Like stock shares, private equity represents an ownership interest in a company. However, unlike stocks, private equity investments are not listed or traded on a public market or exchange (though some firms that specialize in making private equity investments are publicly traded).
Private equity firms are not necessarily required to register with the SEC. Also, firms that manage private equity investments may be more directly involved with management of the individual business or businesses than the average shareholder. Private equity often requires a long-term focus before investments begin to produce any meaningful cash flow–if indeed they ever do. Private equity also typically requires a relatively large investment and is available only to qualified investors such as pension funds, institutional investors and wealthy individuals.
Private equity can take many forms. The following are some examples:
Angel investors are individual investors who provide capital to startup companies and may have a personal stake in the venture, providing business expertise, industry experience and contacts as well as capital.
Venture capital funds invest in companies that are in the early to mid-growth stages of their development and may not yet have a meaningful cash flow or earnings. In exchange, the venture capital fund receives a stake in the company.
Mezzanine financing occurs when private investors agree to lend money to an established company in exchange for a stake in the company if the debt is not completely repaid on time. It is often used to finance expansion or acquisitions and is typically subordinated to other debt. As a result, from an investor’s standpoint, mezzanine financing can be rewarding because the interest paid on the loan can be high.
Distressed-debt firms specialize in taking over the debt of troubled companies, such as those that are in or on the verge of bankruptcy. They frequently function as private equity firms by forgiving the company’s debt in exchange for equity. They often are influential in restructuring or liquidating the company in order to recoup their investment.
Buyouts occur when private investors–often part of a private equity fund–purchase all or part of a public company and take it private. Those investors believe that either the company is undervalued or that they can improve its profitability and sell it later at a higher price, in some cases by combining it with other companies. In some cases, the private investors are the company’s executives, and the process is known as a “management buyout (MBO).” A leveraged buyout (LBO) is financed not only with investor capital but with bonds issued by the private equity group to pay for purchase of the outstanding stock. Buyouts were the subject of books such as Barbarians at the Gate, about the 1988 buyout of RJR Nabisco, and the movie Wall Street. However, buyouts today are typically less hostile than those of the late 1980s; for example, deals often involve the spinoff of a division of a large company or the sale of a family-owned business.
PIPE is an acronym for Private Investment in Public Equity. PIPEs are transactions in which private investors (often hedge funds or private equity firms) buy unregistered securities issued by corporations. In many cases the company eventually registers those shares with the SEC; that registration allows the private investors to resell those shares to the general public. PIPEs are popular with companies that need to raise cash more quickly than would be possible with a typical stock offering. In some cases, a PIPE leads to an eventual buyout.
Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private equity investment advisors were generally exempt from SEC registration. However, the Dodd-Frank legislation required that as of mid-2011, private fund advisors with $150 million or more in assets under management are generally required to register with the SEC. Individual states are responsible for regulation of funds with less than $150 million in assets, though they can choose to exempt private funds from registration requirements.
With the expansion of both private equity and hedge funds, the two have begun to overlap in some areas. For example, some firms have begun to offer both hedge funds and private equity investment opportunities.
Private equity and limited partnerships
Investors in private equity often do so through a limited partnership (LP). A limited partnership is a form of business organization that comprises one or more general partners and one or more limited partners. The general partner manages the organization and has unlimited liability regarding the debts and obligations of the business. The limited partners are passive investors; they provide capital, enjoy limited liability, and forgo an active management role.
Federal income tax is not imposed at the partnership level; instead, financial and tax events flow directly through to the individual or institutional investors. If you invest in a private-equity LP, therefore, you report on your individual tax return only your share of the business’s income, gains, losses, and deductions (see “Tax Considerations,” below).
As an investment vehicle, LPs were considered a very effective tax shelter prior to the Tax Reform Act of 1986. However, as a result of the Act, partnership losses can be deducted only if you have passive gains from another investment to match against them (see below). Although some LPs now emphasize income, appreciation, and safety, their ability to shelter cash flow and their value purely as a tax shelter has been drastically curtailed.
A limited partnership may be either private, as in the case of private equity, or public. A publicly traded limited partnership is known as a master limited partnership.
How can I invest in a private equity firm?
Because private equity often requires such a substantial investment, it can be difficult for individual investors to get access to these investment opportunities. For the most sought-after firms, a million-dollar minimum commitment is not at all unusual. Also, even those considered qualified to invest in private equity may not be able to invest with a given firm; because of the demand for their services, the most sought-after firms are able to pick and choose whom they allow to invest.
Requirements for private-equity investing vary widely. For the most informal arrangements–for example, seed-money investments by an individual investor in a single company–a simple contract may be all that is needed.
At the other end of the spectrum, most investors in private equity firms are what’s known as an “accredited” investor. To qualify, an individual must have either: (1) a net worth of $1 million (not including the value of a primary residence), or (2) have made at least $200,000 in each of the prior two years (or have a joint income with a spouse of $300,000), and expect to make at least that much in the next year. (A firm may have up to 35 unaccredited investors as limited partners.) Institutional investors must either be financially savvy, such as a bank, insurance company, investment company; or have investable assets of $5 million. However, funds of hedge funds, which pool the money of many investors to buy into private equity firms, can sometimes have lower minimums, though those minimums are still dramatically higher than those of a typical mutual fund.
Why do investors put money into private equity?
Its greater investing flexibility provides additional diversification
Private-equity firms argue that because they have more latitude in their investment strategies and decisions, they can deliver returns that are both higher and that are more independent of the rest of the market than other investments. As an alternative asset class, private equity represents yet another way to diversify a portfolio. Returns are often based less on what is happening in the stock market than on the fortunes of an individual company or the skills of a private equity firm’s management.
