What is a private equity fund?

Question: What is a private equity fund?  What is the difference between a private equity fund and a hedge fund?

Answer: For many people who are not familiar with the alternative investment industry, hedge funds and private equity funds look like the same thing.  The distinction is not necessarily in the legal structure (which is similar), but in the investment style.  The GAO’s hedge fund and pension report, which I discussed recently, provided a great definition for private equity funds:

Like hedge funds, there is no legal or commonly accepted definition of private equity funds, but the term generally includes privately managed pools of capital that invest in companies, many of which are not listed on a stock exchange. Although there are some similarities in the structure of hedge funds and private equity funds, the investment strategies employed are different. Unlike many hedge funds, private equity funds typically make longer-term investments in private companies and seek to obtain financial returns not through particular trading strategies and techniques, but through long-term appreciation based on corporate stewardship, improved operating processes and financial restructuring of those companies, which may involve a merger or acquisition of companies. Private equity is generally considered to involve a substantially higher degree of risk than traditional investments, such as stocks and bonds, for a higher return.

While strategies of private equity funds vary, most funds target either venture capital or buy-out opportunities. Venture capital funds invest in young companies often developing a new product or technology. Private equity fund managers may provide expertise to a fledgling company to help it advance toward a position suitable for an initial public offering. Buyout funds generally invest in larger established companies in order to add value, in part, by increasing efficiencies and, in some cases, consolidating resources by merging complementary businesses or technologies. For both venture capital and buy-out strategies, investors hope to profit when the company is eventually sold, either when offered to the public or when sold to another investor or company. Each private equity fund generally focuses on only one type of investment opportunity, usually specializing in either venture capital or buyout and often
specializing further in terms of industry or geographical area. (Other less common types of private equity include mezzanine financing, in which investors provide a final round of financing to help carry the company through its initial public offering, and distressed debt investments, in which firms buy companies that have filed for bankruptcy or may do so and then typically liquidate the company.)

Investment in private equity has grown considerably over recent decades. According to a venture capital industry organization, the amount of capital raised by private equity funds grew from just over $2 billion in 1980 to about $207 billion in 2007; while the number of private equity funds grew from 56 to 432 funds over the same time period.

As with hedge funds, private equity funds operate as privately managed investment pools and have generally not been subject to Securities and Exchange Commission (SEC) examinations. Pension plans typically invest in private equity through limited partnerships in which the general partner develops an investment strategy and limited partners provide the large majority of the capital. After creating a new fund and raising capital from the limited partners, the general partner begins to invest in companies that will make up the fund portfolio. Limited partners have both limited control over the underlying investments and also limited liability for potential debts incurred by the general partners through the fund.