding Period: <5 years

-Target Return: 25 to 35% IRR or +5x

Buyout Stage: Purchase & Flip

-Check Size: Depends on strategy, could be hundreds of thousands to billions

-Holding Period: 3 to 5 years

-Target Return: >18% IRR or +3x

Private Equity Advantages

Private equity investments have some great advantages compared to other investment classes, including:

• Access to capital: Private equity firms provide access to large amounts of capital that would otherwise be unavailable.

• Potential for high returns: Private equity investments can generate higher returns than traditional investments, such as stocks and bonds, over the long term.

• Lower volatility: Private equity investments tend to be less volatile than public markets, offering investors a steady return on their investment.

• Increased control: Investors in private companies often have more influence and control over the direction of their business decisions.

• Tax benefits: Investing in private equity allows investors to take advantage of tax breaks not available in other types of investments.

Private Equity Drawbacks

While private equity investments have the potential to generate higher returns, they also come with some drawbacks. These include:

• Long-term commitment: Private equity investments can be long-term and require commitments of 10–15 years.

• High risk: Private equity is a high-risk asset class, as returns are not guaranteed.

• Limited liquidity: Private equity investments are illiquid and may take 3–5 years to realize returns.

• Costly fees: Private equity firms typically charge high fees, which can erode investment returns over time.

• Regulatory complexity: Investing in private companies often requires navigating complex regulations and legal requirements.

Final Word

Overall, private equity offers investors access to capital and the potential for high returns, but it comes with higher levels of risk. It is important to do your due diligence and weigh the pros and cons before investing in private equity.

If done correctly, private equity can be a great way to diversify your portfolio and generate higher long-term returns.

The power is in finding the right data. Grata allows you to source exclusive private equity deals, making it easier for you to find the best investment targets and opportunities.

Get started now.

Try Grata Today!

Unlock the middle market with Grata

Book a Demo

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Get Updates every month!