Investments in Private Equity
Although the capital for private equity originally came from individual investors or corporations, in the 1970s, private equity became an asset class in which various institutional investors allocated capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets. In the 1980s, insurers were major private equity investors. Later, public pension funds and university and other endowments became more significant sources of capital. For most institutional investors, private equity investments are made as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds) and other alternative assets (e.g., hedge funds, real estate, commodities).
Most institutional investors do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment. Instead, institutional investors will invest indirectly through a private equity fund. Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversified than one a single investor could construct.
Returns on private equity investments are created through one or a combination of three factors that include: debt repayment or cash accumulation through cash flows from operations, operational improvements that increase earnings over the life of the investment and multiple expansion, selling the business for a higher multiple of earnings than was originally paid. A key component of private equity as an asset class for institutional investors is that investments are typically realized after some period of time, which will vary depending on the investment strategy. Private equity investments are typically realized through one of the following avenues:
- an Initial Public Offering (IPO) – shares of the company are offered to the public, typically providing a partial immediate realization to the financial sponsor as well as a public market into which it can later sell additional shares;
- a merger or acquisition – the company is sold for either cash or shares in another company;
- a Recapitalization – cash is distributed to the shareholders (in this case the financial sponsor) and its private equity funds either from cash flow generated by the company or through raising debt or other securities to fund the distribution.
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