Investing in Private Equity – What Is It and How to Navigate Through Them?

If you already invest with us, the term “stock” probably rings a bell. Regardless, repeating is the mother of learning, so let’s remind ourselves what it is.

A stock, a share or an equity is a type of security which gives you an ownership share of a certain company, hence the name share. This means that you become a co-owner of the company and obtain the right to participate in its profits.

The profit is obtained either through a dividend, i.e. directly paid out profit share, or through the growth of the company’s value, and thus your shares, which you may sell afterwards.

Why Do Companies Sell Their Shares? 

The main reason why companies issue and sell their shares is the need to obtain initial or expansion capital. In exchange, they offer investors value growth prospects and shareholder rights in the company (rights to make decisions).

Joint stock companies are one of the basic forms of trading companies (alongside limited-liability companies). Their foundation lies in the principle of separating the ownership of the company from its management. The shareholders, as the company's co-owners do not (usually) participate in the daily activities of the company and its direction.

A joint stock company as a legal form, furthermore, makes co-ownership for smaller shareholders easier, and standardizes the basic rules of the company’s management, structure or alternatively, transferal of shares (stocks).

Stocks we see on the stock exchange usually belong to large companies. When purchased today, they are mostly obtained from somebody who has bought them before, not from the company itself. Small and middle-sized companies seeking an investor who’d provide capital are not really a common occurrence anymore. 

In the past, if small and middle-sized companies sought capital from investors, they’d go straight to the stock exchange. For example, the number of initial public offerings (IPOs), when the company is publicly valued right before entering the stock market for the first time, was 6 519 between 1980 and 2000. However, between 2001 and 2024 the number of IPOs was just 2 734.

The trend is, therefore, clear: Small and middle-sized companies do not seek capital on the stock exchange. The aim of offering shares publicly has shifted: It is no longer about obtaining capital but about selling the shares by the business’s founders or initial investors, to cash out their portion of the enterprise.

Smaller companies seek the necessary financing primarily from private investors via private equity (PE).

What Is Private Equity?

Private equity is purchase and ownership of a company’s shares which is not publicly traded. The equity is offered only to certain subjects, e.g. individual private investors, or companies and funds which specialize in these kinds of investments.

Usually, the term private equity is understood to mean large companies whose core business activity is investing in smaller and middle-sized non-publicly traded companies. Typical private equity players include giants like Blackstone, KKR, Apollo Global Management or Carlyle Group.

The key characteristics of a private equity investment are the inability to purchase their shares on the stock market (thus, not everyone may buy them), and obtaining the capital directly from equity sold like this.

So, Why Not the Stock Exchange? 

This begs the question: Why don’t companies seek investment on the stock exchange anymore? Let's examine a few reasons why it's happening:

• Less Bureaucratic Hassle: In order to issue your shares publicly, you have to make regular reports, to adequately and regularly inform investors, have a sufficient size and meet the minimum proportion of the company’s shares being publicly traded. Overall, you’re under much stricter supervision of the authorities and you need to bear much greater regulatory burden. This doesn’t pose much of an issue to already large, well-established companies, but for a smaller one, which doesn’t have that many funds yet, it is a large spike in its expenses, both in terms of money and time.
• No Market Value Volatility Risk: When we mention the stock exchange, many imagine inclining and declining graphs of various companies’ shares. Their value is often influenced by aspects unrelated to the company’s results, e.g. political situation or investors’ sentiment. The value development of the shares may furthermore influence the company’s budget, e.g. if the share price declines it may be harder to borrow money while easier to lose the trust of its customers and suppliers. There’s no need for such worries in case the company is privately financed, as it is not regularly priced by the market. Therefore, it can focus on building the business instead of nonstop growth and generating profit – results sought by stock market investors.
• Know-How and Expertise: Entrepreneurs and managers are people too and thus cannot be perfect at everything. They may be tremendously skilled and experienced in one area while lacking in other. Especially if the company is in its beginnings, a lot of mistakes are made and a lot of issues occur that have to be solved on the go; and this is where external help may really make a difference.
• Since investors, whether it’s an individual or a company, want their investment to be successful, they are keen to offer expertise and know-how regarding financial management, improving efficiency or strategic planning. On the contrary, you would hardly ever find something like this among anonymous stock-exchange investors.

