As corporate transactions involving private equity have become increasingly common, household names that investors have been used to seeing cross their stock tickers have been disappearing from their television screens. In the past year or two, companies like high-end retailer Neiman Marcus and household pet retailer Petco have gone private. In addition, there have been rumors of huge companies like Home Depot
As one can infer from the increasing trend toward private equity investments, the use of private equity provides advantages over other methods of raising corporate capital. Investors can gain access to potentially large profits in investments that are often unavailable to the bulk of the investing public. Businesses and their managers benefit from increased access to capital as well as from the different expectations private equity investors have.
The payoff for investors
In general, the stakes are higher among private equity investments than with stocks offered to the investing public. For the most part, companies whose shares are made available to all investors through initial public offerings on major exchanges have at least a short history of successful operation. Such companies are required to disclose substantial amounts of information in order to give investors a basis for making an informed decision about their investments. Usually, an investor can determine not only the current status of a public company but also gain insight into its plans for the future. This information lowers the risk for investors in public companies.
Private equity investments, on the other hand, often require taking much more risk. Especially among private equity pools that focus on new ventures, failure rates can be extremely high; for a pool with 10 investments, only one or two may be extremely successful. Yet investors are rewarded for this risk with higher returns. Even with losses on many positions, those one or two successful investments can be enough to produce exceptional overall returns.
Another reason why private equity has become attractive to investors is that private equity returns aren't necessarily correlated to the returns of publicly traded stocks. In other words, if the stock market falls dramatically, that doesn't necessarily mean that the value of a private equity investment will also decline. Although this may sound surprising, the data support the idea that publicly traded stocks are subject to different conditions and exhibit different price behavior than their private equity counterparts. For proponents of modern portfolio theory, the existence of an asset class with high returns and low correlations to other asset classes creates a useful way for investors to diversify their overall investment portfolios without sacrificing return.
Benefits to companies
From the corporate perspective, private equity is invaluable. For startups and young businesses, the existence of private equity is the only way in which they can raise the money they need to establish their footing. For companies that are ailing, demand among traditional investors may dry up, and so private equity provides a life support system that such companies can use to regroup and focus their efforts toward becoming profitable.
Even among mature companies, however, private equity has some real advantages over public offerings. Companies that are privately held aren't subject to the same reporting requirements that public companies face, which saves the expense of compliance. Not having to report publicly also gives private companies a competitive advantage over other businesses in their industry, since it's harder for competitors to analyze how a private company is doing business without access to complete data.
Also, while private equity investors are just as concerned about making a profit as any other investor, their willingness to wait patiently for several years in order to maximize their profits gives company managers the time they need to implement strategies for long-term success without worrying about how their next earnings report will look. By focusing on performance beyond the next quarter's results, private equity groups allow businesses to go the distance with their strategic plans without fear of facing a revolt from public investors.
The price to play
Private equity funds aren't open to everyone. Several requirements may apply, including high minimum investments and minimum levels of income or net worth. In addition, the cost of private equity investments is substantially higher than what mutual fund investors are used to seeing. The managers of private equity pools charge substantial fees for the opportunity to participate; typical arrangements involve annual fees of 2%, with 20% of the profits going to the manager. The argument for these higher costs is that private equity managers are usually much more actively involved in the business of the companies in which they invest, while mutual fund managers often have little or no part in advising the executives who run the companies they own.
Private equity has become an increasingly popular way for institutional investors to profit from opportunities in the stock market. Although the price to participate in private equity pools is higher than that of public equity investment vehicles like stock mutual funds, the long-term perspective that many private equity groups have is a refreshing change from other investments that focus solely on short-term performance.
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Fool contributor Dan Caplinger won't be ponying up for private equity deals anytime soon. He doesn't own shares of the companies mentioned in this article. Home Depot is an Inside Value pick. The Fool's disclosure policy is always alluring.
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