Unlocking Private Equity: A Guide To Smart Investing

Private equity is a form of investment in private companies that takes place outside of the public stock market. Private equity funds are typically offered by private equity firms, which manage and invest the pooled capital of investors. The minimum investment in private equity funds is usually $25 million, although it can sometimes be as low as $250,000 or even $25,000.

Private equity investments are often high-risk, early-stage ventures in sectors such as software, healthcare, and biotechnology. These investments aim to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company's balance sheet.

There are a few ways to invest in private equity, including through mutual funds, exchange-traded funds (ETFs), and special purpose acquisition companies (SPACs). However, it is important to note that private equity investing is not easily accessible to the average investor due to high minimum investment requirements.

Due diligence is critical

Due diligence is a vital step in the private equity investment process. It involves a thorough investigation and evaluation of the investment opportunity, including the private equity firm, the fund, and the underlying portfolio companies. The due diligence process helps investors make informed decisions and identify high-conviction opportunities.

When conducting due diligence, investors should assess the quality and track record of the private equity firm, also known as the general partner (GP). This includes evaluating the firm's management team, investment strategy, historical performance, and existing portfolio. It is crucial to ensure that the GP has the necessary skills and resources to identify and manage successful investments consistently.

In-depth due diligence at the company level is also essential. Investors should analyse the market, operations, labour resources, facilities, equipment, asset base, customers, capital structure, and sources and uses of proceeds of the companies in which the private equity fund intends to invest. This analysis helps identify potential risks and growth opportunities, ensuring that the investment aligns with the investor's goals and risk tolerance.

Due diligence is particularly critical in the private equity space because private equity investments are typically high-risk and illiquid. Private equity funds are not registered with the Securities and Exchange Commission, and private companies are not subject to the same strict disclosure requirements as public companies. Therefore, investors must conduct their own thorough due diligence to make informed decisions.

By partnering with experienced private equity managers who have longstanding relationships with top-performing GPs, investors can gain access to valuable insights and enhance their due diligence process. These managers can provide expertise in evaluating both individual company investments and the embedded portfolios of funds and companies in the secondary market. A selective and disciplined approach to investing, based on a rigorous due diligence process, is key to achieving successful outcomes in private equity.

The importance of investment selection

Investment selection is a critical component of achieving enhanced returns in private equity. The average dispersion of returns within private equity is substantial, at over 1,800 basis points. As such, proactive sourcing, active management, and portfolio implementation are essential to generating attractive returns.

The private equity market is distinct from the public markets, with no perfect sources of information about private companies or investment opportunities. Thus, relationships and deal flow sources become more critical factors. Due diligence is also of paramount importance. Private equity investors must consistently invest with the highest-quality firms, leveraging in-house skills and resources or partnering with managers who have strong relationships with top-performing general partners and a rigorous due diligence process.

Understanding the market segments within the private equity space is another key consideration. For instance, small and mid-sized buyouts often represent the "sweet spot" in the private equity ecosystem, offering the largest addressable market with the lowest entry valuations and more attractive performance compared to larger companies.

Constructing a well-diversified private equity portfolio is crucial. This involves investing across different managers, styles, and geographies. As private equity is a long-term investment, both investors and their financial advisors need a thorough understanding of this asset class.

Understanding market segments

Private markets are made up of three distinct sectors: private equity, private credit, and private real estate. Private equity, which makes up about 60% of the private market landscape, can be further broken down into three stages of involvement: venture capital, growth equity, and leveraged buyouts.

Venture capital involves investing in startups, often in high-growth sectors such as software and healthcare. These companies are targeted for their growth potential and ability to scale rapidly, making them enticing prospects for investors.

Growth equity is the next step, where companies are given further support to continue their growth.

The final stage is leveraged buyouts, where more mature companies are targeted for a potential turnaround and sale. This usually involves a private equity firm buying a company with the aim of selling it later at a profit.

Private equity firms play a crucial role in the economy by infusing capital into struggling companies, potentially saving them from bankruptcy and preserving jobs. They also have the financial resources and strategic expertise to carry out necessary changes and drive growth.

However, private equity firms have also received negative press attention for their aggressive cost-cutting measures, such as layoffs and reductions in worker benefits, which can negatively impact employees and local communities.

Overall, understanding the different market segments within private equity is essential for investors looking to access this asset class, which has been experiencing significant growth in recent years.

Private equity fund fees

Private equity funds have a similar fee structure to hedge funds, typically consisting of a management fee and a performance fee. The management fee is usually around 2% of the committed capital of the fund, while the performance fee is usually around 20% of the profits from investments. This performance fee is also known as carried interest.

The fees associated with private equity funds are a large part of why working in the private equity industry is so lucrative. For example, a $2 billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it successfully generates a profit for investors.

The method by which capital is allocated between investors and the general partner in a private equity fund is described in the distribution waterfall. The waterfall specifies the carried interest percentage that the general partner will earn and also a minimum percentage rate of return, called the "preferred return", which must be realised before the general partner in the fund can receive any carried interest profits.

In addition to the management and performance fees, another controversial aspect of private equity fund fees is the carried interest tax rate. Fund managers' management fee income is taxed at income tax rates, the highest of which is 37%. However, earnings from carried interest are taxed at the much lower long-term capital gains rate. Critics have argued that this is a loophole that allows fund managers to pay an unfairly small amount of tax on a large portion of their earnings.

It is worth noting that the Tax Cuts and Jobs Act of 2017 addressed this issue to some extent by stipulating that investment funds must hold assets for more than three years for carried interest to be taxed at the lower long-term capital gains rate. If the assets are held for three years or less, any gains allocated to investment managers are treated as short-term gains and taxed at a higher rate.

How to become an angel investor

Angel investors are wealthy individuals who invest their own capital into startup companies during their early stages of development in exchange for an ownership stake. They provide up to 90% of outside equity raised by startups, according to the Angel Capital Association.

• Make sure you're qualified: Usually, this means being an accredited investor, with either an earned income of $200,000 or more for the past two years ($300,000 with a spouse) or a net worth of over $1 million in investable assets.
• Know how to source deals: Many angel investors have an established network of startup founders and entrepreneurs within their industry. If you don't have access to this type of network, you can reach out to a startup founder directly or participate in an angel group.
• Do your due diligence: Before negotiating the amount of your capital investment and corresponding share of company ownership, thoroughly research the startup, including its pitch deck, business plan, financial projections, and traction data.
• Understand the risks: Angel investing is a high-risk form of investing, with a high startup failure rate. Understand these risks and develop a plan to mitigate them.
• Use your resources: Find resources to help you make better decisions as an angel investor, such as websites, videos, articles, books, blogs, workshops, and events. Meet experienced angel investors and ask them for advice and networking connections.
• Find and evaluate potential investments: Look for startups with high potential for growth and return on your investment. Common industries that attract angel investors include consumer products and services, mobile telecommunications, and electronics.
• Join a group or platform: Joining an angel investing group can help you find a startup that's a good fit and reduce some of the risks of investing.
• Develop a strategy: Consider why you want to become an angel investor, how many investments you want to make, what types of investments interest you, and how much net worth you want to risk.
• Choose a valuation method: Understand the benchmark and Berkus methods of valuation to determine which one best suits your investment goals.
• Make an investment: Track your investment regularly to assess its success and reflect on the effectiveness of your investment decision.

Frequently asked questions