Private Equity Investment: Reportable Security Status Explained

Private equity investments are a form of investment that takes place outside of the public stock market. Private equity firms buy and manage companies before selling them, and they operate investment funds on behalf of institutional and accredited investors. Private equity funds may acquire private or public companies in their entirety or invest in buyouts as part of a consortium.

Private equity is a way for accredited investors and institutional investment firms to diversify their portfolios and take on more risk in exchange for potentially higher returns than they might achieve by investing in public companies.

In 2023, the US Securities and Exchange Commission (SEC) approved amendments to Form PF, the confidential reporting form required to be filed by certain investment advisers to private funds. The amendments dramatically modify and expand the reporting requirements for private equity fund advisers and large hedge fund advisers.

Private equity investments are not traded on the public market

Private equity firms operate on behalf of institutional investors and accredited investors. These are companies that invest money on behalf of their clients, such as pensions, mutual funds, and insurance companies, as well as high-net-worth individuals.

Private equity funds are not registered with the Securities and Exchange Commission (SEC), so private equity firms are not required to publicly disclose information about their funds. This lack of public scrutiny and the fact that private equity funds are not traded on the public market means that private equity carries a different degree of risk than other asset classes.

Private equity investments often have high investment minimums, which can magnify gains but also magnify losses. There is also a liquidity risk since private equity investors are expected to invest their funds with the firm for several years on average. There is also a market risk since many of the companies that private equity firms invest in are unproven and may fail to live up to expectations.

Private equity firms are involved in several industries, including technology, healthcare, and biotechnology. They may specialise in a particular category of private equity deals, such as distressed investing, growth equity, sector specialists, secondary buyouts, or carve-outs.

Private equity funds are not registered with the SEC

The Investment Company Act of 1940 requires that issuers of securities that are in the business of holding and investing in other securities register with the SEC as an "investment company." Registering as an investment company with the SEC comes with numerous restrictions and additional statutory and regulatory hurdles. For example, registered investment companies must provide ongoing public reporting for investors on their investment holdings and be subject to restrictions on what those holdings can be. The reporting requirements and investment restrictions in the Investment Company Act are incompatible with operating a private fund.

Therefore, private equity funds must find an exemption from the Investment Company Act. The two most common exemptions are Sections 3(c)(1) and 3(c)(7). To rely on Section 3(c)(1), a private fund must not make or propose to make a public offering of its securities and limit the number of investors to no more than 100. To rely on Section 3(c)(7), the fund must not make a public offering of its securities and limit the offering to "qualified purchasers."

Private equity funds also rely on exemptions from registration under the Securities Act of 1933 to sell their interests to investors. The two most common exemptions are Rule 506(b) and Rule 506(c) of Regulation D. Rule 506(b) generally prohibits the use of general solicitation, while Rule 506(c) allows for broad solicitation of investors. Securities purchased under these exemptions need not be registered with the SEC, but the fund must file Form D with the SEC within 15 days of the first sale.

While private equity funds are not registered with the SEC, their managers are required to register with the SEC as investment advisers unless they qualify for an exemption. The most common exemption for private fund advisers is the private fund adviser exemption, which applies to investment advisers that only advise private funds and have less than $150 million in assets under management.

In summary, private equity funds are not registered with the SEC because they qualify for exemptions from registration under the Investment Company Act of 1940 and the Securities Act of 1933. However, private equity fund managers are subject to SEC regulation under the Investment Advisers Act of 1940 and must comply with anti-fraud provisions of federal securities laws.

Private equity investments are illiquid

Private equity investments are generally illiquid. This is because private equity funds pool capital from investors to acquire controlling or minority stakes in unlisted, privately held businesses. These funds require investors to commit capital and subsequently fund this commitment in periodic contributions during the fund's investment period. The businesses are then bought, improved, and ideally sold for a profit, with sales proceeds distributed back to fund investors.

Compared to public equities, private equity funds do not typically offer fund redemptions or investor liquidity. This is because capital stability is important for managers undertaking their strategy to improve or grow the businesses they have acquired over a reasonable period of time, often measured in years, without the additional burden of meeting investors' redemptions.

However, some observers argue that private equity illiquidity has unappreciated behavioural benefits not traditionally considered in the required illiquidity premium. They argue that private equity illiquidity – or the inability to sell – has an unaccounted-for benefit of forcing investors to stay invested regardless of market conditions. That is, being forced to stay the course helps investors avoid emotionally driven panic selling when markets are down.

Private equity investments are also not static. There is an established 'secondary market' where other investors buy and sell existing private investments.

Private equity investments are high-risk

Private equity investments have a high barrier to entry, requiring a large amount of capital for a minimum investment, which can be as much as $25 million. While some firms may cater to lower thresholds, these are still higher than most traditional investment minimums. Due to the large amounts committed, private equity investors stand to gain substantially from even small percentage gains. However, investing can be a double-edged sword, and those large sums can equally lead to significant losses from negative returns.

Liquidity risk is a concern for investors in private equity. Liquidity measures how easily investors can enter or exit investments. Earnings growth for small companies can take time, and private equity investors are expected to leave their funds with the private equity firm for several years, typically between four and seven. Some investments require even longer holding periods before any returns are experienced. In other asset classes, such as stocks, mutual funds, or exchange-traded funds (ETFs), investors can sell an investment on the same day if needed. However, private equity investments do not offer that option.

Private equity investors also face greater market risk with their investments compared to traditional investments since there is no guarantee that any of the small companies in which private equity firms invest will grow at all. Failure is much more common among these companies, with only one or two out of a dozen making any significant return. An ineffective management team, a new product launch that fails, or a new, promising technology that becomes obsolete due to competitors can lead to significant losses for private equity investors.

Additionally, private equity investments may involve the company using a significant amount of debt, which can be costly to service through interest payments over time. Overall, the risk profile of private equity investment is higher than that of other asset classes, but the returns have the potential to be notably higher. For investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of a portfolio.

Private equity investments are high-return

Private equity firms buy and manage companies before selling them at a profit. They buy companies, often mature ones, and overhaul them to increase their value. Private equity firms may also invest in startups, providing seed money to companies with long-term growth potential.

Private equity funds are a type of private capital used for long-term investment in illiquid business enterprises. They are offered by specialised investment funds and limited partnerships that take an active role in the management and structuring of the companies they invest in.

Private equity funds are raised by investment managers, who act as general partners. They raise money from institutional investors such as hedge funds, pension funds, university endowments, and ultra-high-net-worth individuals. The proceeds are placed into an investment fund, where the institutional investors act as limited partners.

The investment manager then purchases equity ownership stakes in companies, using a combination of equity and debt financing. The goal is to generate returns on the equity invested over a target horizon, typically 4-7 years, though private equity funds have a finite term of 10-12 years.

However, aggressive leverage usage by private equity funds has declined in recent decades due to a series of high-profile bankruptcies. While debt financing can increase returns, it can also magnify losses if things go wrong.

Private equity investments also have high investment minimums, which can be as much as $25 million, though some firms have minimums of $250,000. These high minimums can magnify gains but can also magnify losses.

Another type of risk associated with private equity investments is liquidity risk. Private equity investors are expected to invest their funds with the firm for several years on average, typically between four and seven years. Some investments require even longer holding periods before any returns are experienced.

Private equity investors also face greater market risk compared to traditional investments since the companies they invest in are often unproven. Failure is much more common among these companies, with only one or two out of a dozen making any significant return.

Overall, the risk profile of private equity investments is higher than that of other asset classes, but the potential for high returns makes them a lucrative opportunity for investors with the funds and the risk tolerance.

Frequently asked questions