What’s the Difference Between Private Equity Funds and Private Company Shares?

You may have heard the terms private equity (PE) funds and private company shares. Though they sound comparable and share some similarities, there are key differences between the two approaches. Both strategies offer a way to invest in private companies, but how they go about doing so varies significantly.

At a broad level, private equity funds take ownership of companies to seek to increase their value before selling them at a higher price. Private company investing, on the other hand, involves direct ownership of company shares in their pre-initial public offering (IPO) phase, before they go public at potentially greater valuations. Both strategies have the potential to play an important role in diversifying portfolios, as each does not necessarily rise and fall with publicly traded stocks and bonds. But there are crucial differences as well, as we explain below.

An Overview of Private Equity

Modern private equity traces its roots to the 1970s and 1980s. Early PE firms primarily focused on acquiring undervalued companies by raising debt, purchasing and restructuring the companies, and then selling them for a profit. This strategy is known as leveraged buyouts (LBOs).

Throughout the 1990s and early 2000s, private equity continued to grow, diversifying its strategies beyond LBOs. PE firms tend to specialize in several types of target companies, including:

• Distressed investing: PE firms invest in struggling companies and work to improve their operations so they can be sold at a profit.
• Growth equity: PE Firms seek out companies that have grown beyond the startup phase.
• Secondary buyouts: One private equity firm buys a company owned by another private equity firm.
• Carveouts: This approach involves a private equity firm buying a division or subsidiary of a larger company.

The 2008 financial crisis temporarily slowed the pace of private equity activity, but the industry rebounded in the following years, fueled by low interest rates and robust fundraising. Today, PE firms manage $4.4 trillion, about $1 trillion of which the firms keep uninvested — known as “dry powder” — to take advantage of opportunities.³ Large Wall Street firms such as KKR, Blackstone, Apollo, and Bain Capital dominate the private equity investing landscape, though there are many smaller PE shops as well.⁴

What are PE Funds?

Private equity funds are investment vehicles to raise capital from institutional investors and high-net-worth individuals for investing in private companies. The private equity firm acts as the general partner (GP) and manages the fund. Investors, meanwhile, provide the capital but have limited involvement in the fund’s operations. They are known as limited partners (LPs).

Private equity firms use a combination of equity and debt financing to purchase ownership stakes in private companies. The firm’s goal is to generate a profit after making improvements within a target time horizon, usually four to seven years, though the “lockup” period can be much longer.

Private equity firms use some common strategies to seek to realize profits:

• Leveraged buyouts: A combination of debt and equity to acquire underperforming companies.
• Growth equity: Investing in maturing companies in order to fuel their expansion.
• Distressed investing: Targeting companies in financial difficulty, aiming to restructure and turn around their businesses.

It’s important to note that the private equity market extends beyond primary investments. There’s also a secondary market known as private equity secondaries in which investors buy and sell private equity commitments, offering opportunities for liquidity. ⁵

While private equity funds offer the possibility for attractive risk-adjusted returns, they also carry significant risks that can negatively impact returns, including: ⁶

• Lack of liquidity: Investors are typically locked into the fund for a span of 10 to 12 years, and therefore must be willing to tie up their money for an extended period. However, private equity secondaries may provide opportunities for liquidity.
• Financial risk: Private equity funds often use debt financing to boost returns, but that can increase the financial risk.
• Operational risk: The success of private equity investments depends on the operational performance of portfolio companies, which may not materialize.
• Exit risk: To make a profit, private equity firms must be able to exit investments at a favorable valuation, which is affected by market conditions.

How Individuals Can Access PE Funds

Traditionally, private equity has been the domain of institutional investors such as pension funds and endowments. Recently, though, the asset class has attracted interest from individual investors seeking higher returns and portfolio diversification. However, because these investments can be complex and carry additional risk, which is why PE funds are available only to “accredited” investors. Accredited investors are individuals with a net worth over $1 million, not including a primary residence, or in addition, investors must be able to meet private equity funds’ investment minimums, which are typically $200,000 or more.^{7 8}

The GP earns a management fee, typically 2% of the fund’s assets, as well as a share of the fund’s profits, usually 20%, which is commonly known as carried interest.

What’s the Difference Between PE Funds and Owning Pre-IPO Shares?

Another way to own private companies is with shares of pre-IPO companies.

Though these companies haven’t yet gone public, they aren’t necessarily early-stage businesses. Often, they are well-established businesses, with years of operational history, and include household names like OpenAI, Stripe, and Epic Games, to name a few. Owning shares of pre-IPO companies may provide the opportunity to hold equity in high-potential businesses before they become even more widely known.

Some of these companies are eyeing an IPO, but others may choose a different path such as a merger or acquisition. Investing in late-stage pre-IPO companies likely carries less risk than investing in early-stage companies, though the risks associated with investing in private companies still exist, such as illiquidity and valuation fluctuations.

Nevertheless, pre-IPO investments potentially offer unique diversification benefits and give investors greater potential for capital appreciation, effectively complementing traditional asset classes and investment strategies. By investing in pre-IPO companies, you may have access to established, yet growing, enterprises, diversify your portfolio, and position yourself to participate in potentially profitable exits.

Bottom Line

Private equity funds and pre-IPO company shares both involve ownership of private companies and both may be attractive alternative investments. But they differ in what their ownership of private companies entails. These are not mutually exclusive approaches, as accredited investors may desire private company exposure through both private equity funds and directly owning shares in pre-IPO companies.

Investors who are interested in buying and selling shares of private companies can learn more on platforms like Forge Markets.