Why and How to Invest in Private Equity

Introduction and Background to the Asset Class
Introduction
Private equity has arrived as a major component of the alternative investment universe and is now broadly accepted as an established asset class within many institutional portfolios. Many investors still with little or no existing allocation to private equity are now considering establishing or significantly expanding their private equity programs.
Private equity is often categorized an "alternative investment", comprising a variety of investment techniques, strategies and asset classes that are complimentary to the stock and bond portfolios traditionally used by investors. This chart shows the main components of the alternative investment space at a broad level.
Definition of private equity
Private equity investing may broadly be defined as "investing in securities through a negotiated process". The majority of private equity investments are in unquoted companies. Private equity investment is typically a transformational, value-added, active investment strategy. It calls for a specialized skill set which is a key due diligence area for investors' assessment of a manager. The processes of buyout and venture investing call for different application of these skills as they focus on different stages of the life cycle of a company.
Private equity investing is often divided into the categories described below. Each has its own subcategories and dynamics and whilst this is simplistic, it provides a useful basis for portfolio construction. In this article, private equity is the universe of all venture and buyout investing, whether such investments are made through funds, funds of funds or secondary investments.

Venture Capital
Venture capital is investing in companies that have undeveloped or developing products or revenue.
Seed stage Financing provided to research, assess and develop an initial concept before a business has reached the start-up phase.
Start-up stage Financing for product development and initial marketing. Companies may be in the process of being set up or may have been in business for a short time, but have not sold their products commercially and are not yet generating a profit.
Expansion stage Financing for growth and expansion of a company which is breaking even or trading profitably. Capital may be used to finance increased production capacity, market or product development, and/or to provide additional working capital. This stage includes bridge financing and rescue or turnaround investments.
Replacement Capital Purchase of shares from another investor or to reduce gearing via the refinancing of debt.
Buyout A buyout fund typically targets the acquisition of a significant portion or majority control of businesses which normally entails a change of ownership. Buyout funds usually invest in more mature companies with established business plans to finance expansions, consolidations, turnarounds and sales, or spinouts of divisions or subsidiaries. Financing expansion through multiple acquisitions is often referred to as a "buy and build" strategy. Investment styles can vary widely, ranging from growth to value and early to late stage. Furthermore, buyout funds may take either an active or a passive management role.
Special Situation Special situation investing ranges more broadly, including distressed debt, equity-linked debt, project finance, one-time opportunities resulting from changing industry trends or government regulations, and leasing. This category includes investment in subordinated debt, sometimes referred to as mezzanine debt financing, where the debt-holder seeks equity appreciation via such conversion features as rights, warrants or options.
What are the main sources of private equity finance?
The spectrum of investors in private equity has expanded rapidly to include different types of investors with significant long-term commitments to the asset class. The majority of commitments to private equity funds based in respective geographical regions have come from institutions within the same region. This is evolving as investors seek a higher level of geographical diversification in their private equity portfolios.
Why Invest in Private Equity?
The fundamental reason for investing in private equity is to improve the risk and reward characteristics of an investment portfolio. Investing in private equity offers the investor the opportunity to generate higher absolute returns whilst improving portfolio diversification.
Long-term historical out-performance
The long-term returns of private equity represent a premium to the performance of public equities. This has been the case in the US for over 20 years and also in Europe, following an increase in the number of private equity funds, for over 10 years. For many institutions, such a premium over more conventional asset classes justifies the different risk profile of the asset class.
True stock picking in a low inflation, low growth environment
A low inflation environment creates a focus on growth stocks as a means of out-performance. One of the core skills of the successful private equity manager is to pick companies with growth potential and actively to create the conditions for growth in those companies. Since private equity funds own large, often controlling, stakes in companies, few, if any, other private equity managers will have access to the same companies. Private equity managers are therefore true "stock pickers". This contrasts to mutual funds, which will often hold largely the same underlying investments as their peer group, with variations in weightings being fine-tuned to a few basis points.
Absolute returns
Excessive volatility and poor investment performance experienced by quoted equity portfolios, many of which have index-tracking strategies or are benchmarked to an index ("closet trackers"), have led to a swing in favor of strategies that seek absolute returns.
Demographic trends have compounded the desirability of such a change. The need to provide for an ageing population has obliged many institutions to adopt a more absolute return oriented investment approach in order to meet future liabilities. Private equity managers do seek absolute returns and their traditional incentivisation structure, the "carried interest", is highly geared towards achieving net cash returns to investors.
Portfolio diversification improves risk and volatility characteristics
