Private equity funds explained: Types, benefits, and investment insights

The world of alternative investments can feel daunting, especially if you’ve only dealt with traditional options like stocks and bonds. However, once you dive deeper, you’ll discover that private equity funds can offer certain benefits and growth potential for your portfolio. But what are private equity funds, and how do they differ from public market investments?

This article offers an overview of different types of private equity funds, how they operate, and potential considerations when including them in an equity funds investment strategy.

Table of contents

• Defining private equity funds: What they are & how they work
• Different types of private equity funds
• Key reasons to consider private equity investments
• How private equity funds seek to create value
• How private equity funds exit their investments
• Financial requirements: How much do you need to invest?
• Private equity fund fees and expenses
• Assessing the risks of private equity investing
• Step-by-step guide to investing in private equity
• Regulatory environment for private equity funds in India
• How to assess and select a private equity fund

Defining private equity funds: What they are & how they work

Private equity funds are specialised investment vehicles that pool money from accredited investors, institutional clients, and sometimes high-net-worth individuals to buy stakes in companies. They often focus on firms with strong potential, aiming to boost value before selling their ownership interests later. As these companies are not publicly traded, private equity funds have a different risk-return profile than traditional options like stocks or bonds.

High-net-worth individuals, pension funds, and other large entities often participate in this space, searching for above-average returns.

Different types of private equity funds

Private equity funds are often categorised by strategy, target sector, or company stage.

• Venture capital funds supports emerging start-ups needing capital to refine products or expand.
• Growth equity funds help more established ventures scale.
• Buyout funds acquire controlling stakes, leveraging improvements to boost profitability.
• Some funds specialise in distressed investments, purchasing underperforming businesses at lower valuations.
• Other funds focus on leveraged buyouts, using both equity and borrowed capital.

Certain investment strategies resemble private equity mutual funds, blending multiple styles for diversification. Each category has a distinct risk-return profile, so assessing objectives and risk tolerance is vital before allocating capital.

Key reasons to consider private equity investments

Why should investors consider private equity funds? First, private equity funds often have the potential to deliver higher returns compared to some traditional asset classes, thanks to concentrated ownership and active oversight.

Second, these funds allow for hands-on operational improvements rather than mere market speculation. If you invest in private equity, you’re typically partnering with experienced managers who can drive strategic shifts.

Third, private equity offers diversification away from public market volatility, which can be beneficial in uncertain economic climates. While private equity mutual funds might still align partly with equity markets, they generally rely on long-term fundamental growth.

So, if you’re looking to invest in private equity, these advantages might outweigh the potential risks involved.

Read Also: Private vs public equity: Key differences and which is more suitable for you?

How private equity funds seek to create value

Private equity (PE) funds may create value for investors primarily through active management and strategic initiatives across their portfolio companies. Some methods include:

• Operational Improvements: Enhancing efficiency, reducing costs, and optimising processes to potentially boost profitability.
• Multiple Expansion: Investing in companies with potential to improve valuation multiples through improved governance, market positioning, or sector trends.
• Financial Engineering: Using leverage prudently to amplify potential returns.
• Buy-and-Build: Acquiring smaller companies to add capabilities and scale, creating a more valuable combined entity.
• Sustainability & Digital Transformation:Integrating ESG practices and modern technologies to improve long-term growth prospects.

How private equity funds exit their investments

A key part of any private equity strategy is the exit plan. Private equity funds aim to realise returns by selling their stakes once the portfolio company has met certain performance milestones. Common exit routes include an initial public offering (IPO), a secondary sale to another investment group, or a merger with a larger corporation. Timely exits can herald significant gains, rewarding patient investors who supported the company’s growth.

Financial requirements: How much do you need to invest?

A private equity fund is categorised as a Level II Alternative Investment Fund, subject to SEBI’s rules on how to invest in private equity. According to these regulations, AIFs can raise capital from both domestic and international investors, including non-resident Indians.

However, the minimum investment amount is set at Rs. 1 crore. An exception applies to AIF employees or directors, who can invest a minimum of Rs. 25 lakh.

