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What is private equity and how does it work?

Private equity is a  private markets investment that involves investing in companies that are not publicly traded on a stock exchange, or will no longer be publicly traded following the investment. Private equity firms raise money from institutional investors such as pension funds, and high net worth individuals, and use that money to buy stakes in companies.

Private equity funding allows companies that are unable to get capital funding from traditional sources like banks or public markets to grow and become more profitable. It also allows the private equity fund manager to shape how a company is run and make a profit when it's sold.

Private equity firms generally take an active role in managing the companies they invest in, with the goal of improving their performance and increasing their value. A private equity firm will typically hold the investment for several years before selling it, either to another private equity firm, by taking the company public, or selling it back to the management team.

Types of private equity

There are several different types of private equity, each with its own unique set of goals and strategies. The most common types of private equity are listed below.

Leveraged buyouts (LBOs)

In a leveraged buyout (LBO) a company is purchased using debt funding from private equity investors. The goal of an LBO is to take a company private, make it more efficient and profitable, and then sell it off. This type of transaction became popular in the 1980s when interest rates were high and banks were unwilling to lend money to small businesses.

Venture capital

Venture capital is an investment in young, high-growth companies that have the potential to become major players in their industry. The goal is to help these companies grow and achieve profitability.

Real estate private equity

Real estate private equity entails investing in commercial and residential properties to generate income and capital appreciation.

Management Buyouts (MBOs)

A management buyout, or MBO, is a buyout in which a company’s management purchases a controlling stake from the previous owners. The goal is to make the company more efficient and profitable before selling it.

Fund of funds

A fund of funds is an investment fund that invests in other investment funds. This can be a more efficient way to invest in private equity, as it allows investors to access a range of funds with one investment.

Distressed and special situations

Distressed and special situations investments focus on companies/assets that are in financial trouble or undergoing major change. Distressed private equity investments aim to help companies that are in financial trouble to restructure their debt and become more profitable. Special situations private equity investments target companies undergoing a major change or event and aim to help them to take advantage of the situation and maximize their value.

Secondaries

Secondary private equity investors buy stakes in existing private equity funds that are being sold by investors before they are liquidated. They to allow investors to exit their investments in existing funds early and provide capital to new and upcoming private equity funds.

Mezzanine capital

Mezzanine capital is used to finance the growth of a company. It is typically provided by a specialist mezzanine lender. The goal of mezzanine capital is to help companies grow and become more profitable.

Growth capital

Growth capital is used to finance the growth of a company, and help it become profitable. It is typically provided by a specialist growth capital lender.

What is the difference between private equity and other investments?

Private equity vs hedge funds

Private equity and hedge funds are both investment vehicles, but they have key differences. Private equity invests in companies, while hedge funds can invest in a variety of assets, including companies, bonds, and commodities. Private equity investors typically invest in companies that are not publicly traded, while hedge funds can invest in both public and private companies.

Private equity vs growth equity

While private equity is focused on investing in companies in general, growth equity is a form of private equity that specifically invests in high-growth companies. Other key differences include:

  • Investment horizons: private equity investors typically have more patience than growth equity investors and are willing to wait for a greater return on their investment. Growth equity investors are typically looking for shorter-term profits.
  • Private equity investors are more likely to be able to provide financing and expertise that can specifically help a company grow. Private equity investors may be able to provide a company with access to new markets.
  • Growth equity investors are more likely to invest in companies that are already profitable.
  • Private equity investors typically invest in companies that are not publicly traded, while growth equity investors can invest in both public and private companies.

Private equity vs private credit

Private equity involves acquiring a stake in privately-owned companies, while private credit involves providing debt financing to such companies.

Private equity vs public equity

Private equity invests in private companies that are not publicly traded, while public equity invests in stocks that are traded on public exchanges, e.g. the New York Stock Exchange (NYSE).

Private equity firms raise funds from institutional investors and high-net-worth individuals, and aim to generate high returns by acquiring a controlling stake in the company and implementing operational improvements.

Public equity, involves investing in publicly traded companies listed on stock exchanges. Individual and institutional investors can buy shares of these companies' stock, becoming partial owners. They can benefit from capital appreciation and dividends as the company grows and generates profits.

Private equity firms

What are private equity firms and what do they do?

Private equity firms invest in high potential or undervalued companies, with the aim of improving their performance. Private equity firms typically hold their investments for several years, so they can see significant value growth and then sell them off at a substantial profit for their investors. A sale may be done through an initial public offering (IPO) or by selling the company to another organization.

Private equity firms typically raise closed-ended investment funds, investors in which are institutional, such as pension funds, endowments, and high-net-worth individuals. Each fund has a target investment amount, and it will close to new investors once this target is reached. The money raised is invested in private companies, often those that need a turnaround, or have high growth potential but might not have achieved profitability. Each fund will invest in a portfolio of companies.

Target companies may be young, or they may need additional capital to grow. Private equity firms provide this capital, which can help companies expand and become more successful.

Once a private equity firm has invested in a company, it often works closely with management to help grow the business. Private equity firms can offer their expertise and guidance to the companies they invest in. This can be helpful for early-stage companies. Private equity firms often have a great deal of experience with running businesses, and they can share this knowledge with the companies they invest in.

How are private equity firms organized?

Private equity firms can be organized in various ways, but they all have one common goal: to make money for their investors. They typically have a team of professionals who analyze potential investments and make decisions about where to invest the firm's capital. This team includes investment bankers, analysts, and lawyers. Private equity firms typically specialize in a particular industry, such as healthcare or technology, and have extensive knowledge about that industry.

Private equity investing

Private equity capital is invested in companies with the intention of generating a return for their investors. Private equity investors typically seek a higher return on their investment than they could achieve from a public equity investment. Returns can vary depending on the type of private equity investment, the stage of the company's life cycle at which an investment is made and overall economic conditions.

