We recently had some clients ask us what private equity was because they had heard the term used in the news recently.
Like shares of stock, private equity embodies an ownership interest in a company. Unlike stocks, however, private aequity investments aren’t listed or traded on a public exchange. Private equity firms often are more directly involved with management of the business than the normal shareholder. And, private equity usually entails a long-term focus before investments begin to produce any consequential cash flow (if ever). It also typically requires a hefty investment and is available only to qualified investors such as wealthy individuals, pension funds, and institutions.
Private equity can also take different structures:
- “Mezzanine financing” happens when private investors lend money to an established company in exchange for a share in the company (if the loan isn’t repaid on time). Many times, it’s used to finance growth or acquisitions and is typically secondary to other debt. So for an investor, mezzanine financing can be rewarding because the interest paid on the loan can be high.
- “Venture Capital Funds” invest in companies that are in the earlier stages of their development and may not yet have strong cash flow or financial backing. In exchange, the venture capital fund receives a share of the company.
- “Angel Investors” are individual investors who provide capital to startup companies and may have a personal stake in the undertaking, providing business know-how, industry experience and capital.
- “Buyouts” occur when private investors purchase all or part of a public company and take it private. The idea here is that the company is either undervalued or the company’s profitability can be improved. Once the company’s economic condition gets better, it can be sold later at a higher price. In some cases, the private investors are the company’s senior executives, and the buyout is known as a “management buyout.” A “leveraged buyout” is financed not just with investor capital, but with bonds issued by the private equity group to pay for purchase of the outstanding stock.
Some of the common characteristics of private equity are:
- High costs for due diligence because of complex investment structures, the need for specific expertise, and a lack of simplicity in terms of performance communication.
- Difficulty in establishing suitable benchmarks, and thus in performance uation.
- Relative illiquidity, so investors call for a higher return.
Sometimes private equity can provide investors with exposure to risk factors they can’t get from traditional investments, exposure to specialized investment strategies, or a combination both.
Before you decide whether or not private equity is right for you, consult your investment, tax and/or legal advisor(s).
Chip Gordy, MBA, CRPC is a financial advisor with Coastal Wealth Management, LLC, located at 10441 Racetrack Road, Unit 1, in Berlin, who specializes in wealth and retirement planning. He can be reached at 410-208-4545 or chip@coastalwealthmgmt.com.
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