Investors are increasingly drawn to alternative investments[i] to make them less vulnerable to market volatility and to achieve “absolute returns” (investment returns more directly tied to the underlying company’s financial performance).

Within alternative investments, “Private Equity” investment opportunities abound, but what this really means can be confusing.  In this piece, we’ll try to demystify this category of investment. In particular, what are the differences between Private Equity and Private Debt – arguably the two most commonly found forms of private investment?

Background

It’s important that we first define the terms we’ll be using below:

Equity – Securities (often represented by shares or stock) and which represent ownership in a business and, therefore, a share in the future profits of the Company and in its overall growth in value.

Debt – Indebtedness of the company (usually in the form of Promissory Notes) that generates interest payments over its life and must be redeemed by the Issuer within a specific date.  Investors, or lenders, do not share in company profits.

Private – Refers either to a company or a security it issues which has not been registered with the U.S. Securities and Exchange Commission (the “S.E.C.).

Public – Refers either to a company or a security it issues which has been registered with the S.E.C.

Private placement – An offering of securities that is not publicly registered with the S.E.C. (also known as Regulation D offerings) although it is still subject to U.S. securities laws specific to private securities offerings.  Private placements can involve the issuance of either debt or equity securities.

What Private Equity is

Private equity and private debt (loans to private companies) are sometimes incorrectly lumped together under the umbrella term “Private Equity.”  They shouldn’t be, as they are very different forms of investment.

As suggested above, an investment in private equity is an equity investment that was issued privately.  It represents an equity investment made through a private placement offering.

Furthermore, one private equity security will often be very different from another in terms of security structure, relative risks, and potential return.   The operating history and performance of the issuer will largely determine the form of equity issued by the underlying business.  Younger companies (or Venture-stage businesses, often still unprofitable) generally issue preferred equity.  More mature companies and profitable companies may issue common shares.

Have These Been Readily Available to Everyone?

Historically, institutional investors have been the ones to purchase these securities.  Over time, wealthier, high-net-worth (Accredited) individuals have begun investing in them, taking advantage of their potential for higher returns and ability to diversify the risks within an investment portfolio. With the creation of Regulation Crowdfunding, non-accredited investors now have easier access to these investments (see Crowdfunding Overview).

Are There Different Forms of Private Equity?

The simple answer is yes. It’s important to understand the distinctions between the various forms of equity (see Understanding Private Securities).  In it, Carofin discusses what each type of security represents as an obligation of its Issuer, what this means for investors, and how each is structured to generate investment returns for the investor.

Private equity can be in the form of:

• Preferred Equity, or
• Common Equity.

Private equity can also be a way to invest in a wide variety of company stages and industry sectors, including:

• Growth capital in operating companies
• Venture-stage investments in pre-revenue companies
• Recapitalizing distressed companies
• Strategic acquisitions (buying another company)
• Project financing
• Technology development
• Real estate
• Art, wine, coins, crypto-currencies, jewels, plus other collectibles
• Intellectual property such as copyrights, song rights, patents, and trademarks

Here are a few additional comments to bear in mind when considering private equity investments:

• Many offerings require have high minimum investment thresholds.
• Most are illiquid compared to traditional asset classes; and
• Most have been designed for Accredited Investors who have more experience and financial wherewithal to understand the risks and the ability to lose some or all their investment.

However, there are risks and rewards in every form of investing. private equity may provide a means to diversify your risk, reduce volatility, and increase the return in your portfolio.

For more information on the services that Carofin and its affiliates offer, and the details associated with such services, please see our Customer Relationship Summary.

[i] Wall Street Journal, April 3, 2018

Photo by Eric Prouzet on Unsplash