PPrivate equity investors are typically institutional investors such as pension funds, endowments and sovereign wealth funds, as they have the capital to invest and are typically willing to take on the risks.

Private equity investments are often riskier than other types of investments, so it's important to understand those as well as the benefits before investing.

How are private equity investments funded?

Private equity funds are investment vehicles that allow investors to pool their money and invest it in private equity deals. Private equity funds can be raised in several ways, including through a public offering or by invitation only. Private equity funds typically have a high minimum investment.

Private equity funds structures

Private equity funds are usually structured as limited partnerships. In a limited partnership, the general partner – the private equity firm managing the fund - is responsible for the management of the fund and assumes most of the risk. Investors in the fund are limited partners and they have no responsibility for its management.

Private equity market size

The size of the global Private Equity market reached approximately $5.3 trillion in 2023 and is expected to reach $6 trillion by the end of 2024.

Private equity market size by AUM

The North American private equity market is the largest in the world, with total assets under management of $3.4 trillion in 2023.

European private equity AUM totaled $1.1 trillion in 2023, while Asia-Pacific private equity AUM totaled 611 billion.

Source: Preqin

The private equity landscape has shifted in recent years. Some of the trends shaping the private equity market include:

  • A slowdown in exits between 2021 and 2023: PE exits were 20% lower in Q3 2023 than Q3 2021, with longer holding periods testing PE firms’ ability to create value. Exits are now rising.
  • The rise of AI: fund managers are exploring the use of AI in private equity to add value by boosting productivity.
  • Increased regulation: the SEC has implemented new rules for US private fund advisers, designed to increase transparency and accountability.
  • A push towards retail investors: PE funds see individual capital as an area of opportunity and are accelerating outreach to retail investors as the flow of capital from institutional investors slows.
  • PE-backed M&A slumps: Private equity-backed M&A activity is expected to continue slowing into 2024, with smaller-sized transactions and carve-outs most likely.

 

Private equity exits below 2021 levels, but rising: entries slump

Private equity exits were 20% lower in Q3 2023 than the same period in 2021, as fund managers avoided sales or IPOs due to macroeconomic conditions and the high interest rate environment. This resulted in longer  private equity holding periods which test PE firms’ value creation strategies. Exits were, however, 21.6% higher in Q3 2023 versus the same period in 2022, and were higher in 2023 overall compared to 2022. Strong stock market performance and the availability of debt financing is providing more favorable conditions for private equity exits.

Entries, have slumped. The value of private equity and venture capital entries globally fell 22.3% year over year to $28.55 billion in September 2023. This decrease in entries was due to the rising cost of capital due to high interest rates, and private equity firms are concerned about the uncertain economic outlook.

The rise of AI in private equity

More widespread adoption of AI is shaping broader investment themes for private equity firms, who are attempting to position their portfolios to catch AI tailwinds and avoid the sectors and subsectors poised for disruption by the evolving technology. For example, companies in the call center space, translation, and transcription businesses face a "red alert," while companies building and supporting AI systems are increasingly investment targets.

Private equity fund managers are exploring the use of AI in private equity to add value by boosting productivity. The speed at which companies adopt AI could prove to be a critical competitive factor. Some specific examples of how companies are using AI to boost productivity include:

  • Tracking customer interactions and prompting salespeople to make timely follow-up calls
  • Quickly drafting and sending personalized communications to clients
  • Automating tasks that are performed manually
  • Providing financial advisers with immediate access to information and analysis

Private equity firms are also using AI for internal purposes, such as automating routine tasks and producing unique insights from proprietary data. In a June 2023 survey of nearly 300 institutional investors, "employee productivity" and "process efficiencies" were listed as the biggest impacts of AI.

SEC introduces new regulation for US private equity

The SEC introduced a set of rules for private fund advisers, designed to increase transparency and accountability. They include enhanced reporting requirements and investor protections. Compliance costs were a concern for the industry, but the SEC made some concessions to fund managers in the final rules.

Some industry experts maintain that the new rules will increase expenses for funds and could disproportionately impact small and emerging funds, while others suggest that the benefits of the new rules outweigh the costs. They argue that the rules will help to protect investors and ensure that private markets are fair and efficient.

The SEC's emphasis on private markets regulation is likely to continue, having proposed a number of other rules in recent months that could have implications for private market participants.

Private equity fund managers push to grow retail investor base

Private equity funds are accelerating their outreach to retail investors as capital flows from institutional investors slows. Fund managers see individual capital as an area of opportunity, as high net worth individuals hold a significant portion of global private wealth, yet a relatively small portion of such wealth is currently invested in private equity.

Some fund managers are offering tokenized funds (in which shares or units are digitally represented and can be traded and recorded on a distributed ledger), as well as a variety of semi-liquid investment products such as tender offer funds, interval funds, business development companies, and nontraded real estate investment trusts to attract retail investors. These products offer some liquidity, but they still have longer investment horizons than traditional private equity investments.

Private equity-backed M&A activity decreasing

The slowdown in private equity-backed M&A activity is expected to continue into 2023, with smaller-sized transactions and carve-outs being the most likely types of deals to be completed. This is due to factors including macroeconomic headwinds, buyer and seller disconnect (buyers are being more conservative in their valuations, while sellers may still be expecting to get peak multiples for their businesses) and limited availability of debt (investment banks and other lenders are hesitant to provide financing for large deals.)

How we can help: solutions for private equity

S&P Global is well-positioned to support across the entire private equity lifecycle with a wealth of experience and solutions. We bring transparency to the private market universe with data on 52+ million private companies and private markets, credit analytics and risk assessments for over 50 million companies, and rate the creditworthiness of several types of Alternative Investment Fund (AIF).

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