The Long and Obscure Road to a Private Equity Investment
Most of us have been at least thinking about investing in financial markets in some way or another. Probably you have some of your own money invested in stocks, bonds or even cryptocurrencies. You may even have been thinking about how to get a good return on your investment. One of the sectors in finance which has been in for the best returns in the past was private equity. In the last years, the private equity industry has been booming, with ever more money being poured into it and bigger deals being made. So let us have a look at what private equity is, why this industry is so attractive, and why you should care about it.
Private and Public Equity
Simply put, private equity includes all types of company equity, usually represented by shares, which is not listed on a public stock exchange. This stands in contrast to public equity, which describes company shares listed on a public stock market such as the New York Stock Exchange (NYSE) or the London Stock Exchange (LSE).
For you as an investor, the big difference between private and public equity is about how easily it can be traded. Publicly listed equity is easily obtained through a broker, such as your bank. The broker connects you to multiple stock exchanges, so you can easily and almost instantly buy and sell shares at a market price determined by supply and demand. As private equity is not listed on any exchange, it is harder to trade. You would have to draft a contract with a company about how many of its shares you buy at a price you negotiated. That is why private equity investments are often done by a private equity fund — a professional asset manager who pools money of many single investors and selects private companies to invest the pooled money in.
How do Private Equity Investments Work?
As most companies in this world are not listed on a stock exchange, the private equity universe is vast and diverse. Private companies include all company sizes and industries, ranging from your local small and medium sized enterprises (SMEs) to corporate giants such as IKEA, Mars, and Cargill.
A special form of private equity is venture capital, a term used to describe private equity investments into startups and early-stage companies with a promising outlook. These investments usually carry a higher risk, but also a higher potential return than an investment in a more mature company. Virtually all of today’s tech giants received venture capital backing at the beginning of their journey. Prominent examples of companies which had or have venture capital backing are Google/Alphabet, Facebook, Uber, Airbnb, Tesla, Twitter, Alibaba, and Tencent, just to name a few.
Private equity and venture capital funds are financial service providers pooling money from investors in order to buy a stake in a private company in order to generate returns for their investors. Usually, they buy a stake large enough to exert some influence about how the company is run, and use this power to increase the performance of the company they invested in. At some point, usually after 5–7 years, the fund sells its stake. If all goes well, the fund makes a return from both the dividends it earned over the holding period and through selling the company at a higher price than it bought it. In this case, the fund passes on the returns to the investors it raised money from in the beginning.
Why Should I Care About Private Equity?
So even if you aware of the global significance of private markets, you may now ask yourself what you should do with that information. Why should you care in the first place if some company is private or public? The answer is simple: the financial returns generated on money invested into private equity and venture capital are incredibly high. And if you could invest in private equity, you could reap these great returns as well. While the exact performance of course depends on the specific investment, private equity is consistently outperforming public equity. While public equity generates average returns of 4–7% in a given year, private equity and venture capital often generate average returns of 15% or more.
An extreme but prime example for the returns generated by a private company are the early days of Facebook, which went from an idea valued US$ 10 million in 2004 to a company valued US$ 104 billion in 2012, when it went public. If you had invested into Facebook in 2004, you would have more than doubled your money every year until 2012. Over the course of the 12 years and through the magic of compound interest, your initial investment would have become over 10,000 times more valuable. Wouldn’t it be great if you could have done that investment?
But why are private equity investors generating higher returns than their peers investing in public stocks? As always, the performance and its underlying reasons differ from fund to fund, but there are a few common denominators. First, as already mentioned above, private equity funds often try to acquire an equity stake large enough to influence the performance of their new portfolio company for the better. They use their power as strong shareholders to shape central decisions about how the strategy and operations of the company and support the company they invested in with their expertise, network, and resources.
Second, private equity companies are experts in picking promising companies to invest in. Most private equity professionals do not only have significant expertise in finance, but have a thorough knowledge of the industries they invest in. Private equity funds spend significant time and resources on selecting their investments. Their teams often spend weeks or even months on thoroughly evaluating every single company they consider investing in. Both of these things are something even large investors in public equity usually can not do. The amount of shares bought by public investors is usually too small to actively shape the fortune of the company invested in, and investors in public equity usually spread their investments over a larger set of companies and buy and sell companies more often. These two factors limit them in the time they have to evaluate their investment.
How Can I Invest in Private Equity?
So how can you invest your own money to private equity? Here’s where it gets tricky. Chances are that you can’t. If you want to take your money directly to a private equity or venture capital fund, even small funds usually ask for a minimum investment of US$ 5 million. This is because it takes considerable time and resources for a fund to manage all the paperwork needed for a single investor. If you can’t fork over that much cash for now, you can still invest in private equity through your bank, which allows you to invest into private equity and venture capital with a mere US$ 250,000 already. Since you should hold a diversified investment portfolio, and only want to allocate up to 10% of your portfolio to private equity investments, you still need to be a multimillionaire for this option to make sense for you though.
But there’s a catch. As long as you have to invest through your bank, your money travels through a set of intermediaries before it reaches the actual investment target. Usually this includes the bank, a feeder fund, a mutual fund, and the private equity fund. All of these intermediaries charge hefty fees simply for passing on your money, which in turn lower the returns on your investment. So far, you can only make money through private equity investments if you already have a lot of it in the first place.
The Road Ahead
So what if you’re not a multimillionaire? Will there ever be a way to invest in private equity for the rest of us? Nobody knows for sure. The financial industry is neither known for its consumer friendliness nor for its high degree of innovation for a reason. Still, with the rise of FinTech, the financial sector has seen more innovation in the last five years than in the 50 preceding ones. FinTech startups are already successfully starting to give consumers better deals than traditional banks in areas such as foreign exchange, and public equity trading, and have started to develop new ways of saving and investing. So why has private equity been under the radar until now? Probably because it one of the more complex and well-guarded sectors of the financial industry, and is not easily affiliated with customers who are not obscenely wealthy. But as we all know by now, there’s hardly any aspect of our world which is not being disrupted by technology sooner or later. We should all be excited about what the future will bring.
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