Private Equity

Private Equity

Investopedia / Mira Norian

What Is Private Equity?

Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange. Private equity funds invest in private companies or engage in buyouts of public companies.

Institutional and retail investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and bolster and solidify a balance sheet. 

Key Takeaways

  • Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange.
  • Private equity firms earn money by charging management and performance fees from investors in a fund.
  • Private equity capital can be utilized to fund new technology, make acquisitions, and expand working capital for a business. 

Understanding Private Equity

Private equity investment comes primarily from institutional investors and accredited investors, who can dedicate substantial sums of money for extended periods. Long holding periods are often required for private equity investments to ensure a turnaround for distressed companies or to enable liquidity events such as an initial public offering (IPO) or a sale to a public company.


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Pros and Cons of Private Equity

Private equity offers several advantages to companies and startups by providing access to funding from sources like venture capital instead of using funding from traditional financial instruments, like high-interest bank loans.

If a company is de-listed or removed from an exchange, private equity financing provides growth strategies away from the public markets without the pressure to sustain earnings for investors.

Private equity has unique challenges as it can be difficult to liquidate holdings in private equity. Unlike a transaction on an exchange, a firm must search for a buyer to sell its investment or company.

Pricing of shares for a company in private equity is determined through negotiations between buyers and sellers and not by market forces. The rights of private equity shareholders are decided on a case-by-case basis through negotiations instead of a broad governance framework that typically dictates rights for their investors in public entities.

Types of Private Equity 

Distressed Funding

Also known as vulture financing, distressed funding is often available to companies that have filed for Chapter 11 bankruptcy. Funding is invested in troubled companies with underperforming business units or assets to turn them around by making necessary changes to their management or operations and then selling their assets for a profit.

Leveraged Buyouts

The most popular form of private equity funding is a leveraged buyout purchase of a company, using a combination of debt and equity to finance the transaction. Debt financing may account for as much as 90% of the funding. The intention is the improvement of the business and its financial health and reselling it for a profit to an interested party or through an IPO.

Real Estate Private Equity

Real estate private equity funds require higher minimum capital for investment as compared to other funding categories in private equity. Investor funds are also secured for several years in this type of funding. According to research firm Preqin, real estate funds in private equity are expected to grow by 50% by 2023 to reach a market size of $1.2 trillion. 

Fund of Funds

This type of funding focuses on investing in other funds, primarily mutual funds, and hedge funds, offering a backdoor entry to an investor who cannot afford the minimum capital requirements in equity funds.

Venture Capital

Venture capital funding is a form of private equity, in which investors, also known as angels, provide capital to entrepreneurs, commonly in a start-up or as seed financing.

How to Invest In Private Equity

Individual investors can invest in private equity through a Fund of Funds, an Exchange Traded Fund (ETF), or a Special Purpose Acquisition Company (SPAC).

fund of funds holds the shares of many private partnerships that invest in private equities. Investing in a private equity fund may require additional fees paid to the fund or funds manager.

An investor can buy into an exchange-traded fund (ETF) that tracks an index of publicly traded companies investing in private equities, buying individual shares over the stock exchange, without minimum investment requirements.

SPACs are publicly traded shell companies that make private-equity investments in undervalued private companies that hold a high level of risk for an investor. 

Private Equity vs. Public Equity

Public markets provide investors the opportunity to invest in public equity such as stocks and bonds on a market exchange with transparency and liquidity. Public equity investments are readily available for all types of investors.

Private equity is not traded on a public exchange, often requires and long investment time commitment, and provides a low level of liquidity. Investors in private equity are accredited investors, defined by investment regulations with a specified net worth. 

Investment in private equity is viewed as riskier than investing in the public marketplace as private equity investments are less regulated than public investments.

How Are Private Equity Funds Managed?

A private equity fund has limited partners (LP), who typically own 99% of shares in a fund and have limited liability, and general partners (GP), who own 1% of shares and have full liability. The latter is also responsible for executing and operating the investment.

What Is the History of Private Equity Investments?

In 1901, J.P. Morgan conducted the first leveraged buyout of Carnegie Steel Corporation, then among the largest producers of steel in the country, for $480 million, merging with Federal Steel Company and National Tube to create United States Steel, the world’s biggest company. The Glass Steagall Act of 1933 put an end to such mega-consolidations engineered by banks.

How Do Private Equity Firms Make Money?

The primary source of revenue for private equity firms is management fees. The fee structure for private equity firms includes a management fee and a performance fee. Some firms charge a 2% management fee annually on managed assets and require 20% of the profits gained from the sale of a company.

Are Private Equity Firms Regulated?

In 2015, U.S. legislators proposed increased transparency in the private equity industry due largely to the amount of income, earnings, and salaries earned by employees at all private equity firms. As of 2021, legislators have pushed bills and regulations allowing for a bigger window into the inner workings of private equity firms, including the Stop Wall Street Looting Act. However, other lawmakers on Capitol Hill are pushing back, citing limitations of the Securities and Exchange Commission’s (SEC) access to company information.

The Bottom Line

Private equity firms invest in or acquire private companies that are not listed on a public stock exchange. Private equity funds invest in private companies or engage in buyouts of public companies. Accredited investors who commit to private equity funds often require a long investment time commitment and are provided a low level of liquidity.

Article Sources
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  1. Preqin. "The Future of Alternatives," Page 12.

  2. City of Longmont, Colorado. "Carnegie Library."

  3. Howard Means. "Money & Power: The History of Business," Page 147. Wiley Publishers, 2001.

  4. U.S. Congress. "H.R. 5648 - Stop Wall Street Looting Act."

  5. U.S. Congress. "S.1484 - Financial Regulatory Improvement Act of 2015."