Fundamentals of Private Equity

Alternative investments are growing in popularity, with the industry set to eclipse $14 trillion in assets under management in 2023, according to Harvard Business School. For interested parties, private equity remains an attractive route. There are three ways you can enter private equity: become an accredited investor, open your own firm or join an existing firm like The Blackstone Group, The Carlyle Group or KKR. Regardless of your path, it is advantageous to pursue an advanced degree such as a Master of Business Administration (MBA), which will help you stand out as an investor, employee or partner.

What Is Private Equity?

Pitchbook defines private equity as a form of financing where capital is invested into a company. As the name implies, private equity typically involves investing in private companies instead of public ones. This asset class is for accredited investors and typically requires a minimum investment of $250,000.

In addition, private equity (PE) has a higher risk and return profile compared to traditional assets. PE investments tend to be riskier due to their low liquidity. In other words, once you’ve made an investment, it’s hard to quickly convert it back into cash. This is due to a lack of a secondary market to sell shares. Once you’ve invested in a company, you must wait until that company is sold or goes public to get your investment back.

However, with higher risk comes the potential for higher returns. In private equity, it’s possible to earn asymmetrical returns by investing in underperforming companies, making drastic improvements and reaping the rewards of their success.

There are three main types of private equity investments:

  1. Buyout: When an investor purchases a majority stake in a company and “buys out” the other leading investors
  2. Growth: When an investor purchases a minority stake and works alongside existing management to help grow the company
  3. Mezzanine: When businesses combine debt and equity investment and a company takes on capital from a PE firm with an agreement to pay it back with interest

Private Equity Vs. Venture Capital

Both private equity and venture capital involve investing capital in private businesses. However, there are three ways that these funds differ.

First, private equity firms focus on investing in mature businesses, while venture capital firms go after early-stage startups. Second, PE firms prefer to invest in traditional, established industries, whereas VC firms prefer high-growth, emerging markets. Finally, PE firms tend to take majority stakes in companies to oust existing management and redirect the company. VC firms, on the other hand, tend to take minority stakes in young companies and work alongside the founders.

These investment firms are still slightly different from mutual funds, however.

Private Equity Vs. Mutual Funds

The three differences between private equity firms and mutual funds are related to their investor base, strategies and fee structure.

To start, PE firms work with accredited investors, which typically means the fund has a few high-net-worth investors, called “limited partners.” Mutual funds, alternatively, raise money from retail investors and are available to anyone. Additionally, PE firms tend to only invest in private companies, whereas mutual funds invest primarily in public ones. Finally, mutual funds can only collect management fees, while PE firms can collect both management and performance fees.

As mentioned earlier, private equity tends to have a higher risk and return than mutual funds. This is because price discovery and valuations are much more transparent in public markets than in private ones.

For example, consider a public company like the up-and-coming coffee chain Dutch Bros. Since this company is public, investors can access its audited financial statements, revenue/expenses, key investment ratios and more. More importantly, they can compare Dutch Bros to its competitors to get an idea of the market size, industry projections and more.

Comparatively, in private equity, investors might get a glimpse at the financial statements of the company they’re investing in. But, when it comes to competitors and the overall market, they are left to speculate. This makes it more difficult to assign a valuation to a company.

Understanding Private Equity Investments

According to Harvard Business School, there are three stages in a company’s life cycle when a private equity firm may want to invest.

If a PE firm wants to make a venture-capital style investment, it will invest in startups. Most commonly, a PE firm might take a minority stake in a young company and assist the management team in growing it.

If a company is mid-sized but still growing, then a PE firm can make a growth equity investment. These investments offer slightly lower returns since the company has already reached a more mature stage. But, they also have less risk since the company has proven that its business model works.

Finally, if a PE firm wants to invest in a mature public company, it can consider a buyout. The main goal of a buyout is to oust the existing management team and take the company private. This way, they can improve the company internally without the pressure from Wall Street to post quarterly growth.

Entering Private Equity

Private equity is a fascinating yet complex industry; there are many different ways to start and grow your career in this space. Again, you can make your mark on the industry by becoming an accredited investor, allocating your capital, opening your own firm or joining an existing firm. Regardless of your preferred route, there’s one significant way to separate yourself from others in your field: earning a Master of Business Administration.

In addition to equipping you with in-demand business skills, an MBA is an indication to investors and employers that you have the necessary knowledge to succeed. Beyond that, the extensive alumni networks offered by MBA programs can offer some of the best ways to network and access opportunities throughout your career. Plus, an online MBA programs provides students with minimal disruption to their existing schedules and careers.

For example, students can complete the Southern Illinois University of Edwardsville’s online MBA program in 12 months. This program offers electives in relevant subjects such as Entrepreneurial Finance, Managing Organizational Change and Innovation and Competing in Emerging Markets. It specializes in advancing both your technical skills as well as the human factors that enhance managerial effectiveness.

Learn more about Southern Illinois University Edwardsville’s online Master of Business Administration program.

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