Private Equity Investing – What Are The Pros & Cons – that will be the subject of today’s article.
In this article, my staff have looked at all the positives and negatives associated with private equity investments compared to more vanilla instruments
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Table of Contents
Introduction
Surely, you have heard the phrase “private equity investment”, more than once.
Private equity is an investment option that consists of equity that is not listed on a public exchange. Private equity consists of foundations and investors that invest directly in private companies or participate in buybacks of public companies, which results in the exclusion of public capital from the listing.
Institutional and retail investors provide capital for direct investment, and this capital can be used to fund new technologies, make acquisitions, increase working capital, and maintain and strengthen balance sheets.
A private equity fund has limited partners (LPs) who usually own 99% of the fund’s shares and have limited liability, and general partners (GPs) who own only 1% of the shares and are fully responsible. The GPs are also responsible for the execution and management of the investment.
So in this article, we would like to talk about private equity investing in a little more detail: what is the concept, what options exist, and how will this knowledge help you in the trading process?
What is Private Equity?
Private investment (or Private Equity) is a type of assets, which is understood as a share in the capital, share or shares of a company that are not listed on the stock exchange (stock exchange). In a broad sense, private investment means, first of all, the contribution of one’s own funds somewhere (real estate, gold, securities, startups) with the aim of making a profit in the future.
Let’s take this definition of Private Equity (PE) in order:
Alternative investments are investments in any asset class other than shares of public companies (those that can be bought on the stock exchange), bonds and cash. Money invested in a friend’s startup, real estate, gold bullion, paintings are all examples of alternative investments. Tesla shares, OFZ, gold futures, etf – do not apply to alternative investments.
Financial institutions, also called “institutional”, are pension funds, large corporations, family offices, charitable and university funds, foundations of foundations.
Accredited individual investors – according to American law, these are people with assets worth more than $ 1 million (not counting the real estate in which a person lives).
Most often, private investments in literature and articles are reduced to the recognizable abbreviation PE. Investments in PE are divided into several categories:
- Financed buyout (investments in the purchase of securities, currencies, which will be regarded as a contribution to fixed capital) – the company changes the composition of shareholders with an increase in financial leverage, which allows capitalizing savings on sources of funds, replacing more expensive equity capital with borrowed funds.
- Venture capital (high-risk investments in startups and innovative projects) – is an investment in companies that are at the initial stage of their development (start-up), associated with high potential returns and a high level of risk. This is the most common option.
- Growth capital (purchase of securities for the purpose of their further resale in the short term) – entering the capital of relatively mature companies with the aim of bringing these companies to new markets, expanding their activities or making significant acquisitions, without transferring control over the business.
Private investment differs from state and national investments in that it is an internal type of financing. This is the transfer of funds from companies and individuals to other entities in the investment world. However, at the state level, relations between countries are often indirectly dependent on private investment.
Private investments are investments that are designed to generate income for investors.
There is also the term “private gross investment” – this property acquired by the investor for the development of their own production. This does not necessarily have to be funded by third-party investors.
Private investment is in most cases direct. Direct investments differ from other types of investments in that the investor contributes his share in the authorized capital of a developing company (at least 10%), takes part in the management of the company and has a representative on the board of directors. These are the net costs of a business project that may not pay off.
Private equity is the most commonly associated with Venture Capital funds. Venture funds are analogous to business angels. The main difference is that Private Equity is used by more conservative investors. They invest in established companies that generate sustainable income and help them grow further. Business angels, on the other hand, are looking for companies in new industries, thereby increasing the risk of loss of investment.
Private equity funds are a means of investing in various types of shares of companies that are not publicly traded. A career, by the way, can be built in this area.
Working in Private Equity is quite specific. All involved can be divided, conditionally, into clusters. First, those who generate potential profits or generate losses. Analysis of markets and companies, negotiations, it’s all here. Secondly, there are functions that do not directly affect the result from investments. First of all, we are talking about lawyers. And thirdly, administration, accounting, reporting, reports and all that jazz.
In a way, the work of such funds is similar to the work of banking organizations. The same lending is, in a sense, very similar to private investment. Plus – today private investments are quite popular, which are used instead of classic bank loans. Or, they are used as crowdfunding.
Such investments differ from loans, as a rule, in more favorable terms for the investor and less profitable (higher interest rates, for example) for the borrower.
