What are private equity funds? (Benefits explained)

By Indeed Editorial Team

Published 11 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

A private equity fund is a type of financial relief provided by either a professional investment firm or an accredited individual with no public involvement. They can apply to all sorts of industries and sectors. If you're interested in business and finance, it's necessary to understand why private equity funding is so prolific as a type of debt relief for struggling organisations. In this article, we define what private equity funds are, the different types of private equity funding and the advantages and concerns that surround the concept.

Related: What is private equity and how does it work? (With benefits)

What are private equity funds?

Private equity funds refer to the collective financial investment scheme that puts money into an organisation to keep it running. Once a certain amount of money goes into such an organisation, it takes value away from its overall stock on the market. The private element of this fund means that investment has to come from a shareholder rather than a member of the public. There are companies or private equity firms, set up specifically for this purpose. They make their money by managing such investors and subsequently charge them for performance fees.

Private equity funds work more like a loan than a handout for organisations. Investors loan a certain amount of money for an extended period, as an organisation needs time to orchestrate a turnaround. Once such organisations earn a profit, they're expected to pay back investors. If this doesn't happen, private equity investors are the ones who either organise a sale to another public company or offer previously private shares to public stock markets when a company that they've invested in liquidates.

Related: How to become a private equity associate: a complete guide

Types of private equity funds

Private equity funds work through the investment of private or accredited investors putting money into any type of organisation that's struggling. This means that there are several different types of private equity funds:

Buyouts

This is one of the most popular forms of private equity investment. It involves sourcing out a potential target and using a special purpose vehicle to acquire it. Investors then buy out shareholders and take over the organisation in question. Private equity investors then set about improving the company's financial state so that when the time comes to sell it, they're likely to receive back the money they put in and more. Traditionally, such companies sell to similar businesses or their stocks go on the public stock market during an initial public offering.

Once a private investor provides financial relief for an organisation in this way, it often comes with various caveats. To improve the organisation's financial health, they may resort to slashing employee numbers or replacing management staff. Generally, where there's potential for price cuts, they're implemented. This may include slashing product prices and using a sale to boost profits.

Related: What is a leveraged buyout? Definition and common scenarios

Distress funding

Another type of private equity fund is distress funding. This refers to the practice of investing in businesses that have underperforming assets and helping them to shift more units, meaning that it could apply to any type of industry, from pharmaceuticals to retail. Investors then step in and make any necessary changes to secure a profit. As with a buyout, this means that they have the power to replace management staff with their own team. This form of private equity funding was particularly prevalent in the United States after the 2008 financial crisis.

Funds

Private equity funding doesn't always refer to the purchasing of a company, it can also apply to hedge or mutual funds. It works by offering those who've invested in such funds a way to cover the minimum requirements that such capital needs. This is a trickier type of investment, as there may not be a strategy effective enough to guarantee a return, yet it's often used by certain types of investors.

Real estate

Real estate works differently when it involves private equity funding. Rather than fixating on private pieces of real estate, it focuses more on business premises or real estate investment trusts. In particular, investment in real estate trusts is typically quite expensive as it has a higher minimum capital requirement. This is one reason why this type of investment fund is more popular when the market is struggling. Investors often slash prices during this time to sell more real estate. This was particularly evident during the 2008 financial crisis.

Real estate private equity funds often involve high net worth individuals, pension funds or endowments to receive cash relief. It works by allowing a variety of general partners to invest in different pieces of property scattered across a wide geographic area, as prices are so high. Their money might provide for redevelopment, refurbishment or simply a cash injection to allow any pre-existing development to continue. This means that it can take significantly longer for such investors to make any sort of return. The first investment is usually a lump sum that tails off during subsequent payments made over time.

Related: What is a real estate asset manager? A comprehensive guide

Venture capital

Venture capital is a type of private equity fund available for entrepreneurs. This means that it has many different forms. Investors may come in at the beginning of a new startup as a way of ensuring the business goes through the initial formation stages, as this is where new startups often fail. With experienced management staff behind them, such entrepreneurs may find it easier to compete in pre-existing markets. Another type of venture capital may manifest itself as seed investing. This is where an investor injects the necessary funds to scale a prototype up into a viable business.

Private venture capital equity funds are often the only option available to entrepreneurs. If they have a trading history that hasn't quite reached two years, they may struggle to secure access to bank loans, capital markets or other forms of debt relief. This may not be the case for all new startups. Instead, they may decide that they prefer the expertise that comes alongside venture capital. This can be an attractive situation for investors, as equity usually grants them a say in company operations.

Related: A definitive guide to venture capital careers (with tips)

Private equity fund benefits

There are several advantages to using private equity funds:

  • Scale of deals: One of the major advantages of private equity funds is that they deal with large amounts of money, often giving struggling organisations more stress relief than bank loans might.

  • Management: For inexperienced entrepreneurs or managers, the management expertise offered by investors as a part of private equity funds is a benefit that can negotiate them out of their troubles.

  • Incentives: Private equity investors have a much higher incentive to generate a turnover than other bodies of financial relief. This is because they invest their own money into projects, meaning they have their own reasons and a higher motivation for wanting a business to succeed.

  • Higher returns: With the scale of money that private equity investors work with, their managerial involvement and the incentives that they require, private equity funds often have a higher level of return than other types of financial relief.

Disadvantages of private equity funds

Here are some of the disadvantages associated with private equity funds:

  • Management: Although an advantage in some scenarios, the new management that private equity investors bring in can sometimes be a disadvantage. It can put pre-existing managers out of their jobs or lead to a dilution of control, while the managers who keep their jobs may find that they're no longer able to make decisions regarding their own company, such as the hiring or firing of employees.

  • Value: Private equity investors typically see profit as the only point of value. This can cause disputes with the managers who have kept their jobs as they may see the future of their company, employees and consumer relationships as valuable too.

  • Losses: If an investor isn't able to turn around the finances of a struggling company, they may lose out on the money they initially invested. Dismantling a company may not return the same kind of investment, for example.

Problems with private equity funding

There are numerous problems that some people have with private equity funding. For example, there are calls for those who work for private equity firms to be more transparent with their earnings. This comes amongst mounting concerns about how investors can earn their typically large salaries. At present, it's considered that there aren't enough legal grounds for financial bodies to probe this aspect of private equity funding.

Related:

  • Debt market vs equity market: what is the difference?


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