What’s in It for Me as an Investor? 

The first important note is that PE is a form of active investing. Therefore, you pick and choose a concrete investment that you put your money in, instead of investing in the whole market like with passive investing.

It’s definitely not for everyone as it is a riskier investment type, but with greater potential returns. PE investing is, therefore, not a good choice for a less experienced/educated investor.

How Does It Work in Practice?

Let’s say you get an offer to invest in a startup or a middle-sized company which is seeking capital for its future development. It sets a price at which it will sell its shares and offers them to potential investors.

You pick and choose the amount you are willing to put in and you obtain shares in the company in exchange.

For the next few years you observe the company’s development. However, be prepared that you will be significantly less informed compared to publicly listed companies that are obliged to publish at least some standardized data sets.

Another important detail is no regular pricing. You won’t be able to tell how much your shares would be worth at any moment you’d like, unlike with publicly listed companies.

But probably the most significant aspect of PE investments is very low liquidity. Unlike with publicly traded stocks that can be sold and cashed in at any time during the stock exchange’s trading hours, with PE investments there are not many exit options, and you are often incapable of influencing them.

One option is to find an individual buyer of your shares. However, this may meet with obstacles such as the necessary approval of the majority shareholders or their preemptive rights of sale. The whole process is substantially more administratively demanding compared to a simple sale of publicly listed shares on the stock exchange via an investment broker.

Another alternative option to exit your investment is mostly the entry of a new strategic investor by purchasing a part or the entirety of the enterprise. In this case, you, as a small investor, most likely won’t get a say in determining the final price of your shares.

However, the company may go public and begin an initial public offering of its shares. For existing investors this often poses an initial exit opportunity to cash in their investment. Or, alternatively, you may keep your shares and continue to participate in the future development of the company.

What Are the Risks Involved? 

As I have already stated above, PE is a riskier type of investment.

The first reason why is probably the most apparent: You invest in a vastly lower number of titles compared to e.g. an ETF. Or, by folk sayings, you are putting all the eggs in one basket and when you drop the basket you lose all the eggs.

Another, and related to the above, is the risk of loss. Hold on, not volatility or market fluctuations but actual permanent loss. PE investments are directed towards smaller and younger companies, whose success and becoming an established player are not guaranteed.

Anything may go wrong, it’s business. The majority of these investments end in loss, with a complete liquidation of the company or by a takeover for a fraction of the capital invested.

In the EU almost one in five enterprises do not survive their first year and over half of companies cease to exist within five years of their establishment.

Source: https://ec.europa.eu/eurostat/cache/htmlpub/key_figures_on_european_business_2021/business_dynamics.html

These numbers are for Europe for 2018. We see a similar trend on the other side of the Atlantic too. The data below is from 2022.

Over 20% of businesses fail within a year since establishment, over 40% fail within 3 years, almost a half fails within 5 years and over 80% fail within 20 years since establishment.

Source: https://clarifycapital.com/blog/what-percentage-of-businesses-fail 

The aforementioned low liquidity poses a risk of its own too. You will most likely not be able to sell your investment in case you’ll need it, whether it’s due to an emergency or a different investment opportunity.

Liquidity can furthermore affect the return on your investment. E.g. the company may not perform well, and this fact will be well known. You, however, cannot sell your shares as an investor. And all you can do is to sit and watch how the value of your investment fades away over time.

In the case of publicly listed companies, a partial loss is still acceptable and may exit the investment at any time.

The Risk Is High Indeed, What Do I Get in Exchange? 

There is a rule in investing: The higher the risk of failure, the greater the reward in the case of success. 

Returns on successful PE investments are huge, often multiples of the original deposit. That’s why one successful investment compensates for losses of multiple failed ones. Those are the basic rules of PE investing.

