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Private Equity Investing: Definition, Pros & Cons, How to Invest

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Updated April 4, 2024

Private equity investing is done in private companies, which are not listed on public exchanges like the companies you can invest in via the stock market. While it has the potential for high returns, it also comes with risk. Here’s what investors should know about investing in private equity funds before choosing to do so.

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Who can invest in private equity?

Most average investors can’t invest in private equity. The required minimum investments are often as high as $25 million, and the Securities and Exchange Commission (SEC) only allows “accredited investors” to participate.

In order to become an accredited investor, you must either:

  • Have a net worth of more than $1 million, excluding your primary residence (individually or with a spouse or partner).
  • Have an earned income of more than $200,000 (individually) or $300,000 (with a spouse or partner) in each of the prior two years and a reasonable expectation you’ll earn the same amount in the current year.

Investment professionals can also be considered accredited investors if they are at least one of the following:

  • In good standing and hold a Series 7, Series 65, or Series 82 financial securities license.
  • A director, executive officer, or general partner of the company selling the securities (or of a general partner of that company).
  • A “family client” of a “family office” that qualifies as an accredited investor.
  • A “knowledgeable employee” of the fund.

While nonaccredited investors cannot invest directly in private equity, they can do so indirectly (more on that below).

How private equity investing works

Private equity firms pool money from accredited and institutional investors in a private equity fund and then invest that money on behalf of the investors. These firms may use the money to buy a controlling stake in a company, manage it to increase its value, and then sell it.

Private equity funds typically have high investment minimums, with the lowest requirements being near $25,000. Let’s say you invest with a firm that allows a $25,000 investment. That money would then be combined with money from other accredited investors, known as “limited partners.” As with mutual funds, an advisor would determine the private equity opportunities for investing that money on behalf of the overall fund.

Investors considering private equity should know that there are criticisms of some of its strategies, such as buyouts, which can lead to layoffs and furloughs for workers. Private equity firms may also make changes that impact negatively on a company’s customers.

Types of private equity investments

Private equity firms may focus on a specific type of private equity, which can come in various forms, including the following three key types:

Venture capital

When startup founders have an idea, they need the money to make that idea come to fruition. Enter venture capital, a type of private equity investing in which participants, known as “venture capitalists,” supply the seed funding for these small company founders in exchange for a share of that company.

Providing venture capital comes with a potential for large returns but also entails significant risk. Startups that are seeking seed funding haven’t yet proved that they can run a successful company and make enough money for a venture capitalist’s share to be worth their investment. If the startup does make it big, however, venture capitalists—and any private equity investors who invest in their plans—can enjoy high returns.

Buyouts

Private equity firms can also have their eye on public companies. With buyouts, a common form of private equity, a public company is taken private, meaning it’s no longer sold on public exchanges, and a private equity firm buys a controlling stake in the company. The goal is to provide improvements that allow the private equity firm to then sell the company and make a profit. Many well-known companies have been bought and made private before returning to the public market, such as Dollar General in 2007 and Petco in 2000.

Buyouts are called “management buyouts” when the firm’s management buys the stake in the public company, and they’re called “leveraged buyouts” when significant debt is used to make the purchase.

Growth equity

Unlike venture capitalism, growth equity involves investing in companies that are already established. A company that is already in its growth stage still may need funds for hiring more employees or developing new technology. Firms that focus on growth equity can provide that money.

When investing in companies that are already fully formed and have been running for at least several years, private equity firms can analyze a company’s track record and financials—something that can’t be done by venture capitalists. However, there’s still a significant amount of risk involved with growth equity investing.

How to get started investing in private equity

1. Become an accredited investor

If you want to invest in private equity directly, you must be an accredited investor. To calculate whether your net worth exceeds $1 million, add up all your assets (not including your primary residence) and subtract your liabilities. The SEC provides a table that can help with your calculation.

Of course, being an accredited investor is out of the realm of possibility for most investors. If that’s the case for you, feel free to skip to the section below on how to indirectly invest in private equity.

2. Choose a private equity firm

In order to invest in a private equity fund, you’ll need to work with a firm. Some of the largest private equity firms include Blackstone, KKR, CVC Capital Partners, and Carlyle.

Firms may focus on specific sectors of the market, which is something to consider, especially if you’re interested in investing within a certain space, such as tech or healthcare. Be sure to read any disclosures and information on strategy that firms have available, including social corporate responsibility reports, which outline whether a firm is focused on investing in companies that keep track of their social and environmental impacts.

At this stage you’ll also want to check on a firm’s minimum investment requirement. Many high-net-worth individuals work with experts, such as financial advisors (or specialists in their family office), to help them determine which firm to work with. There are many ways to find a financial advisor.