It can offer opportunities to be part of a business success story.
With early-stage and venture capital investing, you may be able to have an impact on the growth of an emerging company. Many investors find psychic reward in helping to develop and nurture a young company.
It can be highly profitable
Though the risks are high, a successful private equity investment can be lucrative. Many of the most skilled managers are drawn to the field because of the opportunities for participating in mergers, acquisitions, and highly profitable deals. And a successful investment in an early-stage company can provide dramatic returns.
For some, limited access lends an image of status
There is a certain perceived status to private equity investing. Because investing minimums are so high and access to the best private equity firms is extremely limited, some investors are drawn to private equity as they would be to an exclusive private club.
What are the disadvantages of private equity investments?
You may not qualify to make a private equity investment
Anyone who is willing to lend money to an entrepreneur can be an angel investor. However, private equity firms are limited in the number of investors they can accept, and those investors must meet standards set by the SEC.
Freedom from regulation is a double-edged sword
Under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private equity firms that have more than $150 million in total assets under management are required to register with the SEC; others are not. Also, the investing freedom that private equity admirers consider a strength can also bring much higher risk. Because there are few restrictions on how a private equity firm must invest, one large disastrous investment has the potential to bring down the entire firm.
It can be difficult to determine how your returns are achieved
Private equity firms have traditionally been guarded in divulging their strategies, which they consider proprietary information. As a limited partner, you rely to a great extent on the general partner’s reputation for skill and integrity.
The investment required can be sizable
Even if you qualify to invest in private equity, the size of the investment required could have a substantial impact on your overall portfolio’s asset allocation, and consequently the overall level of risk you face.
Limited liquidity can be a problem
Private equity by its nature means that there is no established public market for your shares if you should want to get out.
Private equity is a long-term investment
With a private equity investment, you should assume your money will be tied up for a long time, and you may not see any return for several years if you see any return at all. In fact, private equity firms may require a signed agreement that states how long you agree to keep your money invested.
You may or may not have any control over how your money is used.
As an angel or venture capital investor, you may be able to have an active say in the business in which your money is invested. However, as a limited partner of a large private equity firm, your role is likely to be very limited.
Investing costs may be steep
The general partner of a limited partnership will charge a percentage of your investments as a management fee, which can often be 1.5-2.5 percent. In addition, the general partner will take a percentage of whatever profits the partnership realizes, which can be as high as 20-30 percent.
The risks and uncertainty are as high as the potential rewards
By their very nature, early-stage, venture capital and distressed-debt investing are high risk. Typically, you’re investing in a business that has less of a track record, whose products may be untested in the marketplace, and whose management and business plan may or may not be sound. For every success story of investors who had an early stake in Microsoft, there are investors who lost their entire stake in a small company that went bankrupt or never got off the ground.
Tax considerations with limited partnerships
As mentioned above, partnership losses can be deducted only if you have passive gains from another investment to match against them. Limited partners (i.e. passive investors) can use losses from passive investments only to offset passive income.
Example(s): Assume Hal invests $20,000 in a newly organized LP. This is Hal’s only passive investment. At the end of the year, the LP suffers an operating loss, $2,000 of which flows through to Hal as a limited partner. Because Hal does not possess passive income from another source, he cannot utilize the loss on his federal tax return this year. Nevertheless, Hal may carry forward the unused loss to offset passive income in future years.
A passive activity involves the conduct of any trade or business in which the investor does not materially participate. You materially participate in an activity only if you’re involved in the activity’s operations or management on a regular, continuous, and substantial basis. Typically, limited partners do not materially participate in the LP; hence, their partnership income and losses are considered passive.
Tip: Portfolio investment income (e.g., interest and dividends) from stocks, bonds, and the like is not considered passive income. Therefore, income from these sources cannot be used to offset LP losses.
The at-risk rules may also apply to LPs. The at-risk rules apply to any activity carried on for the production of income or carried on as a trade or business. Losses are allowed only to the extent of the investor’s actual financial risk from the activity. Therefore, the amount of losses that exceed your at-risk amount are not deductible. Typically, your amount at risk is identical to your adjusted basis in the business. Amounts at-risk consist of a number of items, including your cash investment in the limited partnership and any amounts borrowed for use in the activity for which you are personally liable (such as a recourse loan).
Tax benefits flow through to individual partners. From the information provided on Schedule K-1, each limited partner reports on an individual income tax return his or her distributive share of the partnership’s taxable income or loss, and separately stated items of partnership income, gain, loss, deductions, and credits. However, a limited partner’s passive losses can be used only to offset passive income from other sources; they cannot be used to offset earned income or investment income. Nevertheless, unused losses may be carried forward to offset a gain from the disposition of the passive investment or may be used against a gain from other passive investments.
A limited partner’s basis consists of the amount of money (and the adjusted basis of any property) he or she contributed to the partnership. This basis is increased by any further contributions and by his or her distributive share of income and (if applicable) the excess of the deductions for depletion over the basis of the property subject to depletion. Basis is decreased (but not below zero) by current distributions to him or her by the partnership and by his or her distributive share of losses and certain nondeductible expenditures. If applicable, basis is also decreased by the amount of his or her deduction for depletion with respect to oil and gas wells.
Net losses are considered tax preference items for purposes of the alternative minimum tax (AMT) Also, most MLPs are now taxable as corporations.
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