Private equity means owning shares in businesses that are not publicly traded, either directly or indirectly. 

Most often, this is done indirectly via a specialist private equity fund, whose managers raise money from investors and then invest that money across a selection of companies in the fund.

Over time, more and more companies have become privately held, as opposed to publicly traded.

Within private equity, managers pursue a range of strategies. Some of the main categories focus on companies according to their stage of development:

Venture capital and growth equity managers target up-and-coming companies that are not yet profitable but have the potential to expand rapidly. These tend to be minority investments in high-growth areas, such as digital technology and the search for cutting-edge medical treatments. 

Buyout managers pursue more mature companies. They typically buy controlling stakes in profitable companies. To do so, they often use debt alongside their own and investors’ money. They then seek to increase the companies’ value before selling them. 

Distressed managers buy the debt of companies that are in trouble and headed for financial restructuring. Having bought the debt at an attractive entry point, distressed managers aim to swap it for a controlling equity stake during the restructuring process. They then seek to sell that stake for a higher price.

While private equity often involves managers acquiring companies listed on stock markets, this asset class is not a straight alternative to public equities. The potentially higher returns come with greater risks. As such, private equity is not suitable for as many investors as public equities. Indeed, regulations demand that individuals satisfy various requirements, including having sufficient financial net worth, knowledge and experience to invest in private equity.

Among the main investors in private equity are institutional investors such as pension funds, sovereign wealth funds and university endowment funds. Sophisticated wealthy individuals – and the family offices that may represent them – also invest in this asset class.  

All private equity managers seek to add to the value of the companies they invest in. 

For venture capital and growth managers, they do so by providing companies with funds to grow but also giving them advice on their technology, business strategy and sales strategy.

Buyout managers typically try to improve the way companies are run, cutting unnecessary costs in the companies they buy, sometimes merging them with other companies and selling off weaker or unnecessary bits of the business. 

Distressed managers use their knowledge of the bankruptcy and restructuring processes to help secure companies’ future and gain themselves a large slice of its shares. 

Once they obtain control of a business, they often take the same steps as a buyout manager to improve the business.

If their investments in companies go well, private equity managers can seek to profit in various ways.

One “exit route” is to sell their stake in a company in the open market, so the private company becomes publicly traded.

Another exit route is selling the whole company to a single buyer. This could be a big company that wants to grow its operations. Or it could be another private equity company. 

Of course, there is no guarantee that the private equity firm will succeed in making money or even breaking even on an investment. 

The earlier-stage companies that venture capitalists invest in often fail to live up to their potential for one reason or another. Sometimes private equity firms have to hold a company longer to break even on their initial investment. They might also need to provide additional funds.

For this reason, venture capitalists make a larger number of smaller investments, with the aim that a few big winners can more than offset losses on those that don’t work out.

The more mature companies that buyout managers acquire can also experience business difficulties or get hit unexpectedly hard in an economic downturn. 

Private equity managers usually take a share of the gains they may achieve for their investors in a fund but only if it achieves a certain minimum return threshold. 

This helps align the interests of investors and the manager. This share is typically called the “carried interest” or “promote”.

So, if the value of the fund they are running grows to at least an agreed level as stated in their offering document, the manager might receive a 20% share of all profits above that. If the fund doesn’t reach that level, though, the managers don’t get a performance fee.

However, that’s not the only way private equity managers can make money. Typically, they also charge investors in their funds an annual management fee, typically around 2% a year. They get this whether their fund performs well or not. 

As an asset class, private equity has delivered attractive returns over time, sometimes an investment in a private equity fund is as long as ten years. But with higher returns come higher risks. Investors seeking to investment in this asset class should consider the longer holding period and should have a higher risk tolerance.

Private equity is an illiquid asset class. Typically, investors have to lock up their money to a fund for several years. Investors who want out before the end of the fund’s lifetime may have to accept an unfavorable price or significant discount if they sell their holding to other buyers, assuming such buyers can be found. There is a limited secondary market for private equity.

Especially in recent years, large amounts of investor cash have flowed into private equity funds. This can end up with lots of money chasing fewer deals, such that private equity funds might overpay. Ultimately, this can threaten the returns they make when they choose to sell.

Because they rely heavily on borrowed money, buyout investments are at risk when borrowing costs go up or company cash flows come under pressure.

The sort of companies that venture capital and growth managers invest in can easily fail because their businesses are still early-stage. Product failures, management misjudgments and cash flow problems are common pitfalls.

Private equity is also less transparent than publicly listed investments. Information about underlying holdings is not readily available in the market place or timely as they do not have the same reporting requirements as a mutual fund or exchange traded fund.

Aside from risks in relation to the underlying investments, private equity investors can fall victim to operational risks. 

These are risks are to do with the private equity manager itself, such as with its personnel, its controls and how it is run and overseen. Inadequate technology, staffing and processes and fraudulent behavior are just some examples of operational risks.

Operational due diligence is the process of seeking to identify and mitigate such risks. Dedicated operational due diligence teams may help with this process.