There are also online platforms, such as Yieldstreet, that allow accredited investors to invest in many different types of alternative investments, including private equity.

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How to invest in private equity indirectly

If you’re not an accredited investor, you can still get access to private equity in your portfolio by investing indirectly. One way to do this is through private equity exchange-traded funds (ETFs). These funds track indexes that include publicly traded private equity firms and can be bought and sold with your typical brokerage.

Everyday investors looking for indirect exposure to private equity can also invest in special purpose acquisition companies (SPACs), which are publicly listed companies designed to acquire a private company or companies, as well as through crowdfunding, which entails private companies raising money from investors online. Be sure to research any fees that may be associated with these options.

Advantages of investing in private equity

Private equity can be appealing to investors, as it gives them access to deals not available on the public market.

Potential for high returns

Likely the biggest appeal of private equity investing is its potential for high returns. Data from investment firm Cambridge Associates shows private market returns have consistently exceeded those of the public market. The firm’s U.S. private equity index returned average annual returns of just above 13% over the 25 years ending in September 2023, while its modified public market equivalent of the Russell 3000 Index—an index commonly used as a benchmark for the overall U.S. stock market—shows an average annual return of approximately 8.5% over the same time period.

Remember, though, as with most investments, higher potential returns come with greater risk.

Diversification

Diversification is an investment strategy that refers to spreading your money over a wide range of assets. This could refer to investing in bonds as well as stocks and, within a stock portfolio, investing in stocks from companies of different sizes and sectors. The idea is that when one part of your portfolio underperforms, another can hold steady or even grow in value.

Alternative assets such as private equity can have a low or no correlation to traditional financial assets such as stocks and bonds, meaning they can be seen as portfolio diversification. However, as economic analyst Allison Schrager of Bloomberg Opinion opined in the Washington Post, the purpose of diversification is to mitigate risk, and investing in private equity doesn’t necessarily do that.

Risks of investing in private equity

While investing in private equity can bring about significant returns, there are also plenty of risks, which is in part why these aren’t considered investments for beginners.

Illiquidity

Fund managers at private equity firms are typically looking at increasing returns over the long term. This means that your investment funds will be illiquid. Investors should be able to keep their money in the fund for at least several years because they likely won’t see their investment pay off before then and firms tend to limit when investors can withdraw their money.

Fewer disclosures and less transparency

According to the SEC, when you invest in public stocks—whether via individual stocks or funds—the companies in which you invest are required to disclose information about their performance and financials regularly, opening them up to public scrutiny. However, private equity funds aren’t required to be registered or regulated as investment securities.

This means private companies are less transparent, and fund managers may have less information to help determine the strength of a company in which they’re investing, especially if it’s in early stages.

Fees

Investing in private equity can come with fees and expenses, and investors need to be diligent about analyzing any offering documents that outline these costs. The SEC has charged fund managers in the past with failure to disclose these fees.

Conflicts of interest

As the SEC points out, private equity firms can have conflicts of interest with the funds they manage, as they often belong to multiple funds and companies. Advisors are required to disclose conflicts of interest, but the SEC has brought about several enforcement actions when it says those requirements haven’t been met.

TIME Stamp: Private equity investing is generally restricted to the wealthy but is potentially more lucrative than public investing

Adding private equity to your portfolio entails investing in companies that are not listed on public stock exchanges through funds run by private equity firms. The strategy isn’t accessible to most investors, as you’re required to be an accredited investor with a high net worth to participate, but there are ways for everyday investors to indirectly invest.

Private equity is appealing to many investors because of the possibility of high returns, but there is also potential for great risk from such elements as illiquidity, fees, lack of disclosure, and possible conflicts of interest.

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Frequently asked questions (FAQs)

How does private equity create value?

Private equity can be used by companies to hire more workers, develop technologies that enhance production, and more. Money, in the form of venture capital, can be provided to startups; growth equity funds can go to companies that are growing or struggling on the public market. Private market investing provides value because of its potential for outsized returns.

How are private equity funds managed?

Private equity funds are managed by private equity firms similarly to how actively managed mutual funds are run. The fund pools the money of various investors, and the private equity firm uses that money to invest in—and often take a controlling stake in—a company. The goal is to increase the value of the company to earn a profit for investors.

What is the history of private equity investments?

American Research and Development Corporation (ARDC) and J.H. Whitney & Co were both founded in 1946 and thought to be the first-ever private equity firms, according to Harvard University. Since then private markets’ assets under management have grown to $13.1 trillion as of June 30, 2023, according to a report from McKinsey & Company.

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