Private Equity FAQs
Private equity invests capital in companies that are perceived to have growth potential and then works with these companies to expand or turnaround the business. This capital is contributed by large institutional investors and is organized into a fund. After three to seven years of ownership and working with the company, the fund manager will seek to “exit” the company by taking the business public or selling it for a higher valuation than it was purchased. This exit distributes profits from the sale (“returns”) to the investors in the fund and the fund manager.
The private equity industry benefits investors, companies, workers, and communities. Investors gain from higher returns and less volatility than public markets. Companies receiving private equity investment benefit from access to capital as well as business mentorship and expertise. Workers benefit from stronger companies that are committed to growth. And communities across the country are bolstered by private equity investment that helps build sustainable companies and jobs.
Private equity invests across the U.S., from major metropolises to rural towns. Our industry doesn’t look at zip codes when it invests, instead we look for potential. Companies receiving private equity investment span every sector, including healthcare, energy, information technology, materials & resources, hospitality, and many more.
The private equity industry injects a significant amount of capital into the U.S. economy. Since 2013, private equity funds have invested over $400 billion annually in tens of thousands of American companies in a variety of states and communities.
Private equity funds depend on capital from institutional investors. These investors include pension funds representing teachers, firefighters, and policemen; endowments of universities and non-profits; sovereign wealth funds; and high-net worth individuals. Since 2000, public pension funds and other investors have increased their investment allocation to private equity because these funds have generated the best performance in their investment portfolio.
Private equity is the best performing asset class and continues to beat public market returns over the long-term investment horizon. Looking at data from the 1980s, 1990s, and 2000s, private equity funds exceeded S&P 500 returns by roughly 3% each year [see Jenkinson et al. 2015]. Private equity funds delivered similarly superior returns when compared with the Russell 2000 small-cap index.
Portfolio companies are businesses that receive investment and management expertise from private equity funds. When fund managers target a company for investment, they look for businesses that could grow with a combination of more capital and a new business strategy. Perhaps the company is a high growth business that requires capital expenditure to reach a new customer market or maybe it’s not expanding as fast as its peers and needs to reassess its distribution strategy. After acquiring all or minority stake in the company, fund managers help to guide the business towards larger distribution networks, more reliable suppliers, a more experience management team, or a more competitive strategy. Throughout the process the private equity managers work side by side with company leadership. After three to seven years, fund managers will determine the best way to exit the investment by either taking a portfolio company public or selling it.
Private equity funds generally maintain ownership or stakes in companies for three to seven years. Over that time, GPs work to improve the business. This involves much more than simply added investment. GPs serve as advisors to portfolio companies, helping to streamline inefficiencies, develop productive leadership teams, and find new avenues for growth.
Private equity fund managers earn income via two different avenues. The first is management fees. These fees have traditionally been two percent of funds’ assets but have recently decreased. Managers pay ordinary income tax rates on this income. The second compensation is carried interest capital gains. Investors generally receive 80 percent of returns, and fund managers earn carried interest, which has historically equaled 20 percent of returns after the hurdle rate. The fund “hurdle rate,” typically eight percent return, is required before fund managers begin to receive any carried interest from the fund’s profits. Fund managers pay capital gains taxes on carried interest compensation.
Carried interest capital gains is the portion of investment profits fund managers contractually receive, based on the agreement with the fund investors. It is not a fee or a loophole. This compensation is profit gained from putting money at risk and investing for the long-term. The key criterion for capital gains treatment is whether the taxpayer has made an entrepreneurial investment – of capital or labor or both. Private equity fund managers meet this test. Carried interest capital gains is important because it serves to align a fund manager’s interests with those of the fund’s limited partners. If the fund does well, the general partner shares in the gains; if the fund does poorly, the general partner receives no carried interest.
Venture capital funds invest in companies at the seed (concept) and start-up (typically in the first ten years) phase of a company and often take minority stakes. Private equity funds invest in more mature companies through buyouts and buy-ins and work to improve efficiencies and boost growth. In the last ten years, private equity firms have increasingly acquired venture-backed companies, as these businesses require even more capital to innovate and reach their growth potential.
Private equity funds invest in private companies – companies not listed on public exchanges – and typically take ownership stakes. Fund managers work with these companies to increase value for the long-term, over three to seven years of ownership. By contrast, hedge funds invest pools of capital for short-term returns, usually through stocks, bonds, or commodities, and do not make controlling investments in companies. Hedge funds typically use complex trading strategies to capitalize on short-term market movements.
The private equity industry in the United States is regulated by the Securities and Exchange Commission’s implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. U.S. private equity firms that operate abroad are also subject to additional regulatory demands by the European Union as well as other national regulatory bodies.