What is Private Equity?

Private equity is money for investments made directly in private companies or in public companies that become private.

How Does Private Equity Work?

Although some private equity comes from private individuals, most private equity funding comes from private equity firms. These firms are often partnerships that obtain their investment funds from wealthy individuals, investment banks, endowments, pension funds, insurance companies, various financial institutions and even corporations wishing to foster new products, businesses or technologies.

A private equity firm must raise the money it needs to make investments in businesses. This fund-raising is typically done by circulating a prospectus to potential investors who then agree to commit money to the fund. Once the private equity firm has enough commitments, the firm may begin collecting or “calling” those commitments when it wants to make an investment. If and when the private equity firm invests all of its money, or if it simply wants to expand its investing activities, it may start another fund. Most funds have a fixed life, meaning they must make their investments within a certain period (usually about 10 years). Private equity firms may have several funds going at the same time.

Private equity firms are different than venture capital firms in that they generally invest only in private companies (or in public companies that want to go private). Whereas venture capital firms tend to concentrate their investments in new and young businesses, private equity firms often aren't afraid to invest in older companies. Private equity firms might also use debt in their financing structures, often when they are participating in leveraged buyouts.

The managers of many private equity firms receive an annual management fee (usually 2% of the invested capital) and a portion of the fund’s net profits (typically 20%). These fees compensate the managers for their expertise and responsibility to help their investments become successful.

Typically, private equity firms decide which companies to invest in by reviewing hundreds of business plans, meeting entrepreneurs and company managers, and performing extensive due diligence on investment candidates. They are very selective because they are seeking opportunities in which their investments will grow and provide a successful exit within a certain time frame.

One of the most common and controversial characteristics of private equity funding is that private equity firms usually take active management roles and board seats in the companies they invest in. This often means that management gives some control over their businesses to the firms. However, private equity firms can also provide crucial managerial or technical expertise, particularly in areas where the management is less confident. This is especially the case when the private equity firm specializes in an industry or niche.

One of the most important parts of a private equity investment is the “exit” or the private equity firm’s plans for selling its investment in a company. Usually the exit, also known as the “harvest,” takes place anywhere from three to 10 years, often via an initial public offering or through the merger or sale of the company.

Why Does Private Equity Matter?

Private equity is an important and necessary form of investment because it fosters liquidity and entrepreneurship, and it creates shareholder value. This in turn promotes job creation and economic growth. At the investment level, private equity can be tremendously lucrative because it allows investors to invest in the world's leading private companies.

However, private equity is not without risk. In fact, it is one of the riskiest investments available because many new companies fail or underperform. Private equity firms anticipate this by diversifying their investments and hoping that their successful investments more than compensate for their losses. Nonetheless, private equity investors must be willing to take significant long-term risks for what can be very high returns.