Private Equity: What is All the Craze?

Private Equity: What is All the Craze?

There has been a bit of mania going on in the investment world, and it is called Private Equity.  It has been garnering a lot of attention lately and has a bigger share of the high-net-worth investors’ wallet share.  We are seeing companies opt to stay private vs go public due to private equity, and furthermore, we are seeing companies go private from public to be part of this private equity world.

To prove what a huge trend this has become, allow me the pleasure of blowing your mind with a statistic you won’t believe.  Currently, in the US, there are more private equity funds than McDonald’s, and it isn’t even that close.  There are roughly 19,000 PE funds to about 14,000 (rounding up) McDonald’s. 

Now, I am certainly not writing this blog to entice anyone to invest in PE. You are likely hearing about it, or work for a PE-backed company, and I thought it my duty to educate on this asset class.

What is private equity?

Private equity investing is much like investing in mutual funds, except you are investing in private equity funds.  This is a pool of investors’ money where they become the limited partners and the pe partners take control, effectively becoming the general partner.  The PE fund then invests in private companies with the goal of increasing their profits and multiples.  Their end game is to invest in a consortium of businesses, merge them together, increase their profit figures and multiples, then exit in about 3-5 years. 

Essentially, they are mercenaries looking to invest in a company with their own and their investors’ money, clean it up, and find an angle to exit with more money than they entered.  Sounds easy, right?

The risk?

There are some very important things to note when it comes to risk and PE investing.  For starters, these investments are generally not very liquid.  Thus, your money must stay invested through the entire term.  Since these are private companies, there is no public exchange for the daily trading of shares.  This means that for the most part, the only way out is to wait for the PE managers to exit and sell their holdings.  Even at that, it generally isn’t one big sale and return of capital.  It can come in chunks over time, so certainly don’t count on this as easily accessible. 

Furthermore, unlike investing in the public markets, there needs to be a buyer for what the PE fund is selling.  The issue is that this isn’t someone buying a few shares in a company on an exchange.  They are generally looking for someone willing to pay tons of money to buy into a private company.  The buyers are limited to a much smaller pool, and that is assuming it is a favorable environment to be selling what they are buying.

Now, these aren’t positioned as “safe” investments and are truly meant to be super high risk, with a better-than-market return (which, of course, is debatable).  That is easier said than done, as if the investment is a stinker, remember you can’t wait it out for markets to rebound like a public stock that has dipped.  In the PE world, you simply get less money, end of story.

Costs?

I’d be remiss if I didn’t mention the costs of these investments.  The typical structure is a 2 and 20 model.  This means you pay 2% management fee for them to manage these dollars.  The 20 speaks of the fact that they keep 20% of the profit, distributing 80% of the sales to the end investors.  It isn’t a secret, and also probably why these PE owners are garnering a larger and larger share of the wealth out there. 

Final thoughts!

It probably sounds like I am down on PE investing, and maybe there is some truth to it.  It can be very lucrative, yet also very risky.  I’ve dealt with plenty of these types of investment vehicles in the past and find they are geared for a very small subset of investors who are OK with all the risks and rewards mentioned above.  That said, I do believe this is a trend that will stick around for a while, and we are seeing signs of them creating vehicles downstream for less wealthy investors, which we are always reviewing for our clients.  There are certainly many hurdles and things to consider before even considering this type of investment.  My best advice is, unless there is a real need or want to add this asset class to your investments, leave it to the ultra-wealthy for now, and the time will come sooner than later where this may make sense for the mass affluent.

Hope you liked my little diatribe on the PE markets, and as always, stay wealthy, healthy, and happy.