Within a balanced portfolio, the introduction of private equity can improve diversification. Although lower correlation of returns between private equity and public market classes is widely debated and needs further investigation, the numbers do indicate a lower correlation.
Exposure to the smaller companies market
The private equity industry has brought corporate governance to smaller companies and provides an attractive manner of gaining exposure to a growth sector that went out of favor with market investors in the mid 1990s for reasons of liquidity.
Access to legitimate inside information
A much greater depth of information on proposed company investments is available to private equity managers. This helps managers more accurately assess the viability of a company's proposed business plan and to project the post-investment strategy to be pursued and expected future performance. This greater level of disclosure contributes significantly to reducing risk in private equity investment. Equivalent information in the public markets would be considered "inside information". By definition, investors in public markets will know less about the companies in which they invest.
Ability to back entrepreneurs
The wider emergence in Europe of entrepreneurs as an important cog in the economy has been facilitated by a period of larger company rationalization. This has reflected similar developments in the US that, for example, fostered rapid growth in technological innovation and substantial knock-on benefits for the whole economy through the 1990s. Entrepreneurs have also been at the heart of developments in Europe, creating value in both traditional and hi-tech industries. The private equity asset class offers the ability to gain investment exposure to the most entrepreneurial sectors of the economy.
Influence over management and flexibility of implementation
Private equity managers generally seek active participation in a company's strategic direction, from the development of a business plan to selection of senior executives, introduction of potential customers, M&A strategy and identification of eventual acquirers of the business. Furthermore, implementation of the desired strategy can normally be effected much more efficiently in the absence of public market scrutiny and regulation. This flexibility represents another feature whereby risk can be reduced in private equity investment.
Leveraging off balance sheet
Buyout managers in particular are able to make efficient use of leverage. They aim to organize each portfolio company's funding in the most efficient way, making full use of different borrowing options from senior secured debt to mezzanine capital and high yield debt. By organizing the company's funding requirements efficiently, the equity returns are potentially enhanced. In addition, because the leverage is organized at the company level and not the fund level, there is a ring-fencing benefit: if one portfolio company fails to repay its borrowing, the rest of the portfolio is not contaminated as a result. Thus the investor has the effective benefit of a leveraged portfolio with less downside risk.
However, there are features that investors might not find attractive and which must be understood.
Long-term investment In general, holding periods between investment and realization can be expected to average three or more years (although this may be shorter when IPO markets are especially healthy). Because the underlying portfolio assets are less liquid, the structure of private equity funds is normally a closed-end structure, meaning that the investor has very limited or no ability to withdraw its investment during the fund's life. Although the investor may receive cash distributions during the fund's life, the timing of these is normally uncertain. "Liquidity risk" is one of the principal risk characteristics of the asset class. Private equity should therefore be viewed as a longer-term investment strategy.
Increased resource requirement As a result of the active investment style typical of the industry and the confidentiality of much of the investment information involved, the task of assessing the relative merits of different private equity fund managers is correspondingly more complex than that of benchmarking quoted fund managers. This makes investment in private equity funds a much more resource-intensive activity than quoted market investment. Likewise, postinvestment monitoring of funds' performance is also more resource-intensive. Resource is a key issue in the development of a private equity program that is suitable for the investor.
"Blind pool" investing When committing to a private equity fund, the commitment is typically to provide cash to the fund on notice from the general partner. Whilst launch documentation will outline the investment strategy and restrictions, investors give a very wide degree of discretion to the manager to select the companies that the investors will have a share in. Unlike some real estate partnerships, there is usually no ability at the launch of a private equity fund to preview portfolio assets before committing, because they have not yet been identified. Also, there is generally no ability to be excused from a particular portfolio investment after the fund is established.
Approaches to Portfolio Construction
Portfolio construction will reflect the principal objectives of investing in private equity, including targeting higher long-term returns and portfolio diversification through reduced correlation to public equity markets. Issues of correlation will apply not only in connection with other assets, but also amongst the assets in the private equity portfolio itself.
Decision 1 - The size of the private equity allocation
Investors in private equity should be able to accept the illiquid character of their investment, hence the extent to which liquidity may be required is often a factor in the size of allocation. For this reason, it is often the case in the US that the investors who make the largest proportional allocations to private equity from their overall portfolios are those who are able to invest for the long term with no specific liabilities anticipated. These would include endowments, charities and foundations. Pension funds also are often large investors in the asset class. Based on the requirement to increase targeted returns and/or reduce volatility, the investor will determine the proportion of its overall portfolio that it believes is appropriate to allocate to private equity.

