Bauer Wealth Blog

What is Private Equity? An Introduction to Alternative Investing

Nov 22, 2019 3:38:00 PM / by Stephen Heitzmann

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Most investors today limit their options to only traditional strategies. They buy into stocks, bonds, or pooled investments and just stop there. However, to the right type of investor, private equity investments are an appealing addition to a healthy and well-diversified portfolio.  

Let’s discover whether private equity investments are right for you.

 

What is Private Equity?

Private equity is an alternative investment that is not publicly traded on big exchanges like the New York stock exchange. It often times consists of capital and/or shares of ownership of privately owned companies or real estate, and is only available to accredited or institutional investors and funds. Investors may also participate in buyouts of other companies because public equity is delisted.

An alternative investment is a type of financial asset that does not fall into one of the standard investment categories such as publicly traded stocks, bonds, cash, etc. Typical alternative investments are held by wealthy individuals or established investing companies who can provide sums of money for extended periods of time because of their complexity and potentially higher degree of risk in hopes for a positive return on investment.

Private equity will have two types of partners who are responsible for executing the investment: 

Limited Partners (LP)

Limited Partners typically own most of the shares but have limited liability and do not partake in managing the business. Limited partners have limited liability up to the amount of the investment.

General Partners (GP)

General partners typically own very little of the shares but have full liability and completely run the business.

Private equity investments typically come from institutional investors or accredited investors:

Institutional Investor

A large organization with a considerable amount of money to invest in securities. Companies that invest a part of their profits in different types of assets are also known as institutional investors. Some institutional investors include hedge funds, pensions, mutual funds, and insurance companies.

Accredited Investor

An accredited investor is a person or organization that meets certain requirements for the purpose of purchasing securities that are not offered to the general public. Accredited investors are entitled to access if they meet the income, net worth, asset size, governance or professional experience requirements.

Additionally, private equity firms should have a fund manager and a group of corporate experts who can be assigned to manage the acquired companies.

 

A Brief History of Private Equity

Private equity has gained a lot of popularity over the last thirty years; however, private equity investments have been around since the early 1900’s. Tactics were used even before then during railroad construction. As the railroads were struggling to find funding from wealthy families, large banks started to invest and restructured business operations.

J.P. Morgan conducted the first leveraged buyout of the Carnegie Steel Corporation for $480 million in 1901. A leveraged buyout involves purchasing a controlling share in a company by its own management using outside capital. J.P. Morgan merged multiple steel companies together by buying them out and creating the world’s biggest steel company with a market capitalization of over $1 billion- United States Steel. He did this before the Glass Steagall Act of 1933 which no longer allows mega-consolidations engineered by banks.

In 1958, President Dwight D. Eisenhower signed the Small Business Act of 1958 which provided government loans to private venture capital firms, permitting them to leverage their own shares to make bigger startup loans. Other than that, there was not much happening in terms of private equity during World War II until the 1970’s.

During the 70’s and 80’s, private equity firms grew in popularity by helping struggling companies and staying clear of the public markets. As private equity firms continued to establish credibility, the amount of capital available for funds multiplied and the average transaction size in private equity dramatically increased.

In the early 1980’s, Congress relaxed pension fund restrictions and capital gains tax which caused money to flow into private equity funds. Some of the largest firms were founded in the 80’s, such as Bain Capital (1984), The Blackstone Group (1985), and the Carlyle Group (1987). In 1988, the multinational purchase of RJR Nabisco by Kohlberg, Kravis & Roberts took place for $30 billion. This was the largest private equity transaction in history until the $45 billion buyout of coal plant, TXU Energy, in 2007.

In 1990 and 1991 during the recession, private equity firms went back to resuming a low profile until the next big boom- technology. As technology evolved in the 90’s, private equity firms experienced some difficulties, but participated in the technology boom through startup funding. Stock prices sky-rocketed and it became challenging for private equity firms to prove their value through the traditional buyout method. Luckily, venture capital was fueling a surge of new companies, so the technology boom was positive overall for private equity firms.

The hottest years for private equity were 2000-2007. The dot-com bubble which occurred from 2000-2004, made the stock market practical again and created several new opportunities for private equity firms. Many firms were able to buy new companies for an unbeatable price, while others purchased technology and patents that were up for resale. Many private equity firms were affected by the mortgage crisis that began in the summer of 2007. Since the financial crisis, private equity firms have continued to work regularly with private credit funds, especially pension funds.



