What Is Private Equity? (Plus FAQ About Private Equity)

By Indeed Editorial Team

Published May 11, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Related: Becoming a Private Equity Associate

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Private equity is a form of investing in which the equity is owned by private entities, rather than by the public. Private equity investing has been growing quickly and is an important part of many funds, including pensions and investment portfolios. If you're interested in investing in private equity, you may want to learn more about the benefits and drawbacks. In this article, we cover what private equity is, the pros and cons, its importance, who should understand it and the different methods of private equity investing.

Related: What Are Private Equity Firms?

What is private equity?

Private equity is an investment process in which the equity, or the thing you're investing in, is not open to public trade. The stock market is an example of public equity investing, because the public owns many of the shares of stock market company shares. Private equity investing is when there are fewer parties involved in the investment. This usually includes the investors, who are also known as the limited partners, and the firm executing the investment, which can also be called the general partner.

Private equity firms identify which businesses are underperforming, purchase those businesses, implement strategy and improvements to increase the business's success and worth and then sell the company for a profit. In this way, private equity is a lot like house flipping for the business and investment world. Most private equity investments take five to fifteen years to make a profit, so the people involved in private equity understand that they are waiting for long-term growth for their investments. It is not like other short-term investments such as trading stocks where you might expect to see a return on your investments in less than a year.

Related: How To Become Private Equity Associate

Benefits of private equity

These are some potential benefits of private equity firms:

Private equity firms can help underperforming businesses

When a business isn't performing to its full potential, private equity investors purchase the company to improve it. For some businesses, this can be the difference between closing down and staying open. Private equity investors can help these organizations expand and grow their profits. By improving the company, this process can also maintain current employee positions and create the need for more jobs as well.

The process can help you grow your investments

Private equity has found considerable success in the financial industry, and for some it's an investment with the potential for very high rewards. If you are looking to grow your current investment portfolio, investing with private equity firms can be a great way to do so.

Can ease the pressure of being a publicly listed company

For some organizations, receiving their funding from private equity firms means they don't face the pressure of being a publicly listed company. When many people have a stake in a company, they may all want to contribute their opinions on what the company should do or how it should improve. Publicly funded companies may also lose their funding if they make business decisions that their backers don't support. By being privately funded, companies may have more room to attempt unconventional growth tactics.

Related: How To Get Into Private Equity

Potential private equity drawbacks

These are some potential drawbacks to private equity investment:

It may be difficult to find a buyer for the equity

After a private equity firm helps a company implement new procedures and increase their profit and worth, it's not guaranteed that there is always a suitable buyer. Occasionally, private equity firms may decide to present the company's initial public offering instead of selling privately again.

Negotiation determines the value of the company

When a private equity firm sells the company, it's the negotiation between the firm and the interested party that determines the value of the company. With publicly held businesses, it's the market that determines a business's worth, so private selling can be more unreliable.

Private equity firms do not prioritize tradition or nostalgia

When active private equity firms purchase a company, they implement new policies and procedures to improve that business as much as possible. Because the firm's primary objective is to increase the profit potential and value of the company, they may not be interested in the company's traditions. The firm may choose to eliminate positions and terminate long-term employees if it means increasing the monetary value of the company.

Related: How To Write a Resume for the Private Equity Industry

Importance of private equity

Private equity is important because it's a method of investing that has resulted in high returns in recent financial history. There are many organizations that invest in private equity to help their funds grow. You may have a retirement or private pension fund that's diversified partly in private equity. These are some other investors in private equity:

  • Corporate pension funds

  • Wealthy individuals

  • Varied foundations

  • Family wealth offices

Who needs to understand private equity?

Understanding private equity is important for anyone working in the financial field, but it can also be important to those who may profit or lose money based on the success of the industry. Everyone takes part in the economy, so it can be a good idea to understand the various forms of investment that take place. If you are interested in investing in private equity, you may have a higher chance of a large return on investment if you understand how the firms and the funding work. These are some people who need to understand private equity:

  • Financial experts

  • Individual investors

  • Pension recipients

  • Informed citizens

Types of private equity firms

There are two different methods that private equity firms use when acquiring and investing in companies, and they are:

Passive private equity firms

Passive private equity firms prefer to rely on the current management of the company to make positive changes rather than playing an active role in the company's improvement. This kind of private equity firm believes they can maximize their return by minimizing the amount of money, time and energy invested into each of their acquisitions.

Active private equity firms

The other method of private equity is active investing, and these firms prefer to provide operational support to the businesses they acquire. These firms believe that by playing an active role in the company's improvement, they can greatly increase their return on investment.

What do private equity firms do?

The process of investing in private equity is complex, and these are some of the things that private equity firms do during the process:

  • Raise capital and funds: A private equity investor may look for limited partners to invest in their acquisitions and provide most of the funds for investments.

  • Source potential companies: Identifying underperforming companies with the potential for an increase in profit and value is a large part of what investment firms do.

  • Perform due diligence: Once they've identified an underperforming company, the firm assesses the company's strategies, business model, financial health and current industry outlook.

  • Improve operations: If a private equity firm engages in active investing, they'll offer operational support to the company to help them improve their profits and value.

  • Close investing deals: If they've determined a company is a sound investment, the firm offers a deal to that business. They negotiate with the company owners to exchange funds for equity.

  • Exit from companies: Firms negotiate with buyers to sell the company once it's reached its full potential, or coordinate the business's initial public offering to receive the maximum return on their investment.

FAQ about private equity

These are answers to some commonly asked questions about private equity firms and funds:

How do private equity firms make their money?

Private equity firms compensate employees both with management fees and carried interest capital gains. Firms pay management fees to the employees for performing investing duties such as raising capital, sourcing investments, performing due diligence, closing deals, improving operations and offering IPOs. Carried interest capital gains are profits from selling the private equity the firm invests in.

What is the impact of private equity on the economy?

Private equity is growing fast and may have a positive effect on the economy. Private equity funds are integral in many funds, like pensions and personal investing.

Is the private equity industry regulated?

There are government commissions that regulate the private equity industry through various reforms and acts implemented since private equity became a larger part of the economy. If firms function internationally, they are also subject to international regulatory bodies.

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