Private equity is a broad term that refers to any
type of equity investment in an asset in which the equity is not freely tradable
on a public stock market. Categories of private equity investment include
leveraged buyout, venture capital, growth capital, angel investing, mezzanine
capital and others.
Private equity securities
Private equity securities refer
to securities in companies that are not listed on a public stock exchange; while
technically the opposite of public equity they are broadly equivalent to stocks,
though return on investment often takes much longer. As they are not listed on
an exchange, any investor wishing to sell securities in private companies must
find a buyer in the absence of a traditional marketplace such as a stock
exchange. In addition, there are many transfer restrictions on private
securities. This long term investment area currently has over US$710 billion in
The sale of private securities is used by companies to generate capital.
Investors generally receive their return through one of three ways: an initial
public offering, a sale or merger, or a recapitalization. Unlisted securities
may be sold directly to investors by the company (called a private offering) or
to a private equity fund, which pools contributions from smaller investors to
create a capital pool.
Private equity funds
Although other structures exist,
private equity funds are generally organized as limited partnerships which are
controlled by the private equity firm that acts as the general partner. The fund
obtains commitments from certain qualified investors such as pension funds,
financial institutions and wealthy individuals to invest a specified amount.
These investors become passive limited partners in the fund partnership and at
such time as the general partner identifies an appropriate investment
opportunity, it is entitled to "call" the required equity capital at which time
each limited partner funds a pro rata portion of its commitment. All investment
decisions are made by the General Partner which also manages the fund's
investments (commonly referred to as the "portfolio"). Over the life of a fund
which often extends up to ten years, the fund will typically make between 15 and
25 separate investments with usually no single investment exceeding 10 percent
of the total commitments.
General partners are typically compensated with a
management fee, defined as a percentage of the fund's total equity capital. In
addition, the general partner usually is entitled to "carried interest",
effectively a performance fee, based on the profits generated by the fund.
Typically, the general partner will receive an annual management fee of 2
percent of committed capital and carried interest of 20 percent of profits above
some target rate of return (called "hurdle rate"). Gross private equity returns
may be in excess of 20 percent per year, which in the case of leveraged buyout
firms is primarily due to leverage, and otherwise due to the high level of risk
associated with early stage investments. Although there is a limited market for
limited partnership interests, such interests are not freely tradeable like
mutual fund interests.
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