Private Equity is a form of business interaction where investments or acquisitions occur to companies that are not yet publicly traded on a stock market. With investments, a Private Equity fund will obtain a certain percentage of the company, whereas an acquisition gives the PE (Private Equity) firm total control of the company they are acquiring, also known as a buyout in the financial world. In some instances, if the PE firm has enough capital, they can even buy out a company that is already public! Through these investments and acquisitions, PE firms contribute and affect the global markets by inserting excess capital into a company, allowing it to grow, mature, and develop at a faster rate. Overall, the field of Private Equity has heightened and developed over recent years, having over $6 trillion in assets under management (AUM), an all-time high. Now, where do these PE firms find the capital necessary to invest in and acquire outside companies, thus affecting numerous markets across the world? Let us find out in these next two sections!
The first way PE firms allocate necessary capital is through accredited investors. Accredited investors are, by definition, individuals or a business entity that is allowed to trade securities that may not be registered with financial authorities. In other words, they are people or businesses that can invest in any company, including PE firms, they desire to due to special requirements they have met. These “requirements” can be many factors, however, most commonly, they are income, net worth, and professional validation. If a person or group does not contain at least one of these qualifications, they are legally not permitted to invest in a company. The requirements can sometimes be a little tricky, so let us break them down a little further:
– Net Worth: A person can be considered an accredited investor if they have a net worth that exceeds $1 million, either as an individual or a married couple. A person’s net worth can be determined by their assets (mortgage, car value, savings account, etc.) minus liabilities (loans, long-term debt, etc.).
– Income: A person can be considered an accredited investor if their income is greater than $200,000 or their joint income with their spouse exceeds $300,000 for the most recent two years. In other words, if your joint or individual income exceeds these values within the last two calendar years, then you are an accredited investor.
– Professional Validation: Any sort of validation obtained from a firm or individual can exempt them from income or net worth requirements. In essence, this “validation” comes from a financial holding of FINRA Series 7, 65, 62, and more. These holdings essentially prove to others that you are knowledgeable and trustworthy based on investing in others’ businesses.
Just one of these requirements is enough for you to be considered an accredited investor. So, let’s say you have a net worth of $3 million, but only made $150,000 as an individual last year, and do not have a FINRA holding of any sort. You would still, by law, be given the right to invest in other companies and PE firms. Of course, there are other requirements the Security and Exchange Commission (SEC) considers, but these three are the main forms of verification accredited investors obtain that allow them to perform financial acts.
The second way PE firms gather necessary capital is through institutional investors. When you think of institutional investors, think of the big guys. They are the ones closing the massive deals that affect stock markets and Consumer Price Indexes in every and any sector of this economy. Institutional investors are, by definition, a company or organization that invests money on behalf of other people. So, if an individual has a great sum of money but does not know anything about finance, economics, or any subject related to the business world, they allocate their capital to institutional investors who manage and invest their money for them in exchange for a commission, and in some cases, this capital gets passed on to PE firms! In most cases, institutional investors are more knowledgeable and experienced than other investors, such as accredited investors, and thus control larger amounts of money. In addition, institutional investors are subject to lesser restrictions than accredited investors. There are six main types of institutional investors:
– Endowment Funds
– Hedge Funds
– Mutual Funds
– Pension Funds
– Insurance Companies
– Commercial Banks
While all six of these sectors are extremely different, they all serve the purpose of being institutional investors to their respective clients and serve the purpose of delivering income to certain PE firms.
While there are many more topics to dive into within Private Equity, such as different types of PE firms and their investment strategies, it is important to understand the basics of what exactly Private Equity is and the different ways they obtain the capital necessary to invest into other firms. Overall, Private Equity is an important sector of the financial world as it allows a business of all sorts to grow and develop faster and with additional, outside aid.