Decision 2 - Number of private equity funds to commit to
It is a challenge for investors to avoid concentration of risk within their private equity portfolio and to control portfolio volatility. It is appropriate to aim for some diversification. The chart below indicates that a level of diversification can be achieved by holding at least 6 different funds.
Decision 3 - Ways of achieving diversification
Stage There is negative correlation between returns from different stages of private equity. Diversification can therefore reduce risk within a private equity portfolio and this should be an important consideration.
Geography Geographical diversification can be secured in Europe through the use of country-specific, regional and pan-European funds. Non-European exposure is also widely available, in particular through US funds, but also for example through Global, Israeli, Latin American and Asian funds.
Manager Selecting a variety of managers will reduce manager specific risk.
Vintage year Timing has an impact on the performance of funds, as opportunities for investment and exit will be impacted by external economic circumstances. For this reason it has become a normal practice to compare the performance of funds against others of the same vintage. There may be marked differences in performance from one vintage year to another. In order to ensure participation in the better years, it is generally perceived to be wiser to invest consistently through vintage years, as opposed to "timing the market" by trying to predict which vintage years will produce better performance.
Industry In venture investing, most of the focus tends to be on technology based industries. These can be subdivided, for example into healthcare / life sciences, information technology and communications. Buyout funds tend to focus on technology to a lesser extent, providing exposure to such sectors as financial institutions, retail and consumer, transport, engineering and chemicals. Some have a specific sector focus.
Decision 4 - How to implement the strategy
Given the typical minimum investment size of private equity funds, establishing a diversified portfolio will require certain minimum levels of capital commitment. It will also take time to put into effect, bearing in mind vintage year diversification and the over-riding objective to identify the best managers in a given area.
Decision 5 - How to plan for the volatility of cash flows - the J-curve
An investor is typically required to fund only a small percentage of its total capital commitment at the outset. This initial funding may be followed by subsequent drawdowns (the timing and size of which are generally made known to the investor two or three weeks in advance) as needed to make new investments. Just-in-time drawdowns are used to minimize the amount of time that a fund holds uninvested cash, which is a drag on fund performance when measured as an internal rate of return ("IRR"). Investors need to maintain sufficient liquid assets to meet drawdown obligations whenever called. Penalty charges can be incurred for late payment or, in extreme cases, forfeiture of an investor's interest in the fund. In most funds' early years, investors can expect low or negative returns, partly due to the small amount of capital actually invested at the outset combined with the customary establishment costs, management fees and running expenses.
As portfolio companies mature and exits occur, the fund will begin to distribute proceeds. This will take a few years from the date of first investment and the timing and amounts will be volatile.
When drawdowns and distributions are combined to show the net cash flows to investors, this normally results in a "J-curve", illustrated in the chart below. As distributions normally commence before the whole commitment has been drawn, it is unusual for an investor ever to have the full amount of its commitment actually managed by the manager. In the illustration below, net drawn commitments peak at around 80%.

The Practical Aspects of Investment
Principal means of private equity investment
The principal means of private equity investment are:

Investing in private equity funds.
Outsourcing selection of private equity funds.
Direct investment in private companies.

