- Private equity is an asset class in which various institutional investors allocate capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets. In the 1980s, insurers were major private equity investors. Later, public pension funds and university and other endowments became more significant sources of capital. For most institutional investors, private equity investments are made as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds) and other alternative assets (e.g., hedge funds, real estate, commodities).
Most institutional investors do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversified than one a single investor could construct.
Returns on private equity investments are created through one or a combination of three factors that include: debt repayment or cash accumulation through cash flows from operations, operational improvements that increase earnings over the life of the investment and multiple expansions, selling the business for a higher multiple of earnings than was originally paid. A key component of private equity as an asset class for institutional investors is that investments are typically realized after some period of time, which will vary depending on the investment strategy. Private equity investments are typically realized through one of the following avenues:
- Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund in which it has invested.
Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles.
The amount of time that a private equity firm spends raising capital varies depending on the level of interest among investors, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital when they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months.
Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for new investors to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.
Due to limited disclosure, studying the returns to private equity is relatively difficult. Unlike mutual funds, private equity funds need not disclose performance data. And, as they invest in private companies, it is difficult to examine the underlying investments.