What is PE? In a broad and general sense, PE is a term that commonly refers to any type of “equity” investment in an asset, but in which the underlying equity does not trade freely on a public stock market like the New York Stock Exchange or Nasdaq. Also, in a general sense, PE refers to the manner in which the funds have been raised, namely on the private markets. Many people use the term “private equity” interchangeably with the term “private equity funds,” which are committed pools of managed capital, raised from private sources.

Currently, some PE funds invest across a broad spectrum of industries. KKR, Texas Pacific Group, Blackstone, and Carlyle are well-known names in this area, and there are many others. Some PE funds focus on investments in particular industries, such as energy, technology, or health care. In many instances, PE firms invest in companies listed on public exchanges, by buying up the stocks and taking them private. But PE might also purchase a company from private holders, such as an individual or family (often as part of a succession plan), or from a closely held group of owners who want to cash out.

Spectrum of Investment Methods: Not a Hedge Fund

PE funds are part of a spectrum of investment methods. For comparison, let’s look at how PE differs from hedge funds. Hedge funds are vehicles that work with an investment of pooled funds, almost always open only to “accredited investors.” PE tends to take a relatively long-term view of investing, such as a four-eight-year horizon (and sometimes even longer), for reasons that we will review toward the end. In contrast, a hedge fund usually is focused on short-term trading opportunities, with traders using instruments such as arbitrage, swaps, derivatives, and other forms of financial leverage. In many instances, and again unlike the case with PE, the hedge fund traders might have little fundamental knowledge of the companies or industries in which they are conducting their trading, but to them it does not matter. The hedge fund traders are following the trading action, the price movement, and the overall market volatility in an effort to capture short-term gains.

Hedge funds usually charge a performance fee against both the principal within the fund, and any gains over time. Despite much criticism of their short-term view of just trading in and trading out of stocks and other ownership instruments, hedge funds have grown very much in size and influence on both the public securities and private investment markets.

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PE also differs from venture capital (VC). PE focuses on more mature companies or business efforts. VC, in contrast, invests in the early stage of startup enterprises. Thus, there is relatively more risk associated with the VC investment. Typical VC is provided by professional or institutionally backed outside investors, infusing cash in exchange for shares (and often one or more seats on the board) of the company that is being assisted. VC finds its place in the market because the enterprise under consideration is usually too risky for standard capital markets or sizeable bank loans. But while VC is usually high risk, it can offer the potential for above-average returns.

VC funding is a step up from what is called the “angel investor.” An angel is an individual or pool of funds that provides capital for a business startup, except it does so at an earlier stage than does the VC. That is, someone starts a business in the proverbial garage, or otherwise on a shoestring and a prayer. Not a few businesses have been started using the line of credit on a founder’s personal credit card. Angels and their capital are said to fill the gap in startup financing, between what are known as the “three Fs” (friends, family, and fools) of seed money, and the more discriminating VC.

As most people who have ever tried can attest, it is usually difficult to raise more than a few hundred thousand dollars from friends and family. (You might get lucky with the fools, but even that will eventually come to an end.) At some point, the fact is that red ink is thicker than blood, and your friends and family, and even the fools, will shut you off. The standard in the industry is that most VC funds do not consider investments under about $1-2 million. Thus, angel investment is the common second round of financing, in the range of about a quarter million to couple of million dollars, for startup companies with great hope, if not high growth prospects. Typical for startups, angel investments carry high risk and need to offer very high returns on investment (ROI).
The fact is that a large proportion of angel investments are completely lost when early-stage companies fail. Thus, professional angel investors look for investments that have the potential to return at least 10 or more times their original investment within about five years. Angels tend to be an expensive source of funds, but cheaper sources of capital such as bank loans are usually not available for most early-stage ventures. And after the initial five-year development period, the angel is looking for an exit strategy such as an infusion of cash from VC, or an initial public offering of stock (IPO) or other acquisition. That “other acquisition” may also be a sale to PE.

Continued tomorrow.