Private equity refers to investments funds structured as limited partnerships that are not listed on a public exchange and its investors include large institutional investors, wealthy individuals, and university endowments.
It is formed by investors whose aim is to directly invest in other companies rather than buy stocks and they usually buy the entire company. It uses various investment strategies such as leveraged buyout, venture capital and growth capital.
A private equity firm raises pools of capital or the private equity funds, and it also receives periodic management fees. The private equity firms receive a return on their investments through an initial public offering (IPO), a merger or an acquisition or through a recapitalization. Here are 6 things you should know before you invest in private equity:
1. The Private Equity Returns and Value Creation
The returns of a private equity investment depend on the manager’s ability to find, improve and exit his or her investments successfully. Evaluate the manager carefully before you invest. Check the past performance of the manager in the past opportunities. There are three basic value creation drivers which include financial engineering, multiple expansion, and operational improvement.
2. The Track Record
After you know the fund managers return record, determine if it is possible to get a repeat of the same. Find out if those elements that were used to achieve the success are present in the next fund. Rely on qualitative and quantitative analysis to verify the past performance. Check the sector, equity check size, a source of investment and geography of the previous fund. Find out the manager's loss ratio and dispersion of returns.
It is not only prudent to check the track record but also assess the historical performance against that of its peers. It is good to check how the peers who pursued a similar strategy performed in the same year.
4. Investment Strategy and Market Opportunities
Evaluate the private equity manager’s strategy and find out how it fits with the expected market environment over the investment period of the fund. Ensure that you are certain about the strategy the manager plans to use.
5. Investment Team
Assess the team capabilities that will be responsible for sourcing, negotiating, monitoring and exiting the firms’ investments. It is prudent for the firms’ potential investors to investigate the backgrounds and the experience of the firm’s investment professionals and also the team’s continuity and experience of effectively working together. Another crucial aspect is the teams’ relationships and networks in terms of volume and quality of the managers deal flow and the firm’s ability to identify strong management teams for its portfolio companies.
6. Deal Sourcing and the Investment Process
Another important factor is the managers’ ability to source a huge enough volume of high-quality investment opportunities. It is also important for the manager to have an organized process ready to seize the opportunities and to identify the companies that are best positioned for future growth or are ideal candidates for a turnaround strategy.
Majority of investors lack the relationships, expertise, and resources necessary to invest in privately owned companies. Others may just be unable to get attractive investments, conduct due diligence or negotiate and structure the transaction. Private equity funds provide professional management and larger diversification than a single asset.