To get a better idea, all you need to do is to realize that any large company, whether it’s Apple, Microsoft, Mercedes Benz or Coca-Cola, was once a small company that brought something new into the market.

For more illustration, here is a graph of the market price of Apple since its public listing in 1980.

Source: https://www.nytimes.com/2022/01/03/technology/apple-3-trillion-market-value.html

Apple was founded in 1976 in a garage of Steve Jobs’s parents. To obtain initial capital, Jobs sold his Volkswagen Transporter and Steve Wozniak sold his HP scientific calculator. Together they pooled in $1 300 ( around $7 200 today).

Further capital and advisory was provided by a multimillionaire Mark Markkula, who obtained a third of the company for $250 000. Since then the company has grown exponentially.

The IPO was announced in December of 1980. A total of 4.6 million shares were sold for $22 a share. By the end of the day, the price per share reached $29 with a market cap around $1.8 billion. At the time of writing this article, Apple is valued at $2.94 trillion, a difference of 163 233% since 1980.

This is also associated with the story of one of the company's founders, Ronald Wayne. He left the company just 12 days after its founding and sold his 10% share back to Steve Jobs and Steve Wozniak for $800. Hadn’t he sold his shares, that 10% stake would be worth $294 billion nowadays and he would be one of the richest people alive. 

I need to emphasize that this example is for illustration only. Success stories like Apple’s do not repeat every day, please take that into account. That’s why we can have a look at some realistic numbers too.

PE funds have performed 13.1% p.a. on average between 1998 and 2023. For comparison an average market yield is mostly 8% p.a. If you were to invest €100 a month for 30 years, the difference between a PE fund and the market would be over €240 000.

Private Equity Offers an Alternative Unheard of on the Stock Exchange

Historically, the largest yields were on average produced by small and middle-sized enterprises. Over the past two decades, however, it is no longer true. One of the reasons why is because successful startups get publicly listed only in the stage when they’re already considered big, as I already mentioned before.

PE still offers investing into lucrative businesses in their early stages – in a key framing period, when their value has the greatest growth potential. Therefore, if an investor seeks to participate in new potential booms of innovative and disruptive companies, they have to enter the world of private equity.

This is why even large-scale and well-renowned asset managers and advisory firms change the definitions they used for so long. A standard portfolio, traditionally used by trustworthy investors in the Anglo-Saxon world 60/40 (60% equity and 40% bonds) loses popularity.

Experts continue to call for enriching the portfolio with alternative investments such as private equity or private credit, real estate, commodities or cryptocurrencies. Many now refer to 40/30/30 (40% equity, 30% bonds and 30% alternatives) as the new 60/40.

Supporting the Local Economy and Entrepreneurship 

Investing in PE has one last advantage, especially if you are patriotic.

Your investment supports a concrete enterprise according to your preferences. Your investing may go beyond financial gain and appreciating wealth. It may furthermore support local businesses and thus the local economy, which will affect your and community’s life.

However, private equity can support entrepreneurship as a concept. Have you ever thought to yourself why the US is economically so far ahead of Europe?

Yes, taxes, legislation or bureaucracy all play a certain role, but more important one is played by access to capital. Americans are willing to undergo risk way more compared to conservative Europeans, therefore, it’s much easier to find an investor for your project on the other side of the Atlantic.

Therefore, it allows you to contribute towards an easier business setup and help to make the world a better place.

Conclusion?

Investing in private equity is definitely not for everyone. You need to be ready for much greater risk, going as far as potentially losing your entire investment. Therefore, if you can’t afford it and you are not keen on undertaking risk this high, PE is not suitable for you.

The majority of invested assets of every investor should be in a diversified portfolio comprised of low-cost ETFs. 

Consider PE as a complement to your already existing portfolio, if you have it. In other words, if you already have a well set-up portfolio, you can afford to exchange well diversified risk for greater profit potential.

Last but not least, if you decide to try investing in PE, there is a piece of homework for you: Highly reputable companies and funds that mediate PE investing often require high minimum investment amounts, often 5 or even 6 figures. Therefore, be cautious if certain deals sound too good to be true.

In private equity always think thrice cut once.