What Are Private Equity Funds?
Private equity (PE) funds are alternative investment vehicles that use a pool of money from investors to make direct investments in companies, usually with the goal of making improvements to sell them later at a much higher price. Although PE funds have some similarities with hedge funds, they are quite different in the way they use their money, their risk levels, and their investment time horizons.
Both PE funds and hedge funds use money that institutional and other large "accredited" investors—those that meet certain asset-size minimum requirements—invest with them. They're both generally not open to small, retail investors. They're also loosely regulated compared to other investment companies, such as mutual funds, which means they don't have to make periodic disclosure statements. They both tend to charge very high fees to their investors as well. However, the similarities pretty much end there.
The principal objective of hedge funds is to maximize returns for their investors as quickly as possible by investing in just about anything that the managers believe will meet their objectives. That includes publicly traded stocks and bonds, commodities, options and futures, currencies and derivatives. They also employ various strategies, such as shorting assets and using leverage to magnify returns. Investing in hedge funds can be very risky.
Long Investment Horizon
PE firms have a very long-term investment horizon, usually many years, sometimes 10 years or longer. Unlike hedge funds, which move in and out of investments quickly, PE funds take an active role in the companies they invest in through ownership stakes or buying up entire companies and then managing them. As a result, they tend to be less risky than investing in hedge funds.
Typically, a PE firm targets a publicly-traded or privately-held company that it believes:
- is underperforming or facing severe financial problems, such as a debt default or bankruptcy
- it can turn around over a period of time, with the ultimate goal of selling it or having it go public
The PE firm generally has a team of turnaround specialists or industry experts which it inserts into the company to manage it and make changes. Those changes can include layoffs, process improvements, or a merger with another company. Being private allows the fund to operate without the pressure of having to satisfy shareholders every quarter, like publicly-traded companies do. At some point the PE firm elects to sell the company, reaping a profit, often a large one.
Some private equity funds, however, take a more passive approach. They may buy minority stakes in startup companies, for instance, much like venture capital firms.
Liquidity And Fees
Because of its long-term investment and corporate turnaround strategy, investors in PE funds are usually required to hold their investments for a long time, often for many years, before they see a return. As a result, PE funds are generally very illiquid. That's a big difference from publicly traded mutual funds and exchange-traded funds (ETFs). They offer investors the ability to liquidate their holdings either immediately while the market is open, in the case of ETFs, or at the end of the trading day, in the case of mutual funds. Hedge funds also don't have long lockup periods like PE funds.
Like hedge funds, PE firms charge very high fees for investors to invest in them. They typically charge a 2% annual management fee and then take a 20% profit off the top when it sells one of its holdings.
However, investors in PE funds are willing to forgo that lack of liquidity and high fees for the promise of above-market returns, but without the risk that hedge funds often carry. A study by Cambridge Associates LLC found that for the 25 years ended in March 2019, PE funds returned more than 13% a year, compared to about 9% for the S&P 500. Investing in PE funds is also seen as a diversification away from the public financial markets because they tend not to track those markets.
Criticisms Of Private Equity Firms
PE firms have come under criticism for a variety of reasons over the years.
In the U.S., for example, that 20% profit portion known as called "carried interest" receives favourable tax treatment as a long-term capital gain, which is taxed at a lower rate than regular income. It has generated criticism that this is preferential tax treatment for already-wealthy PE partners. However, defenders of PE firms argue that since they hold their investments for long periods, being taxed at long-term capital gains rates is only fair.
Critics of PE firms also note that executives simply make too much money. According to Bloomberg Businessweek magazine, "More private equity managers make at least US$100 million a year than top financial executives, investment bankers, and professional athletes combined." Proponents say PE firms are being fairly compensated for the risks they take.
Some PE firms have also been criticised for engaging in alleged predatory business practices, such as overburdening the companies they own with debt, in order to pay themselves special dividends, which allows them to cash in part of their investments sooner rather than having to wait until they sell the company. Some of these companies struggle to pay this debt long after the PE firm has cashed out, which sometimes leads to large employee layoffs or cutbacks in pay and benefits.
Top Private Equity Firms
The largest private equity firms are mostly based in the U.S., and some of them, including the two biggest, are publicly traded.
- Blackstone Group
- Apollo Management
- Carlyle Group
- Ares Management
- Oaktree Capital Management
- Fortress Investment Group
- Bain Capital Group
- TPG Capital
Private equity funds use pools of investor money to invest in companies they feel present favourable long-term return opportunities. PE funds play active roles in the companies they invest in, usually inserting their own set of managers to make improvements in order to set the companies up for eventual sale.
PE funds are generally open only to large, institutional investors, who are willing to lock up their money for many years and pay high fees for the promise of above-market returns. Some PE firms have been accused of engaging in predatory business practices in the companies they invest in, such as saddling them with high levels of debt or firing workers.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…