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Whether you realize it or not, many of the goods, services and products you use every day are from private equity-backed companies. From picking up a box of doughnuts at Krispy Kreme to grabbing dog food at PetSmart or securing your home with a system like Vivint, private equity is all around us—all the time. Picking up Arby’s or Panera Bread on the way home? PE-backed. Looking into your family history with Ancestry? PE-backed.
But what exactly is private equity? A foundational concept for anyone interested in learning about—or working in an industry tangential to—the private markets, this blog breaks down the basics of PE.
What is private equity?
Private equity [PE] is a form of financing where money, or capital, is invested into a company. Typically, PE investments are made into mature businesses in traditional industries in exchange for equity, or ownership stake. PE is a major subset of a larger, more complex piece of the financial landscape known as the private markets.
Private equity is an alternative asset class alongside real estate, venture capital, distressed securities and more. Alternative asset classes are considered less traditional equity investments, which means they are not as easily accessed as stocks and bonds in the public markets. Learn more about the difference between the public and private sectors in our in-depth breakdown.
What is a private equity firm?
A private equity firm is a type of investment firm. They invest in businesses with a goal of increasing their value over time before eventually selling the company at a profit. Similar to venture capital [VC] firms, PE firms use capital raised from limited partners [LPs] to invest in promising private companies.
Unlike VC firms, PE firms often take a majority stake—50% ownership or more—when they invest in companies. Private equity firms usually have majority ownership of multiple companies at once. A firm's array of companies is called its portfolio, and the businesses themselves, portfolio companies.
What is a private equity investor?
Investors working at a private equity firm are called private equity investors. They are critical to raising capital as well as identifying companies that will make good investment opportunities. As of 2017, there were 3,953 active PE investors, which represents a 51% increase since 2007.
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What is a private equity fund?
To invest in a company, private equity investors raise pools of capital from limited partners to form a fund—also known as a private equity fund. Once they’ve hit their fundraising goal, they close the fund and invest that capital into promising companies.
PE funds vs. hedge funds
Both private equity funds and hedge funds are restricted to accredited investors. However, the biggest differences between PE funds and hedge funds are fund structure and investment targets. Hedge funds tend to operate in the public markets, investing in publicly-traded companies while PE funds focus on private companies.
PE funds vs. mutual funds
The biggest differences between PE funds and mutual funds are where capital comes from, the types of companies the fund invests in and how the firm collects fees. PE funds raise capital from LPs, which are accredited, institutional investors and mutual funds leverage capital from everyday investors. PE funds typically invest in private companies whereas mutual funds typically invest in publicly-traded companies. And mutual funds are only allowed to collect management fees, whereas PE funds can collect performance fees, discussed in more depth below.
How do private equity firms make money?
PE funds collect both management and performance fees. These can vary from fund to fund, but the typical fee structure follows the 2-and-20 rule.
What are management fees?
Calculated as a percentage of assets under management or AUM, typically around 2%. These fees are intended to cover daily expenses and overhead and are incurred regularly.
What are performance fees?
Calculated as a percentage of the profits from investing, typically around 20%. These fees are intended to incentivize greater returns and are paid out to employees to reward their success.
How does private equity work?
To invest in a company, private equity investors raise pools of capital from limited partners to form the fund. Once they’ve hit their fundraising goal, they close the fund and invest that capital into promising companies.
PE investors may invest in a company that’s stagnant, or potentially distressed, but still shows signs for growth potential. Although the structure of investments can vary, the most common deal type is a leveraged buyout, or LBO.
In a leveraged buyout, an investor purchases a controlling stake in a company using a combination of equity and a significant amount of debt, which must eventually be repaid by the company. In the interim, the investor works to improve profitability, so that the debt repayment is less of a financial burden for the company.
When a PE firm sells one of its portfolio companies to another company or investor, the firm usually makes a profit and distributes returns to the limited partners that invested in its fund. Some private equity-backed companies may also go public.
What are some examples of private equity firms?
The Blackstone Group
Headquartered in New York, The Blackstone Group is an investment firm that invests in PE, real estate and more. Service King, Optiv and Change Healthcare are portfolio companies under Blackstone.
TPG Capital
TPG Capital is a global firm based in San Francisco. Some of its current portfolio companies are Greencross, Reading International and Wind River Systems.
The Carlyle Group
Headquartered in Washington, DC, The Carlyle Group is a PE firm and business development company that focuses on a wide range of sectors. Memsource, X-Chem and Vault Health are among its current portfolio companies.
HarbourVest Partners
HarbourVest Partners is a PE firm headquartered in Boston. Its current roster of portfolio companies include Flash Networks, Fundbox and Rodenstock.
What’s the difference between private equity and venture capital?
Private equity refers to investments or ownership in private companies. It’s also used as a term for the PE strategy of investing. Venture capital investments are a form of PE investment that tend to focus more on early-stage startups. So, VC is a form of private equity.
Here are some additional distinctions between PE and VC.
Unique characteristics of private equity
- PE firms often invest in mature businesses in traditional industries.
- Using capital committed from LPs, PE investors invest in promising companies—typically taking a majority stake [>50%].
- When a PE firm sells one of its portfolio companies to another company or investor, returns are distributed to the PE investors and to the LPs. Investors typically receive 20% of the returns, while LPs get 80%.
Unique characteristics of venture capital
- VC firms often invest in tech-focused startups and other young companies in their seed.
- Using committed
capital, VC investors usually take a minority stake [