Overall, this is a classic financial industry that is well suited for those who do not want to be a solo player on the stock exchange. And if not, then in any case, knowledge of the features of such a specific industry will help you in the trading process.
At least, because now, all over the world, the total volume of Private Equity assets is $ 4 trillion, which, you must agree, is more than significant. It is this kind of investment that is the most popular approach to investing today.
It is important to take into account the knowledge of private investments in the trading process and take into account, in general, that this is the most important part of the market, on which a huge number of processes depend.
More about Venture Capital
So we found out that PE is more connected to Venture capital (VC), which is another alternative type of investment. Unlike PE, this is about seed funding for early stage startups. At the same time, venture capitalists believe in the long-term growth potential of the recipient firm.
Startups do not have access to bank loans, which is why VC is an important source of funds during the company’s rapid growth stage. Venture capital usually comes from high net worth individuals (business angels), institutional or large companies. The latter are looking for investment opportunities by creating divisions in charge of venture capital.
VC is a high-risk strategy for investors, as most startups do not realize their growth potential, therefore do not provide a return on investment and end their activities. However, early on, venture capitalists acquire 10-20% of a startup for a small investment compared to checks in PE.
VC is usually provided by angels or their associations (syndicates) and venture capital funds. Venture capital firms raise funds for early-stage start-up investment strategies. Angels are often experienced entrepreneurs or startup founders who have made money from selling it.
Using venture capital funding, a startup can grow exponentially. By acquiring stakes in dozens of growing companies, angels and foundations are hoping to raise a “unicorn” (a company worth more than $ billion) that will recoup the investment in all startups and bring profit to investors. Companies that attract venture capital investments actually make more than just money, as venture capitalists often offer technical and management expertise to drive startup growth.
To summarize from a startup perspective, we can say that at an early stage, the company raises money to ensure growth through VC, and PE will be relevant at the stage when the startup has already grown, and the founder, together with venture capitalists on board, want to sell the company and take profit.
Private foundations
One of the most effective private equity investment ideas is the creation of a private investment fund.
The assets of the fund can be inherited, the shareholders of the fund can receive passive income (royalties and dividends). The investor can be one of the founders of the company in which the funds are invested.
The key difference between private funds is that the fund’s shares are not listed on the stock exchange. They can only be sold to the owner of the fund, inherited or transferred for a fee to third parties.
A private foundation can be owned by a legal entity or an individual. Usually this is a closed structure, investors enter the fund when it is opened, and in the future they can be invited in a limited number. Since the fund does not need to be registered with government agencies, but it is created for the purpose of making a profit and promoting private projects, information about the fund is not public. The attraction of new funds is due to the investments of permanent investors.
One example of a private fund is a hedge fund or a private equity firm. A foundation can be called independent if it is managed by a group of individuals, and associate if it is funded by a company.
Key points
- A private fund is a special opportunity for investors.
- Ability to flexibly reallocate assets and control them
- Convenient and efficient inheritance scheme
- Fund anonymity
- continuity of foundation
- Endowment (untouchable capital) of the fund.
In some legal areas, the fund’s capabilities expand to create tax minimization schemes or simplify the asset inheritance scheme, which, for example, cannot be realized when investing in conventional mutual funds.
The legislation allows not to advertise the beneficiaries of the fund, and the fund itself can be established with the help of a trustee. The founder of the fund will not necessarily be the owner of the bank accounts that the fund uses. Public services can only get access to information about the registration data of the fund, the name and address of the official representative, members of the board of directors of the fund.
A private foundation continues its activities even after the death of its founder, without the need to pay and distribute shares and repay debts.
The creator of the foundation can specify how the assets of the foundation will be inherited and distributed after his death.
By inheriting the assets of a fund, investors can avoid the legal formalities that inevitably accompany the division of assets of ordinary funds after a change of ownership.
The inheritance of property is determined in accordance with the rules established by the founder, while the heirs cannot protest the transfer of the bequeathed property to the foundation and cannot revoke the foundation of the foundation.
In some European countries, the practice of creating private investment funds is becoming more and more widespread. But the lack of sufficient endowment capital does not allow them to function at full capacity: they have to attract funds for the implementation of programs from third-party sources.
Not in the most favorable way, the development of funds is influenced by the fact that the fund is established at the expense of a certain group of persons who are related or in close ties. In such funds, the governing councils exist nominally and do not influence the activities of the fund.
What Are The Pros & Cons of Private equity investment?
