A Primer on Private Equity

For those of us who have not attended the business schools at Harvard, UCLA, or Wharton, private equity investing can seem esoteric. However it’s not quite as mysterious as it seems.

A History of Private Equity

J.P. Morgan was considered to have made the first private equity investment (what is now called a leveraged buyout) when he purchased the Carnegie Steel Company in 1901 from Andrew Carnegie and Henry Phipps. (This price tag was for $480 million.) Morgan employed a substantial amount of debt to assist with this purchase.  In 1946, the first two ongoing private-equity firms were established: the American Research and Development Corporation, and J.H. Whitney & Company.

In today’s business world there are three broad categories of investing that are included in the term private equity:

• • Real Estate Investing (often done through partnerships)

• • Startup Investing (new companies are developed in stages and eventually sold to other companies or brought to the stock market through an IPO)

• Restructurings and Recapitalizations (large companies that are privately held or publicly traded are restructured and then sold)

A Completely Imaginary Example: the U.S. Post Office

Almost everyone has an opinion about how the U.S. Post Office could be improved. Let’s imagine that you form a partnership and raise enough money to buy the U.S. Post Office. You then sell off part of its operations to UPS, and restructure the branches as franchise businesses. Restructuring the post office, and selling it for a profit, might take six or seven years. In the world of private equity investing, your money is tied up until you can convince someone to buy the business you are developing or restructuring. Typically, private equity investments take ten years to mature.

Private Equity Funds

There are hundreds of private equity funds that invest in portfolios of deals. The very best of them have outperformed the stock market; however many of them have not. And some funds have turned out to be outright scams.  There are no benchmarks such as the S&P 500 index that will tell you how you are doing until you get your money back – if you get it back. So, if you are inclined to participate in private equity investing, proceed with caution and do your due diligence thoroughly.

Also, the fees for private equity funds are very steep. Typically, private equity funds charge “2 and 20.” This means you pay 2% on a yearly basis and 20% of any profit when the fund finally matures.

You May Already Be Invested in Private Equity

Large pension plans are very keen on private equity investments. If you have a pension with CalSTRS or CalPERS, or the University of California, you very likely own some private equity investments.

In order to invest in private equity funds as an individual, you need to be what is called an Accredited Investor. This means that you have a net worth of $1 million (excluding your primary residence), or that you have had an income of more than $200,000 for the past two years ($300,000 if your spouse works).

Private equity investing is a high risk/high return proposition that is not suitable for everyone. It works best for people who have a sophisticated understanding of how businesses grow in value and understand the risks involved in starting a new company, or restructuring an existing one.

The Economy vs. the Stock Market

A large part of the U.S. economy (and the world economy) is not represented on the stock market. For example, you may want to invest in infrastructure projects in Africa, or biotech companies in Uruguay. (Yes, there is a burgeoning biotech industry in Uruguay.) It would be difficult, if not impossible, to find publicly traded companies that allow you to invest in these areas. Private equity might allow you to take advantage of opportunities that are not available in the stock market. It goes without saying that such opportunities carry very big risks.

Some of the leading investment minds believe it is essential to capture some of the economic activity not represented on stock exchanges through private equity investing. However, there are equally successful investment minds who believe that the risks (and costs) of private equity investments outweigh the benefits.

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Private equity is a big subject that needs careful investigation before making any investments. For this reason, individuals may wish to consult with a fee-only investment professional before electing to invest in private equity, or any alternative investments.