Private equity funds

Direct investment in private companies

Private equity funds pool investors money to invest directly into private companies. Here we explain how private equity funds work, what sort of companies they invest in and how you might have exposure to this type of investment.

What is a private equity fund?

A private equity fund is a fund that invests directly in private companies by providing capital and management expertise to help them become more profitable.

There is no standard structure for a private equity fund, however in Australia, private equity funds are usually unit trusts or limited partnerships.

Who can invest in private equity?

Private equity funds are for institutional and sophisticated investors. Typically capital is raised from institutional investors such as super funds, life insurance companies, funds of funds and other companies. Family offices, trusts and wealthy individuals may also invest in private equity funds.

Private equity investors use this type of investment to add diversification to their portfolios and expect higher than average returns than those of traditional equity investments, because they are taking on bigger risks to achieve potentially higher returns.

Private equity funds are usually not available to retail investors as the minimum investment is often $500,000 or higher, however retail investors may have exposure to private equity funds through their superannuation fund.

How do private equity funds work?

Private equity funds use investors' capital to buy a stake in private companies that are looking to expand, develop new products or services or need to be turned around to remain viable. This usually involves the private equity fund buying a share in a target company, taking an active management role in the company and providing expertise in areas such as business development, marketing, financial analysis and business networks.

This high level of involvement has often led to private equity investments achieving higher returns than standard equity investments, although not without increased risk.

Private equity investment life cycle

Private equity investments take an average of 5 to 7 years to reach their potential, however investors money could be tied up for longer. A private equity investment will usually go through the following stages:

  1. Company investment - The private equity fund buys or commits to invest in a company it thinks can profit from a capital injection and/or management expertise. Funds may be drawn down gradually over the first 5 years of the investment.
  2. Additional management - A representative from the private equity company will join the board of the investee company, usually someone with expertise that matches a pre-determined need.
  3. Add value - Private equity managers will focus on growing the business and adding value through financial support, restructuring, corporate governance and operational improvements.
  4. Exit investment - The private equity fund will then usually sell the investment, through an initial public offering (IPO), a backdoor listing, a sale to a third party who may operate in the same industry or a sale to another private equity company who specialises in later-stage businesses. They could also exit the investment through a share buyback arrangement, or via a liquidation if the company has failed.
  5. Return of funds to investors - Finally any capital and profits, less fees, will be returned to investors.

Private equity investments are long-term investments, that are likely to be close-ended which means investors need to be committed for the life of the fund.

Private equity fund fees

The fee structure of private equity funds is often higher than that of other managed investment funds. Fund managers charge a fixed management fee, typically 1-2% each year, as well as a performance fee (often referred to as 'carried interest') that applies once pre-determined performance hurdles are met.

What do private equity funds invest in?

Private equity funds invest in companies seeking a capital injection into their business. There are many reasons a company may be looking for a private equity partner. Common reasons include:

  • They are in early stages - The company has a product or service that has potential for growth but needs a capital injection and/or management expertise to expand and grow.
  • They are in distress - They might be able to be turned around with a business restructure.
  • The owners want to exit - If the owners want to retire or start a new business they might want to sell their current business.

Private equity funds are a long-term investment strategy, suitable for sophisticated investors and large institutions that have substantial amounts of money to invest. Retail investors may be able to gain exposure to private equity investments through their super fund. Risks can vary between funds so investors need to do careful research before committing funds to a private equity investment.

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Last updated: 19 Jan 2018