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What is a private equity firm?

By Priyasha Sen Gupta

Private equity (PE) is a form of financing in which money, or capital, is invested in a business. Typically, PE investments are made in mature companies in traditional industries in exchange for shares or equity. The PE is an important subset of a larger and more complex part of the financial landscape known as private markets.

In addition to real estate, venture capital, distressed securities, etc., private equity is an alternative asset class. Alternative asset classes are considered less traditional equity investments, which means that they are not as readily available in public markets as stocks and bonds.

Private Equity Firms: What are they?

A private equity firm may be a variety of investment firms. They invest in businesses with the aim of increasing their value over time before selling the business for a profit. Like venture capital firms (VCs), private equity firms use the capital raised from limited liability companies (LPs) to invest in promising private companies.

Unlike venture capital firms, private equity firms often take a controlling stake – 50% or more – when investing in companies. Private equity firms usually have ownership in more than one company at the same time. A firm’s array of companies is named its portfolio, and also the businesses themselves, portfolio firms.

A private equity investor

Investors who work in a private equity firm are called private equity investors. They are essential for raising capital and identifying companies that will create good investment opportunities. In 2017, there were 3,953 active private equity investors, which represent a 51% increase over 2007.

How do private equity firms make money?

PE funds receive both management and performance fees. These will vary from fund to fund, however, the everyday fee structure follows the 2 and 20 rule.

  • Management fees 

Calculated as a percentage of assets under management or assets under management, generally around 2%. These fees are intended to cover daily expenses and overhead costs and are incurred on a regular basis.

  • Performance fee 

Calculated as a percentage of investment income, typically around 20%. These commissions are aimed at increasing returns and are paid to employees as a reward for their success.

How does private equity work?

To invest in a very company, private equity investors raise mutual funds from limited partners to make the fund. Once they have reached their fundraising goal, they shut the fund and invest that capital in promising businesses.

Investors in PE may invest in a company that is stagnant or potentially struggling, but still shows signs of growth potential. Although the investment structure may vary, the most common type of transaction is a leveraged buyout or LBO.

In a leveraged buyout, an investor purchases a majority stake in an exceeding company with a mix of equity and a major quantity of the debt that ultimately has got to be paid back by the company. Meanwhile, the investor works to boost profitableness so the debt settlement is a smaller amount of a monetary burden on the company.

When a private equity firm sells one of its portfolio companies to another company or investor, the company typically makes a profit and distributes the proceeds to the limited partners who have invested in its fund. Some companies that are backed by private equity can also go public.

The difference between private equity and venture capital

Private equity refers to investments or has ownership in private companies. It is also used as a term for the PE investment strategy. Venture capital investments are a form of private equity investments that tend to focus more on early-stage start-ups. Therefore, venture capital is a form of private equity.

Some additional distinctions between PE and VC are as follows:

  • Private equity

• Private equity firms often invest in mature companies in traditional sectors.
• Using LP’s committed capital, PE investors invest in promising companies, usually taking a majority of the stake (> 50%).
• When a private equity firm sells one of its portfolio companies to another company or investor, the returns are distributed to both private  equity and LP investors. Investors typically get 20% of the returns, while LPs get 80%.

  • Venture capital

• Venture capital firms often invest in tech-driven startups and other young start-ups.
• Using committed capital, venture capitalists generally take a minority stake (elt; 50%) in the companies in which they invest.
• Most of these businesses are not fully established or profitable, so they may be risky investments, but with that risk comes the possibility of significant returns.
• The company makes a profit if a company in which it has invested goes public or is acquired, or by selling part of its shares to another investor in the secondary market.