What are the benefits of Private Equity? (The Pros)

The private equity industry provides as a whole several benefits to the economy by supplying a significant amount of capital. Private equity financing has several advantages over other forms of funding. Here are the main benefits:

 

Active Involvement

With many other forms of funding, investors have very little involvement in running the business. Private equity firms allow investors to be much more hands-on with the business. 

Large Amounts of Funding

Private equity typically provides a lot more money than other funding options.

Incentives

Private equity firms borrow large sums of money to make their investments. Because of this, private equity firms must pay all the money back to generate a return for their investors on top of paying back all of the initial investment. They need their businesses to succeed, so they will often offer personal incentives to increase the company’s value.

High Returns

Nearly 75% of all private equity deals result in an annual profit growth of at least 20%. About half of private equity deals result in a 50% or higher annual profit growth.

Special Tax Treatment

The IRS allows private equity executives to pay a lower income tax rate on their income. Many private equity firms are taxed as “carried interest,” which means they are taxed at the 15% capital gains rate.

Private equity allows companies to prove their worth. With the capital that private equity firms and their funds provide, they can drive their development and remain independent

Venture capital, a form of private equity, is best known for financing ideas and starting up early stage companies. Companies often prefer private equity because it lets them access their liquid assets instead of paying high-interest bank loans or listing through public markets.

When companies are delisted, financing from a private equity firm can help in some unconventional ways that avoid using public markets. Not having the stress of quarterly earnings also allows a company’s management to focus on turning the company around by cutting losses and strategizing new ways to make money.

 

 

What are the risks of private equity? (The Cons) 

Since private equity investments involve large sums of money, there can be some downsides to private equity investments. Some of these downsides include:

Loss of Managerial Control

As mentioned, private equity investments allow investors to be involved in complex business operations. While having more responsibility can often be beneficial, it sometimes means losing control of basic responsibilities. Losing control of hiring, training, and terminations, for example, is risky to an investor who is not choosing the management team and staff. 

Loss of Ownership

Private equity firms typically require a majority stake in the company which can leave a business owner with nothing if business operations do not pan out the way it’s expected to.

Eligibility

Private equity firms only work with specific types of companies. They must be large enough companies with high probability for large profits within a short time period. A business that cannot pay their investors within five years will have a difficult time getting an investment from a private equity firm.

Conflicting Values

Business owners generally think long-term with their business and want to be successful for as long as they can. Because of this, business owners put more time into growing their reputation and establishing long standing relationships with customers. Private equity firms are more concerned with where the company is at five years after the investment.

Additionally, it is sometimes challenging to liquidate holdings in private equity investments because the firm must search themselves to find a potential buyer for their company or investment. Public markets, for example, have suggested buyers and sellers that can be contacted.

Since private equity investments are not publicly listed, it can be difficult to negotiate pricing and shares between buyers and sellers rather than market forces. Plus, private equity investors must negotiate their rights on a case-by-case basis rather than using a broad governance model to dictate their rights.

 

How to Find a Private Equity Firm

With private equity, there are no sales pitches or trying to persuade investors to lend money. Private equity firms are always looking for new opportunities and actively reaching out to other firms. Businesses may also reach out to private equity firms that meet their criteria. There are also public listings of private equity firms to help guide a business to a private equity partner.

Personal connections are important when choosing a partner because whoever invests will play a large role in running the business as well as directing its future. In addition to money, its best to choose a trustworthy partner that you see yourself getting along with. Do not always necessarily choose the investor offering the highest valuation. 

Ask Bauer Wealth how we can help you find Private Equity opportunities. Check with us to see if we have any private equity deals through our partner firm, Shephard Kaplan Krochuk currently available.

 

If you are an accredited investor ready to discover what opportunities are available...

-Schedule an appt. today-

 

If you'd like to learn more about Private Equity...

-Download our Private Equity eBook-

 

Topics: Private Equity

Stephen Heitzmann

Written by Stephen Heitzmann

Stephen Heitzmann is the CEO of Bauer Wealth Management, a Wealth Management Firm, based in Colorado Springs, CO. www.bauerwealthmanagement.com Bauer Wealth Management is a Registered Investment Advisor (CRD#: 152977/SEC#: 801-71090) with the Securities and Exchange Commission. This article does not represent an investment recommendation or endorsement of any kind. Please consult with your advisor regarding your specific situation. Investing in securities does involve risk of loss that clients should be prepared to bear. The risks can range from failing to keep pace with inflation to losing some or all of the money you invest.