What is private equity?
Investing in companies that are not listed on a stock exchange: how a fund works, where the returns come from and how it differs from the stock market.
Private equity is a form of investment in companies that are not listed on a stock exchange. Unlike listed shares, shares in these companies are not traded every day. Instead, specialised funds invest in them for a longer period, with the aim of developing the business further and ultimately selling it at a higher value.
Private equity has become an important asset class for institutional investors, family offices and, increasingly, high-net-worth individuals. One reason is that it offers a different way of investing from traditional stock market investments: less focused on daily share price movements and more on creating long-term value within companies.
How does a private equity fund work?
Private equity funds pool capital from a number of investors. This capital is not invested all at once. It is called during the term of the fund, as suitable investment opportunities arise. The fund then builds a portfolio of carefully selected companies. When an investment is sold after several years, the proceeds flow back to the investors.
A fund does not usually invest in dozens of companies at once. It deliberately chooses a limited number of companies in which value can be actively created. This allows the investor to work closely with the company's management.
Active ownership
Private equity is about more than providing capital. Throughout the holding period, a fund works closely with management to develop the business further. Ways of doing this include commercial growth, professionalising the organisation, operational improvements, strategic acquisitions and international expansion.
- 1Commercial growth
- 2Professionalisation
- 3Operational improvement
- 4International expansion
- 5Add-on acquisitions (buy-and-build)
The aim is to increase the intrinsic value of the business on a lasting basis, rather than to make a short-term profit.
Where do the returns come from?
At its core, the return in private equity comes from a company being worth more after a period of value creation than at the time it was bought. Funds typically stay invested in a company for 4 to 6 years before it is sold. During that period, the work focuses on increasing profitability, improving operational performance and strengthening the company's strategic position.
Value creation can come from several sources, including earnings growth, operational improvements, acquisitions and, where appropriate, a more efficient capital structure. At the same time, investing in private equity still carries risk, and positive returns are never guaranteed.
A long-term investment
The fund term of a private equity fund is often around 10 years, but that does not mean every euro is tied up for the full period. Capital is called in stages as investments are made, and proceeds are distributed in stages during the fund term once companies have been successfully sold. The result is an investment cycle in which different companies are at different stages at the same time.
Private equity therefore requires a long-term view. Investors give fund managers time to develop companies further, with the aim of lasting value creation rather than short-term returns.
Private equity versus the stock market
Private equity and listed shares both involve investing in companies, but the way value is created is fundamentally different.
When investing in listed shares, investors usually buy a small minority stake in a company. Managers of equity funds and hedge funds, for example, can increase or reduce their positions, but in most cases they have no direct say in the company's strategic direction. Their return therefore depends largely on how the share price develops and on how well the management of the underlying companies performs.
Private equity takes a different approach. Private equity funds often acquire a controlling or majority stake in companies, which allows them to take an active part in decisions on the company's strategy, governance and operational development. Together with management, they work on initiatives that make the business stronger for the long term, such as commercial growth, digitalisation, international expansion, operational improvements and strategic acquisitions.
"Instead of buying small amounts of stock in lots of different companies for lots of people, private equity collects money from investors to buy an entire company. Then they run that company entirely as their own for five to ten years."John Coates
It is this active involvement that sets private equity apart from traditional stock market investing. Whereas stock market investors mainly react to developments within a company, private equity investors can, to a large extent, help shape those developments themselves.
For many investors, this is an important reason to allocate part of their wealth to private equity. It gives access to an asset class in which value creation does not depend solely on market sentiment or daily price movements: much of it is achieved through active entrepreneurship, a long-term view and direct influence on how the underlying companies develop.
