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When you invest, you can choose to put your money into familiar assets like stocks, bonds, mutual funds and exchange-traded funds. But there's another type of investment you may be unaware of: private equity.
Private equity refers to investing in privately owned companies rather than companies whose stock is publicly traded on markets like the New York Stock Exchange and Nasdaq. The private equity sector accounts for trillions of dollars in investments.
Let's take a look at how private equity works, the benefits and risks of private equity investing and how you can get involved in private equity investing.
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How Does Private Equity Work?
People and organizations pump private equity into privately owned companies in hopes of gaining an attractive return on their investment.
Private equity firms, for instance, raise money for investment funds. When a fund hits its monetary goal, the firm "closes" the fund and starts investing in targeted companies, such as startups, established companies or even struggling businesses. Investors in the fund share in gains and losses.
A private equity fund might buy a 50% stake in a promising software company, for example. The fund may aim to grow that stake through a sale of the business or the business becoming a publicly traded company whose stock is sold on markets like the New York Stock Exchange or Nasdaq.
Private equity is broken down into three types:
- Growth equity: Investing in an established company with growth potential
- Venture capital: Investing in a company that's in the startup stage or an early stage of doing business
- Buyout: Purchasing an established company or one of its business units
Private equity attracts investors because the returns can be higher than they might find with stocks purchased through public markets. But those returns are often accompanied by considerable risk. For example, an investor might need to hold on to a private equity investment for a number of years—perhaps 10 or more—before realizing a return (or maybe losing money).
Who Can Invest in Private Equity?
Private equity investment generally is geared toward people or organizations with hundreds of thousands or millions of dollars at their disposal.
For example, a wealthy person might opt to become a limited partner in a private equity fund. To become a limited partner, a private equity investor typically must chip in at least $25 million.
Private equity funds usually limit their investments to accredited investors and qualified clients who have plenty of money to contribute. This includes institutional investors such as pension funds, insurance companies and university endowments as well as high-net-worth individuals.
Benefits of Investing in Private Equity
Benefits of investing in private equity include:
- Potentially solid returns: Private equity firms generally invest in companies with a high likelihood of achieving great success.
- Portfolio diversification: So-called alternative investments like those in private equity funds can help a person or organization diversify their investment portfolio, potentially easing investment risks or boosting investment returns.
- Access to unique investments: Some investment opportunities may be restricted only to private equity investors.
Risks of Investing in Private Equity
Risks of investing in private equity include:
- Lack of liquidity: In many cases, an investor must hang on to a private equity investment for a long period in order to realize a return on their investment. This means all or part of the investment may essentially be frozen, with an investor able to withdraw little to no cash.
- Expenses: Fees and other expenses a private equity fund charges might reduce an investor's returns.
- Conflicts of interest: Private equity firms frequently invest in and help run companies in their portfolios. This kind of arrangement might be at odds with the interests of the company and its shareholders. A private equity firm might, for instance, decide to turn a fast profit by selling a company for less than it's really worth.
How to Invest in Private Equity
Investors can put money into the private equity sector in several ways:
- High-net-worth individuals can invest their own money into funds run by private equity firms. Major private equity firms include Blackstone, KKR, TPG and Warburg Pincus. The minimum investment in a private equity fund might be in the hundreds of thousands of dollars, but it's often $25 million.
- Many institutional investors participate in private equity funds. Among them are pension funds, university endowment funds and insurance companies.
- Individual investors who aren't wealthy may also participate in private equity investments, although not directly. You may not realize it, but you might benefit from investment in a private equity fund as an owner of an insurance policy or a participant in a pension plan, for example.
- Individual investors can take advantage of private equity's ability to make a profit by purchasing shares of stock in publicly traded private equity investment firms.
- Exchange-traded funds (ETFs) are another avenue for tapping into the private equity market. For example, Invesco's Global Listed Private Equity ETF owns shares of stock in private equity companies such as Blackstone, The Carlyle Group, KKR and TPG.
- Crowdfunding platforms such as StartEngine and Wefunder offer an opportunity for investors to invest directly—and perhaps just a few thousand dollars—in a privately owned company. These platforms are open to a variety of investors, including those who aren't wealthy.
The Bottom Line
As with any type of investment, private equity comes with risks and rewards. For example, an investor might be rewarded with generous investment returns—but only after holding on to that investment for a long period.
As a result, private equity investments are best suited for well-to-do investors who can afford to lose access to cash for a significant stretch of time and potentially lose money in the long run. However, individuals with pension funds or certain types of insurance policies may also benefit from private equity's inclusion in their accounts.