Understanding Private Equity

Private equity (PE) is a type of investment where funds are used to acquire ownership stakes in private companies—those not listed on public exchanges. This asset class is popular among institutional investors and high-net-worth individuals looking for opportunities outside the stock and bond markets. But what exactly is private equity, and how does it fit into a diversified investment portfolio?

What is Private Equity?

Private equity typically involves investing in companies that need capital to grow, restructure, or go public. The capital for these investments comes from PE firms, which pool money from investors, often in the form of private equity funds. These investments are generally long-term, spanning five to ten years or more. After investing, the private equity firm works closely with the company’s management team to improve its operations, grow revenues, and eventually sell the company for a profit.

Who Uses Private Equity?

Private equity is mostly used by institutional investors, such as pension funds, endowments, insurance companies, and sovereign wealth funds, as well as ultra-high-net-worth individuals. These investors are attracted to PE for its potential to deliver returns that exceed those of traditional asset classes like stocks and bonds.

Risk and Return Profile

One of the key characteristics of private equity is its potential for higher returns, though it comes with a higher risk. PE firms invest in businesses that are often underperforming or require significant restructuring, which can lead to large payoffs if the firm is successful in turning the company around.

However, these investments are illiquid, meaning they can’t easily be sold or traded on the open market. Investors are typically locked into their investment for years, making private equity less flexible than stocks or bonds. Additionally, the risk of loss is higher, as the success of the investment depends heavily on the company’s performance and the private equity firm’s ability to create value.

Private Equity vs. Other Asset Classes

Compared to public equities, private equity investments tend to be less volatile but also less transparent. Investors have less information about the company’s operations and financials since they are not required to report to the public, like publicly traded companies. Additionally, the illiquidity of private equity investments means they require more patient capital.

Compared to bonds, private equity typically offers higher potential returns but with much higher risk and volatility. Bonds, especially government bonds, are seen as safer, lower-return investments, making them a stabilizing force in a portfolio, whereas private equity can offer more growth potential.

Types of Private Equity Strategies

Private equity encompasses several strategies, each with a distinct approach:

1. Venture Capital (VC): Focuses on investing in early-stage startups with high growth potential. Venture capital is inherently risky, as many startups fail, but successful investments can yield substantial returns.
2. Growth Equity: Targets more mature companies that need capital to expand or restructure. These companies are often past the startup phase but still have significant growth potential.
3. Buyouts: The most common strategy, where private equity firms acquire a controlling interest in a company, often using leverage (borrowed money) to increase returns. Buyouts focus on mature companies and typically involve significant operational improvements.

Conclusion

Private equity plays an important role in a diversified investment portfolio, offering opportunities for high returns, though with considerable risks and long-term commitments. Understanding the strategies and risk profiles is key for any investor, especially for institutional players and high-net-worth individuals who seek diversification beyond traditional asset classes. For those just starting their journey into finance, private equity provides a compelling example of how alternative investments can shape a financial strategy.

Author: Alex Lau, CFA, CAIA, Associate, Brookfield Asset Management