Private equity
6 min

What is Private Equity? Definition | Advantages and disadvantages

In the following article, we will show you what private equity is, how it works and what opportunities and risks you need to be prepared for. Above all, you will learn how you can profit from this asset class in the future.

Mona Feather

What is Private Equity? Definition | Advantages and disadvantages (2022)

As a private investor, you have certainly heard of private equity, haven't you? Success stories like those of Facebook, Airbnb or Uber would never have been realised without external investors. If you want to participate in the positive performance of such companies, you can invest not only in shares but also in established companies that are not listed on the stock exchange - and that before the companies are worth billions. 

In the following article, we will show you what private equity actually is, how it works and what opportunities and risks you need to be prepared for. Above all, you will learn how you can profit from this asset class in the future.

What is private equity?

Private equity (PE) refers to off-market investments in companies. Large institutional investors - such as insurance companies, banks or pension funds - have been allocating a significant portion of their liquid funds to private equity for decades. Roughly summarised, companies are bought whose market value is to be increased through financial, operational and strategic measures. For this purpose, private equity companies employ specially trained sector experts in the respective companies. 

The companies included in private equity funds predominantly belong to the SME sector. Many well-known German companies use PE as a form of financing: Fielmann, Rossmann, Tom Taylor, MTU or FlixMobility (parent company of FlixBus) are just a few prominent examples. An initial public offering (IPO) is not ruled out after a PE investment. However, studies show that the company value tends to grow faster before the IPO than in the period afterwards - more on this in a moment. For private investors, this has been a sad realisation so far, as it is not possible for them to make these investments themselves due to the high barriers to entry. That could soon change.

Before we talk about the opportunities and risks of private equity, let's take a brief look at how a private equity fund works.

What are Private Equity Funds?

Before a private equity company can invest in companies, it has to do a kind of "fundraising" and collect money from institutional or high-net-worth private investors. The total capital is then pooled into a fund. The fund is then closed once the previously targeted amount of capital has been reached. Closed in this context means that the fund does not raise any more money.

The term of a fund is usually between ten and twelve years. The period can be divided into three phases. In the first phase , a market screening is carried out: the PE company identifies potential investment stocks that match the investment focus of the fund and carries out valuations to check suitability. The focus of a PE fund can be on certain industries, growth phases or even regions.

After the investment, the second phase of the fund begins. The goal is to quickly increase the value of the company. To achieve this, investment companies rely on internal teams of industry experts who, in cooperation with the management of the investment, initiate and drive forward value-enhancing measures. Often these are efficiency or internationalisation projects. This should also make it clear that private equity funds take a much more active role in company development than equity funds. There, the influence is limited to voting at the annual general meeting.

Private equity companies pursue the goal of selling their investments at a profit. The third phase is the so-called exit phase. During this period, preparations are made for the sale of the company. One way to sell the shares is to go public. All company shares that were previously privately traded are now offered publicly on the capital market. Until now, this has also been the point at which private investors can invest. Fielmann, for example, has opted for an IPO.

Another option is the "buy-back". In this case, the founders or co-partners of the company buy back the shares in order to increase their stake in the company. Often this form of buy-back is carried out with a high input of debt capital.

In some cases, the shares are also sold to a competitor (so-called "trade sale"). In addition, there are many other exit options that PE companies can use.

Opportunities and risks at a glance

Historically, PE investors have achieved returns that have outperformed the global equity market. In return, investors have to accept that their invested capital is tied up for a certain period of time. A typical fund has a term of about ten to twelve years. Those who withdraw their capital earlier must reckon with high markdowns that reduce a large part of the return. What seems disadvantageous at first can turn out to be a significant advantage. A long holding period reduces the risk of loss when investing money.

Here'san example: according to an analysis of the return distribution of the MSCI World, which summarises the performance of the 1,600 largest companies (by market capitalisation) from 23 industrialised countries, investors who have invested since its inception in the 1970s have always achieved a positive return if they have been invested for at least 15 years . The longer the investment horizon, the lower the probability of loss.

