What is private equity?
Private equity is an equity position in a company that isn’t publicly traded – that hasn’t been listed on a public stock exchange. For ordinary investors, there are two ways to invest in private equity. You can invest in a private equity fund, or you can give money to a friend or family member in exchange for a share of their business venture. Limited partners of Bain Capital’s Asia XI Fund are private equity investors, as are your neighbors who have an interest in Uncle Theo’s pizza business down the avenue. As was the guy who painted a mural for Mark Zuckerberg’s start-up back in 2005 in exchange for early, non-public Facebook shares – later worth hundreds of millions of dollars.
Public equity funds also have direct ownership in their underlying investments. Investors in private equity funds need to be accredited. They need to have enough wealth and/or income to qualify. Their investments can be locked up for years. If you’re investing in a friend’s business, you don’t need to pass a test, but the underlying economics are the same. You’re at the mercy of the firm and the other shareholders, especially if you want to buy a bigger stake or sell some of your shares. If the business raises more capital when you can’t or don’t want to participate, your stake could be diluted.
With all these issues, why should investors want to own private shares? Both private and public shares represent the same residual claim on a company’s cash flow. But private shares enjoy one advantage: governance. Shareholders don’t have to go through the proxy process to hold management accountable. If a majority mistrust management’s accounting, they can bring their own auditors in to check the books. If a CEO behaves badly in the morning, he can be out the door in the afternoon. And if management wants to pursue a high-risk long-term strategy, they don’t have to worry about activist shareholders demanding greenmail when things get a little dicey.
Private equity can be risky because it often is part of a smaller firm with more volatile prospects. Sometimes those companies make it big, like Uber and Airbnb. But more often they fail, or just cruise along – a “lifestyle” company that Uncle Theo works at, along with other family members. It also tends to be concentrated, so investors can have a meaningful stake. As with many funds, returns are skewed positively, with most of the excess coming from a few successful investments.
Private equity isn’t a separate asset class, but it’s another way for large institutions and wealthy individuals to put their money to work – with big potential. But it’s not for everyone. Just because someone is accredited doesn’t mean they can afford the risk.
Douglas R. Tengdin, CFA