Alternatives: Private Equity

Private equity means investing in companies not listed on a stock market. As an investor in private equity, you’re providing money to entrepreneurs in the early stages of their companies.

Private equity is often categorized according to the stage of development of the companies. Categories include venture capital, buy-outs, and distressed investing.

Venture Capital

Venture capital consists of financing the early stage of companies that have an innovative business idea. Venture capitalists frequently invest in “start-up” companies that exist only as an idea or a business plan. The company may have few employees, little or no revenue, and still be developing its product or business model.

Entrepreneurs are often looking for advice and expertise from venture capitalists about how to establish and run their company.

Venture capital is considered the riskiest type of private equity investment strategy because many more companies fail than succeed.

It can take many years before a company becomes successful, with many years of unprofitable activity.  So, venture capital investing requires patience. However, those companies that do succeed are rewarding for private equity investors.

Buyouts

Buyouts are another kind of private equity investment strategy. This strategy consists of investing in companies that require money to restructure and change ownership. Buyout investments sometimes involve making a publicly-traded company, private.

For example, Hertz and Hilton Hotels were once public companies, but each had a buyout and went private.

Distressed Investing

When in financial trouble, a company is at risk of not being able to pay interest to its bondholders. This risk is known as credit or default risk.

Distressed investing involves buying the debt of companies on the brink of default, or already in default on bond interest payments.

Frequently, the debt is bought at a significant discount to par value (the amount owed to the bondholders at maturity).

For example, an investor who buys the debt of a troubled company may only offer 20% or 30% of the amount bondholders are owed. The bondholders will sell for this discounted price if they think it’s better than nothing.

If the company can recover, the value of its debt will increase, and the “distressed debt” investor will profit.

While some add private equity to their portfolios to enhance returns, many just want to reduce risk through diversification.

Diversification benefits occur because alternative investments and other asset classes are typically uncorrelated. Unfortunately, the benefits of diversification are reduced in periods of financial crisis when returns tend to become more correlated.