The essential guide to private equity

If you’re feeling like investment in public markets has gotten riskier over the past few months, you’re not alone.

Over the past two years, the global pandemic has caused massive disruptions in supply chains and forced national governments to release tremendous amounts of money to support hard-hit households. Those two factors, among others, have led to a drastic escalation in prices, pushing inflation to levels that haven’t been seen in decades. Russia’s war on the Ukraine has only added to the uncertainty.

Because of that, an increasing number of investors are looking to diversify their portfolios with alternative investments, which includes investing in private equity. But what exactly is private equity investment? How is it different from public equities? And what does a private equity firm do? We’ll answer these questions and more in the paragraphs below.

What is private equity?

Broadly, private equity can be defined as a form of financing where money is invested directly into a company in return for a stake in the business. But unlike people who buy shares on stock exchanges, where companies are expected to report their earnings on a quarterly basis, private equity investors don’t necessarily have as much visibility into the finances of the companies they put money in.

Private equity is one of many different types of alternative asset classes, which is the catch-all term for assets that aren’t available in the public equity or fixed-income markets. Traditionally, private equity was a way for businesses in their early stages to raise capital until they’re able to get listed on a public stock exchange. But as more company owners view public listings as too costly and burdensome – public companies are subject to a greater degree of regulation – there’s been a growing tendency for companies to stay in the private equity space, which has grown tremendously as a result.

How does private equity work?

The private equity space is run by private equity firms, which employ investment professionals. Those firms collect pools of capital from large investors called limited partners – they can be large institutions like pension funds, or high-net-worth individuals with millions in investable assets – to create a fund. Once enough money has been collected in the fund, it can be closed and then invested into promising companies.

The basic aim of a private equity fund is to have a selection of portfolio companies that have the potential to grow more profitable over time. A fund’s investment in companies usually lasts for the long term (10 years is a typical benchmark).

Over time, a private equity firm may be able to profit from its portfolio companies through various exit strategies, such as selling them to other private equity firms or listing them publicly through an IPO; those transactions aren’t expected to happen at once. Each time a portfolio company is successfully sold or goes public, the private equity firm makes a profit and distributes returns to its limited partners.

What does a private equity firm do?

A simple way to understand private equity firms is to think of them like house-flippers, but for businesses. They may invest in a company that’s not well-developed, stagnant, or maybe even distressed, but still shows the potential for growth.

Once the private equity firm invests in a company, their management team steps in to turn things around. They may look at the company’s operations and make changes to improve productivity, for example, or they may use connections to help generate more business and revenue. That’s why in a lot of cases, a private equity firm would start funds with a specific focus, and its management team would have people with experience in the industry that their portfolio companies are operating in.

Of course, the work to nurture portfolio companies into profitability isn’t free. Investors in private equity funds will be expected to regularly pay a management fee, typically around 2% of assets under management, to cover daily expenses and overhead.

Examples of private equity strategies

Private equity investments can be divided into three key types of strategies: venture capital, or VC, growth equity, and buyouts.

In venture capital, an investor or a firm buys a stake in an early-stage startup. This is the kind of investment most people would probably be familiar with from stories about tech companies in Silicon Valley: someone has an idea for a web-based platform or service, which they have to pitch to investors so they can have the capital to get it off the ground. But venture capital firms could potentially invest in companies across a variety of industries.

Among the different types of private equity investment, venture capital is the most inherently risky; a lot of startups aren’t that far past the idea stage when they make their pitch, and it could take years before they can prove their ability to turn a profit – if they can be profitable at all. Still, for a lot of venture capitalists, the chance to get in on the ground floor of the next Facebook or Netflix is worth it.

Meanwhile, growth equity strategies focus on making capital investments in established, growing companies. While those companies are further along in their business cycle, they still need additional funding to grow or be competitive with their industry rivals. Because they focus on companies that already have a business history, growth equity investors have a chance to do more research – look at a company’s financial records, interview clients, and try its product out, for example – before they make an investment.

Finally, buyout strategies involve private equity firms purchasing companies that are mature and typically publicly listed. This is the most common category in the private equity space.

When a buyout occurs, all of the previous investors in the company cash in on their shares and exit, leaving the private equity firm as the sole investor with a controlling stake (i.e., more than 50% of the company’s shares). With that controlling share, the PE firm or management team has a greater say in how the company is run, giving them more of an opportunity to implement internal improvements that, hopefully, will provide a return on investment over time.

What are some private equity firms in Canada?

When you think about private equity in Canada, the biggest name is Brookfield Asset Management. Its CEO, Bruce Flatt, has been at the helm since 2002, and he’s increased the firm’s assets under management to $923 billion. That’s a return of more than 3,700% during his leadership. The firm also has a global footprint, with offices in Toronto, New York, London, Rio de Janeiro, and Sydney.

Another notable private equity player in Canada is Onex. Founded in 1984, it manages and invests capital for shareholders, institutional investors, and high-net-worth clients from around the world. Its private equity platform, Onex Partners, focuses on investing in mid- to large-cap companies.

Finally, Birch Hill Equity Partners is a Canadian mid-market private equity firm. With over $3 billion in capital under management, 15 partners companies, and 43 fully realized investments since 1994, it holds a leadership position in long-term creation with Canada’s mid-market business space.