Now we reached to the most important part. Let’s continue to talk about private equity investment and examine the main advantages and disadvantages of this kind of investment. As you know, in any process or phenomenon you can find your advantages and disadvantages, negative and positive moments. Not an exception and investment process.
Pros:
Investment is passive income. Perhaps the main advantage of investment, those for which people and begin to invest, is that private investment brings passive income. The investor spends on managing his capital at times less time and labor than a hired employee who earns in an active way. In this case, it does not work for money, and money is working for him.
Investment is the ability to diversify income. If the hired employee receives income, as a rule, from one source – less often of two or three, but no more, the private investment makes it possible to create an unlimited number of sources of income by investing capital in different assets, different financial institutions and different investment instruments. And this is a big plus, because it makes it possible to significantly protect a personal or family budget: if the income is lost in one source, it will continue to act from other sources.
Investment is an unlimited income. If the active income is always limited by the number of time and labor, which a person can highlight for its creation, then in the case of an investment passive income there are no such restrictions. Due to reinvestment and complex percentage, it has a property of growing exhibit.
Investment is interesting and informative. In fact, investment activity is indeed very interesting: in the process, the investor learns a lot of new things for himself, increases its financial literacy, gains experience that will never be superfluous. In this regard, in comparison with the routine work, which many actually hate, private investments are well winning.
Investment is the possibility of self-realization and achievement of goals. As practice shows, the greatest chances of achieving success and the living goals, which, as is known, in the overwhelming majority of cases are directly dependent on the material component, there are investors. They are the most rich people of the world, countries, cities. The investor always has a lot of free time that can spend on himself and his loved ones, to occupy what he likes, on self-realization.
So Private Equity investments have many advantages, thanks to which are very popular. This means of obtaining passive income is to invest, private investor no longer spends strength and time to commit any work. Accordingly, it has a time resource that can be used in another direction.
Investments are a competent approach to risk management. If you invest in several projects immediately, you can reasonably distribute your risks. Since the likelihood of simultaneous termination of the work of each project is extremely small, then the income will any equal income.
Private investments allow you to purchase almost unlimited income – it all depends on the specific project and the instructions of the investor to determine potential profitability.
Thanks to the successful experience of investing, a person can get ideas about how to conduct business, learn to assess the profitability of the project in the long run. Such skills will be very useful when opening their business.
Thus, private investments are not only an interesting tool for increasing finance, but also useful economic activities that brings great benefits for personal and professional human development.
Cons:
Investment is the risk of capital loss. The main minus investment, of course, are investment risks. Investing somewhere in your capital, the investor always risks losing it, partially or even completely. Even if the investment asset seems very reliable, the risks of capital loss are always, they are simply small.
Investment is non-marginal and non-permanent income. In most cases. Of course, there are options when the income income is guaranteed, but they are not very much. Mostly, investors are focused on the forecast income, and it may not be, in addition, in certain periods, private investments can affect losses. Active earnings in this case gives much more guarantees for receiving income.
Investment is permanent experiences for your money. In any case, novice investors. Especially if the asset they acquired, begins to fall in price and bring losses, innovation investors are not found and can even be subject to serious psychological stress.
To invest, you need capital. And so that the investment brought income, at least sufficient to live on it and contain a family – quite large for ordinary person Capital. It is not so easy to create it, for many years they go.
To invest, you need to have experience or at least understand it well. You need to be financially literate and constantly developing and improve your financial literacy. On the one hand, it will never be good and superfluous, but on the other, it takes time and banal desire, which many, unfortunately, no. And without this, private investments are becoming a certain step in the unknown.
Private Equity Investment Risks
Investments are considered to be a high risk activity, so knowledge of the fundamental risk of management and the ability to apply them in practice are inalienable requirements for investment. Along with the risks of the minuses of private investments are as follows:
- The income in this case is not fixed and in principle not guaranteed. Investing is a type of entrepreneurial activity in which all risks take on the businessman himself.
- In most cases, it is necessary to accomplish the starting capital for embedding, which will first have to accumulate.
- Investing without professional knowledge related to financial literacy and awareness of the project, which is supposed to invest, rather risky and even dangerous.
Private investments are a path for financial independence, but it is possible to proceed to it only after long-term self-education.
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Further Reading
The article below will look at:
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- What is hedonistic adaptation and how can you avoid it? I look at the relationship between money and happiness, and how you can increase happiness by making the right choices.
- What is the best financial advice you could probably be given?
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