With private equity, investors are not subject to the risk of reacting impulsively to strong market fluctuations and constantly adjusting their portfolios. In the traditional capital market, only brokers profit from this back-and-forth, because they collect fees for every transaction their clients carry out.

Private equity can also be a valuable building block in the portfolio by providing the retail investor with another opportunity for diversification due to the reduced correlation of PE to the public market (stock exchange). Due to the active role of PE companies in their investee companies, crises are more likely to be better managed. In an emergency, companies receive additional financial and strategic support in crisis phases. Of course, this does not apply to every PE company.

Important note: However, investors must also be aware of the risks of private equity. Often it only becomes apparent after an investment that a business model is not viable. Depending on the weighting in the fund, such a case can significantly reduce the total return or lead to a total loss. PE funds try to avoid such cluster risks through broad diversification. However, default risk can never be eliminated. Nor is the high capital commitment always advantageous, since investors are exposed to the arbitrariness of the PE managers in this case. Not all decisions serve the long-term good of an investment. Employee layoffs are among the measures often taken to save costs in the short term.

Difference to the classic equity fund

Even though both are funds, equity funds and private equity funds have virtually nothing in common. Both models pursue the goal of achieving an above-average return. Equity fund managers, on the other hand, do not actively influence the management of their holdings. The influence is limited - if at all - to the exercise of voting rights at the general meeting. Relevant management decisions must be accepted in case of doubt. 

Fund managers of a PE company deal with far fewer companies, but all the more intensively. They spend years with the portfolio companies and are in active exchange with the management. They can actively steer the company's development, whereas equity fund managers have to rely on their valuation models working out.

Here too, however, it should be noted that the active component is not always an advantage. It happens that PE companies make unsustainable decisions in order to achieve short-term increases in value (e.g. through cost savings) for their investors. This can (but does not have to) be disadvantageous for the long-term success of the company. Investors can neither actively manage nor reallocate their investments.

Private Equity vs Venture Capital

Private equity is often confused with venture capital, although there are major differences between the two forms of investment. The central difference lies in the life phase of the investments, the investment sums and the shares. Private equity, for example, focuses on already established companies. These are often medium-sized companies. The investment sums per investment are therefore higher, but the risk of loss is also lower.

Venture capital focuses on companies in growth phases. Often these are even still in product development and do not yet have a customer base. These start-ups are working on the completion of their products or services. Since they do not normally rely on (or have) their own financial resources, they are dependent on external capital to sustain the company in the long term from their own sales power. 

Venture capital investments usually lead to a minority stake, while private equity companies usually target a majority stake in the target company.

Company values often arise before the IPO

Since Facebook's IPO in May 2012, investors have achieved a return of over 740 percent (as of 02/2022 - own calculations). That is 25 percent per year - astonishing when you consider that the global stock market (MSCI World) has grown by just under eight percent per year during this period. Peter Thiel invested 500,000 US dollars in Facebook a few months after it was founded. The company valuation at the time was 5 million US dollars. In May 2012 (pre-IPO), the valuation was 104 billion US dollars. This corresponds to an increase in value of 20,800 percent compared to +740 percent after the IPO.

The divergence is no coincidence. Many other companies, such as Airbnb, Uber, Beyond Meat, Netflix or Coinbase, have built up a large part of their enterprise value as over-the-counter companies.

Sources for infographic on pre- and post-IPO growth:

For whom is PE a suitable asset class?

In theory, private equity is an asset class used by institutional investors and high-net-worth individuals (HNWIs) in particular. In recent decades, average returns have outperformed the global equity market. The long capital lock-up periods (up to 12 years) can be an advantage for emotional investors as they prevent impulsive reactions to stock market events. On the other hand, as an investor you are dependent on the actions of the fund managers (who are not always in the interests of the companies) and can only withdraw your own capital prematurely with large discounts.

Despite the advantages, we advocate - as always - broad diversification. Private equity offers attractive return opportunities, but also harbours investment risks that, in the worst case, can be accompanied by a total loss. Companies can get into difficulties due to shifts in demand or faulty actions by PE managers. In such cases, a PE fund can be liquidated. Investors then receive a share of the proceeds corresponding to their investments.

Mona Feather
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