Private Equity Fundamentals – What It is and How It Works

Key takeaways

• Private equity investments generally have a higher risk-return profile because they have lower liquidity, and price discovery and valuation are more difficult.

• Investing in pre-IPO (initial public offering) companies through a private equity vehicle can potentially offer higher return to institutional investors and high net worth individuals that are allowed to invest in the space – namely qualified purchasers and accredited investors.

• Yieldstreet lowers the minimum to access the space, allowing investors to modernize their portfolios, increase their exposure to – and diversification within – alternative investments.

What is private equity?

Private equity tends to have a higher risk/return profile due to its limited liquidity – in the absence of a secondary market – which makes price discovery and valuations more difficult. 

Moreover, unlike public equity investments which trade on a day-to-day basis, private equity investments tend to have longer maturity  and do not have a secondary market, which makes them more illiquid. The flip side is that investors can have more control over the decision-making process in the companies in which they invest, including steering critical decisions.

A brief history of private equity

Along with the industrial revolution came the need to raise large sums of capital to develop railroads, steel mills, factories, telegraph systems and other large-scale endeavors. The acquisition of Carnegie Steel by J.P Morgan in 1901 is generally recognized as the first significant buyout transaction. Carnegie Steel’s valuation at the time was $480 million.

Some 45 years later, American Research and Development Corporation (ARDC) and J.H. Whitney & Company—the first two venture capital firms—were founded. The two pioneering leveraged buyout transactions took place in 1955, when McLean Industries used borrowed money to fund the purchases of the Pan-Atlantic Steamship Company and Waterman Steamship Corporation. 

Three years later, the Small Business Investment Act of 1958  afforded venture capitalists the opportunity to leverage federal funds against private investment funds at a ratio of 4:1. This led to the emergence of pooled private equity funds with investment professionals serving as general partners. 

Leveraged buyout activity accelerated in the 1980s, owing to the ready availability of high-yield debt financing (also known as junk bonds). However, this practice got out of hand, which led to a crash in 1989. Stricter government regulation resulted in attempts to curtail outsized risk-taking. 

With this development, private equity took on a longer-term approach in the 1990s. Leveraged activity declined and venture capital deals began to flourish, just as the growth of the Internet led to the dotcom boom. Most of today’s most successful publicly traded tech companies were funded by venture capitalists. These include Amazon (NASDAQ: AMZN), eBay (NASDAQ: EBAY) and Alphabet (NASDAQ: GOOGL), which has its own venture capital division. However, there were far more failures than successes during that period, which slowed global activity as the new millennium dawned. 

To counter this, the Fed lowered interest rates in 2002 to support growth. Lower borrowing costs made it possible to  fund larger acquisitions, which, in turn, drew investors to private equity in search of higher yields and accelerated the volume and increased the size of private equity deals. 

The 2008 collapse of Lehman Brothers marked the beginning of an era of slower economic activity. However, things eventually turned, and in 2011, capital distributions began exceeding capital calls. Asset owners who had managed to hold on during the crisis suddenly found themselves highly liquid, which drove deal volume.  

As public markets became overcrowded in the past five years, demand for private equity has increased. 

How the investment process works

Private equity firms that cater to the lower end of the market typically require a minimum investment of $250,000, but it’s not unusual to see firms requiring investors to place $25 million or more with them. 

That is why private equity firms typically aggregate investment capital from institutional investors such as insurance companies or pension plans, as well as high-net-worth individuals. These firms create pools of dollars, from which private equity instruments such as buyouts and venture capital are funded. 

It is important to note the risk/return profile of private equity is quite high. 

Privately held companies do not have to meet the same disclosure requirements as those enforced by the SEC on publicly traded firms. Moreover, while mature companies have years of earnings and operational data to share with investors, early-stage startups do not. This can make pre-IPO venture capital investments riskier than, say, a growth equity investment in a well-established expanding company. 

But again, along with that elevated risk comes the potential for more significant rewards. Thus, investing in pre-IPO companies through a private equity vehicle has opened the door to potential higher returns.

Diversification and returns

Qualified investors looking to diversify would do well to consider private equity.

As an alternative asset class, a private equity investment can be a lucrative aspect of a diversified portfolio for those with risk tolerance. Because it functions independently of the stock market, private equity also has the potential to mitigate volatility. 

Private equity has also proven to exhibit less downside sensitivity than publicly traded equities. They also have strict liquidity restrictions. However, that illiquidity can serve as a deterrent against an investor impulsively selling into a falling market. 

Types of Private Equity firms

Private equity firms typically follow one of three strategies: venture capital, growth equity or buyouts. Operating with long-term investment horizons of five to seven years, some of the top private equity firms include Blackstone Inc. (NYSE: BX), KKR & Co. (NYSE: KKR) and The Carlyle Group (NASDAQ: CG). The largest of these, Blackstone, reported $880.9 billion in assets under management at the end 2021. 

Venture Capital (VC) firms provide seed money to start-up companies in exchange for shares. These firms generally don’t require majority shares in the companies they support. While they stand to make billions of dollars when the investment proves fruitful, they also take on a great deal of risk. Growth equity-oriented firms get involved with companies that are much further along in their development than startups. These investors also take a minority share of ownership in the companies they back. 

Firms specializing in buyouts usually pursue one of two strategies. The first of these, management buyouts, entails purchasing a company’s assets and taking a controlling position. This is useful when a public company needs internal restructuring and wants to go private before implementing those changes. This gives stakeholders an opportunity to liquidate their positions before the new management team takes over. This is also a mechanism by which business owners can exit when they want to retire. 

Leveraged buyouts help companies make sizable acquisitions while preserving liquid capital. Assets of all companies involved in the transaction are pledged as collateral to secure financing. The goal here is to gain control of the company being bought to make changes and capitalize on the enhanced value those changes create. 

Fees

Private equity fees fall under two headings, management fees and performance fees. The purpose of the management fee is to compensate investment managers for overseeing the fund. Firms typically charge annual management fees of approximately 2% of the fund’s committed capital. Performance fees – also referred to as carried interest – are usually calculated as a percentage of the profits returned from investments. The average performance fee is 20%, and the fund’s stated distribution waterfall  governs the method by which that percentage is calculated. Gains are distributed between investors and the general partner based on a series of sequential cascading tiers, which is why it is called a waterfall. The carried interest percentage accruing to the general partner is based on the stated preferred return afforded investors in the prospectus. 

Investing in Private Equity

Yieldstreet offers a curated selection of private equity investment opportunities, with accessible minimums and early liquidity options.

Learn more about the ways Yieldstreet can help diversify and grow your portfolio.