What is Private Equity? Understanding Private Equity
What is a private equity
Private Equity (PE) is another source of investment capital that invests in the equity capital of privately held companies, I.e. companies that are not publically traded. Private Equity actually derives from high net worth individuals and institutional investors that acquire equity shares of privately held companies or acquire a controlling stake in publically traded companies to make them private, eventually becoming delisted from public stock exchanges. These companies are not listed or traded on any stock exchanges. The PE capital can be used to develop new products and technologies, expand working capital, make acquisitions, or strengthen a company’s balance sheet. Now private equity has gained a great amount of influence in today’s financial marketplace.
Private equity investors generally work towards funding new technology, making new acquisitions, expanding working capital and bolstering the balance sheets of companies. Private Equity firms also work in the same manner as Venture Capitalists — invest in the long term in startups to help them grow and then reap benefits after the companies go public or merge with other firms. Unlike mutual funds or hedge funds, however, private equity firms often focus on long-term investment opportunities in assets that take time to sell with an investment time horizon typically of 10 or more years.
Two metrics are typically used to assess the performance of private equity investments: the internal rate of return (“IRR”) and the cash on cash return multiple. Strictly defined, the IRR is the discount rate that sets the net present value of a series of cash flows equal to zero. It is perhaps the most widely used performance measurement tool for private equity. By contrast, the return multiple looks at the ratio of the money returned to money invested. For example, $1 invested in a private equity fund that generates $2.50 in distributions implies a 2.5 times return multiple. There are pros and cons associated with using each metric.
1. Internal Rate of Return (IRR)
Using an IRR allows investors to measure the performance of a series of periodic uneven positive and negative cash flows. This feature is especially relevant in the context of private equity investing because capital is drawn down and invested over time (negative cash flows) with distributions paid out over time (positive cash flows). This contrasts with many traditional investments that consist of one lump-sum investment and one cash-out, which tends to make performance calculations much simpler. Despite its advantages, the IRR does have several drawbacks.
It places too much weight on investments that return capital after short investment periods, even if the absolute dollar returns lag behind those of their peers. This tendency was most evident in the fevered VC market of the late 1990s, when companies progressed from start-up to IPO in record time, generating high initial IRRs for many venture funds. Another drawback is the lack of an industry standard in computing IRRs. Different private equity firms may use slightly different methodologies in computing their investments’ IRRs. Even a small change in the methodology can have a dramatic impact on the results.