However, smaller investors can still invest in private equity through feeder funds, specialised platforms, or certain private equity mutual funds. These structures pool money from several participants, lowering the individual barrier to entry. Regardless, it’s important to remember that private equity demands a long-term horizon.

Private equity fund fees and expenses

Like any investment, private equity funds come with their own set of risks. Liquidity risk ranks high on the list, as you usually cannot sell your stake easily or quickly as you would with publicly traded stocks.

There’s also operational risk, because the success of equity funds investment hinges on effective management, strategic improvements, and market conditions.

Additionally, private equity often employs leverage, which magnifies gains but also amplifies losses. Valuation challenges arise too, because you’re investing in companies that are not regularly priced by the market.

Read Also: Investment funds: Meaning, types and examples

Assessing the risks of private equity investing

Step-by-step guide to investing in private equity

If you’re ready to explore how to invest in private equity, here’s a detailed roadmap:

1. Determine your goals and risk tolerance: Clarify your investment objective, whether it’s growth, diversification, or a hedge against public market volatility.
2. Research funds and structures: Decide between direct private equity funds, feeder funds, or private equity mutual funds.
3. Check minimum investments and fees: Many funds operate under a “2 and 20” fee structure, so read the fine print.
4. Engage a distributor under the regular plan: To stay compliant and simplify administrative tasks, consider investment through distributors under the regular plan, which can help you navigate product offerings.
5. Monitor progress: Private equity funds can run for several years; review periodic updates from fund managers.

Regulatory environment for private equity funds in India

• Private equity funds are regulated by SEBI under the Alternative Investment Funds (AIF) Regulations, governing fund registration, investment limits, disclosures, and investor protections.​
• Funds must register as AIFs and comply with investment norms, reporting standards, and valuation guidelines.​
• SEBI requires minimum investment amounts and mandates investor suitability assessments due to PE’s illiquid and high-risk nature.​
• Regulatory focus is on transparency, minimising conflicts of interest, and attempting to safeguard investor interests in complex PE structures.

How to assess and select a private equity fund

You may consider the following factors when selecting a private equity fund:

• Track Record:You may review historical fund performance, including IRR and multiple on invested capital (MOIC).
• Team Expertise:You may evaluate fund manager experience in target sectors and their operational involvement.
• Investment Strategy:You are advised to understand focus areas (buyout, growth, venture), deal sourcing, and value creation approach.
• Fee Structure:You could analyse management and performance fees for fairness and alignment with investor interests.
• Fund Size & Portfolio:You may consider fund size relative to strategy and diversification across sectors and geographies.
• Due Diligence Practices:You may assess rigour in evaluating portfolio companies and risk controls.
• Exit Opportunities:You could look for clear exit plans and historical ability to realise returns.

Past performance may or may not be sustained in future.

Conclusion

Private equity represents a compelling avenue for those who seek long-term capital growth, hands-on management approaches, and diversification from public markets. Yet, it isn’t for everyone. The illiquid nature, higher risk profile, and substantial capital requirements make it best suited for experienced or well-capitalised investors. Before diving in, consulting a financial advisor is essential to ensure that private equity funds align with your broader objectives. A tailored plan will help you navigate the complexities and unlock the potential rewards of private equity.

Frequently Asked Questions (FAQs):

Can everyday investors participate in private equity?

Yes. While many private equity funds favour large institutions, everyday investors can access the market through feeder funds, specialised platforms, or private equity mutual funds, which aggregate smaller capital commitments.

What is the minimum investment required for private equity?

It varies, but many direct private equity funds set minimum investment amounts. Lower thresholds often exist via pooled vehicles or certain equity funds investment schemes, making entry more accessible.

How can someone start a career or investment journey in private equity?

For a career, strong academic credentials in finance or economics, plus analytical experience, are valuable. For investing, begin by researching reputable funds, consulting advisors, and allocating capital that fits your risk profile.

What does the "Rule of 72" mean in private equity investing?

The “Rule of 72” is a quick mental math shortcut to estimate how long it takes an investment to double, given a fixed annual return. While not specific to private equity, it’s widely referenced.

What is the "2 and 20" fee structure in private equity?

In private equity, the manager typically charges a 2% annual management fee on assets, plus a 20% performance fee on profits exceeding a defined hurdle rate.