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What is a Private Equity Investment? Thumbnail

What is a Private Equity Investment?

Prefers to ownership in companies that do not have shares listed for trading on a public stock exchange.  So when you think of IBM, Microsoft, Apple or Wal-Mart, you are referring to publicly traded companies.  You can buy shares of these companies simply by funding a brokerage account and placing the trade online.  I guess some folks might still call their trade into a broker, but that way of doing business is fast disappearing.  Our focus here is on owning shares of companies that are not yet or may never be traded on the exchange.

We have three learning objectives for this post:

  1. First, to understand the differences between public and private companies
  2. Next, to learn about the different types of private equity
  3. Last, to review who private equity investments are appropriate for based on your personal situation

Our opening paragraph revealed the major difference between public and private companies.   Public companies are easy to buy or sell shares of by simply opening and funding a brokerage account and learning how to enter purchase or sale orders.  This is a simple process.  While you own public companies, their share prices will fluctuate at least a little every day as other buyer and sellers enter orders.  

At times, based on company-specific news or general market news that causes fear or greed to increase, stock prices may fluctuate more wildly on a daily basis. Often, this has nothing to do with the operation of the company itself.  They may be selling the same amount of product or service they sell every day, but the share price could be up or down quite a bit.

Private companies are not priced by the market each day based on investor demand.  Companies are generally valued based on metrics such as sales, profits, and the assets owned by the corporation.

Other differences include the requirement of public companies to file various reports with the Securities and Exchange Commission, also known as the SEC, that become public knowledge.   Reports include quarterly profit & loss statements and other disclosures of any significant corporate events that might impact the companies’ operations.  

Private companies have no such obligations for reporting.  Obviously, we can view this issue of transparency two ways.  It is easier for private companies to potentially hide information, which seems bad, and if management is unscrupulous it would be.   However, with miniscule reporting obligations, we can make the case that private companies can spend more time running their business and less time worried about short-term reporting.

If private companies don’t have shares traded on the exchange, the question becomes how do you get ownership?  Short of being a friend or family member of a private company owner, the most common way to participate in owning private companies is through a fund or pooled investment vehicle that bundles together the money from many investors to purchase ownership positions.  The advantage of a fund is that the larger scale allows for a portfolio of private companies to be assembled rather than betting on just one company.  It should be apparent that investing in private companies is generally riskier than buying shares in a public company.   First, these firms are smaller and may not be able to access financing as easily as a larger public company.   Second, is the access to your money, which we call liquidity.

If you own shares in a public company in your brokerage account, you can choose to sell and get your money out on any business day.  You may absorb a loss, but at least you can get the current value of the share price.  Private companies usually do not have any form of liquidity to “cash-out” investors.   Some private equity funds do offer investors at least limited liquidity on a periodic basis.  In summary, investing in a private equity fund reduces risk through diversification and may offer periodic liquidity, depending on the nature of the fund.

Let’s now review the types of private equity funds available to investors.  Depending on an investor’s personal situation, primarily liquid net worth and annual income, private funds are available in three levels:

Publicly Registered – Non-Traded: These funds invest in private investments but the fund itself files reports with the SEC.  This form of fund has modest net worth and income qualifications for investors to participate.  These funds offer well-defined liquidity options where investors can get at least part of their money back, if needed, usually on a monthly or quarterly basis.

Partnerships for Accredited Investors: Funds for accredited investors do not file reports with the SEC, but most do have their financial statements audited every year.  An accredited investor is defined in a few different ways but the most common is at least a $1 million dollar liquid net worth or $200,000 annual income for a single person ($300,000 for a married couple).   These partnership funds may or may not offer liquidity and investors may have to be invested until the fund is eventually liquidated, which could be several years or more.

Partnerships for Qualified Purchasers: Similar to funds for accredited investors, qualified purchaser funds requires a $5 million net worth.  Use of this structure is generally to minimize the number of investors and investment minimums are correspondingly higher.  These partnerships may or may not offer periodic liquidity.

Fund structure aside, there are also differences in the types of private equity investments that can be placed in the funds described above:

Venture Capital (VC): Venture capital funds tend to invest in early-stage companies that have new and innovative ideas or products.  In this space, one or two winners out of ten investments can be a success due to the magnitude of growth in value from the ones that work out, even if the other eight never materialize.  This is the highest risk form of private equity investing.

Buyout (BO) or Leveraged Buyout (LBO): Both buyout and leveraged buyout funds take the majority control of businesses, but the goals may be different.  LBO firms often buy a company to tear it apart into smaller businesses.  The hope is that the total value of the separate businesses is greater than what it cost them to buy the original company.  Often, the buyer borrows a lot of money to make the purchase, hence the term leverage.  Leverage increases risk if things don’t work out though.  You are not only losing your own money, but that which you borrowed and needs to be paid back.

BO funds usually take majority control of successful private companies with the goal of continuing to operate and grow the company for the purpose of using the profits to make distributions to the fund shareholders and increase the value of the businesses owned by the fund. This type of private equity fund is the most conservative. While profits may end up being lower than a VC or LBO fund, the risk to the investors is also lower.

In summary, for wealthier investors who can meet fund investment minimums and do not need access to their invested capital for several years, the more aggressive venture capital and leveraged buyout funds are perhaps appropriate.  For more mainstream or more conservative investors who want to participate in private funds and have greater access to their capital if needed, the publicly registered non-traded fund or the buyout type fund are probably more appropriate, if they can meet the investment qualifications and can handle the limited access to their invested capital.

If you would like to learn more our investment and financial planning services, including how private equity investments can help diversify your portfolio, contact us today at (941) 778-1900 or Click Here to schedule a call.