Living and working in the technology-rich Pacific Northwest, it’s generally assumed that everyone has heard of private equity. Yet many people might not understand what private equity actually is, how investors access it and whether it should be included in their investment portfolio.
A Cornerstone Private Equity Primer
In many ways, private equity investing isn’t that different from investing in public stocks. The goal is to buy the equity of a growing company so that your investment will become more valuable over time. The difference is that when investors buy public stocks, they own microscopic pieces of enormous public companies like Amazon or Starbucks where they have no influence over the company’s growth prospects or business strategy. In contrast, private equity investors seek to own large portions of non-public companies where they can exert a high degree of control over the investment outcome.
By actively building value in the companies they own, private equity investors can receive multiples on their invested capital when the company is later sold. This active ownership model is one of the reasons why private equity investors often achieve higher long-term investment returns than public market investors.
There are two types of partners in private equity investing: limited and general. Most investors do not have the time or expertise to invest in private companies directly. Therefore, institutions and individuals primarily invest through limited partnership structures (often referred to as private equity funds) where they are passive investors with minimal involvement. The selection of investments is left to the general partner, a skilled business operator, who typically has five years to identify multiple investments and another five years to sell them. In this fund structure, a limited partner’s capital is “committed” up front but is invested over time as opportunities are identified. In later years as investments mature and are sold, the proceeds will be “distributed” back to the limited partner.
So what exactly does a general partner do? Their skill sets can run the gambit from business management, leadership and personnel, accounting and finance, all the way to production of the final product and positioning it in the market. In addition, they must have an in-depth understanding of how and when to sell the investment. It’s also worth noting that general partners have “skin in the game” just the same as the limited partner. In other words, they are investing their own money alongside the money of the limited partners.
Now that we know the basic structure of the typical private equity investment, let’s take a look at two distinct types of private equity investments, each with unique dynamics, risks and return profiles: Venture Capital and Buyouts.
Entrepreneurs develop business plans, frequently known as startups (or startup companies) that often require capital to bring those plans to life. Venture capital firms supply equity financing to startups that do not have the track record to attract traditional financing from banks. In addition to supplying capital, venture capitalists help the startup by offering corporate relationships and advice, access to technology and resources plus other support.
Since these are often unproven ideas and businesses with little or no revenue, they are highly risky and many investments fail. In this model, wealth creation comes as the result of disruptive innovation from a few giant successes that change or create an entire industry and produce massive payoffs for investors.
Venture capital has helped grow many successful businesses, including locals like Amazon, Microsoft and Starbucks. It has also participated in the creation of entirely new industries such as biotechnology, nanotechnology and semiconductors. Today areas such as robotics, 3D printing, mobile, cloud computing and artificial intelligence are being fueled by venture capital.
Unlike venture capital, buyouts focus on larger, established companies with revenues and earnings. Because these are mature companies with more predictable outcomes, buyout investments will succeed more than they fail, but the potential payoffs aren’t as massive.
Another distinction is that venture capital investors make minority investments, while buyout investors assume majority control of a company and then drive specific plans to increase the profitability and long-term value of those companies. This could be accomplished in a number of ways including cutting costs, changing a marketing strategy or bringing in new talent.
These investments are often referred to as leveraged buyouts because they typically use both debt (leverage) and equity to finance the transaction. The use of leverage increases the potential return of these investments and also makes it possible for investors to purchase larger companies (like using a mortgage to buy a house).
An example of this type of investment is the local company Brooks Sports, which was successfully improved under private equity ownership through a new management team, product focus and marketing strategy.
So…Is Private Equity Right for You?
If you’re interested in private equity investing, there are a number of things to consider. And while specific considerations will be different for each person, here’s a good starting point. First of all, consider the liquidity needs for your portfolio. Private equity is an illiquid investment and should be limited to the portion of your portfolio that can be invested for 10 or more years.
Ask yourself if you have the background for appropriate due diligence and the time, experience and capital to invest in and manage companies directly. If not, you will need to become a limited partner and invest through a private equity fund managed by a skilled general partner. But, be aware that there is a very wide dispersion of investment returns for private equity managers, so it is critical to identify the most successful ones. In addition, in order to mitigate some of the risks associated with the asset class, it is important to diversify your investments over time, investment focus and geography.
In the end, private equity helps startups get off the ground and mature companies become more valuable. As an investor, there is great opportunity in private equity but there is also corresponding risk that should be understood, carefully considered and mitigated to the extent possible through thoughtful implementation.
If you have interest in private equity investing with Cornerstone, please contact Katie Robinette via email or by calling 425-646-7600.