While it is sometimes the ultimate objective of investors to make direct investments into companies, compared with investing through funds it requires more capital, a different skill set, more resource and different evaluation techniques. Whilst this can be mitigated by co-investing with a fund and the rewards can be high, there is higher risk and the potential for complete loss of invested capital. This strategy is recommended only to experienced private equity investors. For most investors the use of private equity funds would be preferred.
In-house private equity fund investment program
Investors in a fund generally expect to gain broader exposure through a portfolio built during the commitment period by investment professionals who specialise in discovering, analysing, investing, managing and exiting from private company investments. Being diversified amongst a number of different investments helps ensure that the risk of total loss of capital in the fund is relatively low compared to investing directly in unquoted companies. Compared to quoted equity funds, private equity funds often invest in relatively concentrated portfolios, for example there might be 10–15 companies in a typical buyout portfolio or 20–40 companies in a venture capital portfolio.
Outsourcing
Fund of Funds A fund of funds is a pooled fund vehicle whose manager evaluates, selects and allocates capital amongst a number of private equity funds. Because many funds of funds have existing relationships with leading fund managers, and because commitments are made on behalf of a pool of underlying investors, this can be an effective way for some investors to gain access to funds with a higher minimum commitment or to heavily subscribed funds. Many funds of funds are "blind" pools, meaning that exposure to particular underlying funds is not guaranteed. Rather the investor is relying on the record of the manager to identify and secure access to suitable funds. Some funds of funds, however, disclose a preselected list of investments. Investors in funds of funds need to balance the extra layer of management fees and expenses involved against the cost of the extra resource that the investor would need itself to select and manage a portfolio.
Consultants Consultants will offer similar expertise to fund of fund managers, but may offer a choice of discretionary or advisory services. The latter will facilitate construction of a tailor-made portfolio, as opposed to committing to a blind pool alongside other investors. Consultants may also offer segregated rather than pooled accounts. Consultancy services are also offered by some fund of funds managers.
Private equity fund structures

An example of a simplified fund structure is provided in the graphic below.
Legal and taxation aspects
Often it is necessary to create two or more vehicles, with different structures or domiciles, to permit investors in different countries to co-invest in a common portfolio. Two of the principal considerations in any fund structure are:- the structure should not prejudice the investor's tax position; and- investors should have the benefit of limited liability.
In relation to tax, it is important that there should be no additional layer of tax at the level of the fund, nor should investors be rendered liable to tax in another country as a result of the fund's activities. As a result, fund structures are often based on the principle of "transparency". In other words, investors are treated as investing directly in the underlying portfolio companies. A common structure used internationally is the US or English limited partnership. Although based on the principal of transparency, they may not always be recognised as transparent in other jurisdictions.
Liquidity
Private equity investing is a long-term investment activity and for this reason private equity managers generally impose rigid restrictions on the transferability of interests in their funds. Issues of liquidity can therefore put some investors off. However, there are ways to circumvent these.
Quoted private equity funds There are a number of high-quality private equity funds in Europe that are quoted on major European stock exchanges. Whilst many of these were established to take advantage of tax benefits, they remain less common than privately held vehicles. Some of the reasons for this include:- the tendency of quoted investment companies to trade at a discount to asset value, which may fluctuate, eroding the return on investment or making it more volatile;- the limited ability to return cash to investors - this means that when portfolio investments are realised, the cash received remains inside the fund and dilutes its performance until such time as it can be re-invested.Still, some investors can for regulatory reasons only invest in quoted securities and for these investors quoted private equity funds remain a good option.
Development of the secondary market There is a rapidly developing market in interests in existing private equity funds, referred to as "secondaries". A secondary offering may comprise a single manager's entire fund of direct investments or, more commonly, a portfolio of interests in a number of different funds. There is a growing number of well-financed investors that specialize in purchasing interests in existing funds from their original investors. Generally, however, secondary purchasers do not offer a liquid or attractive exit path.For the larger secondary portfolios, a buyer is commonly secured through an auction process. For the smaller transactions, these are often effected in a confidential manner, sometimes with buyer and seller matched by the fund's manager or by an intermediary. One of the keys to a secondary transaction is securing the goodwill of the underlying manager. The manager often has the ability to refuse or restrict transfer of the interest. In addition, valuation of the underlying assets is facilitated by the co-operation of the manager. As institutional private equity programs increase and start to reach maturity, the ability for investors to realize some existing commitments in order to raise cash for future commitments will become more attractive. This will be one of the factors that accelerates the development of the secondaries market going forward.
Breaking new ground
Structured products Specialist techniques of structuring funds have more recently allowed private equity fund products to be offered with features that are attractive to particular types of investors. Through securitization, incorporated fund vehicles are able to offer interests to investors in the form of notes or bonds with credit ratings, including convertible securities. Such interests may also benefit from partial or complete guarantees of the principal sum invested. To date, such products have usually been funds of funds structured as "evergreen" funds, meaning that realized investment returns are not distributed to investors but reinvested within the fund. Likewise, commitments have generally been drawn down at the outset rather than on a just-in-time basis for investment. These funds are normally quoted.
High Net Worth Investors Since it is not practical for many to secure diversified exposure to a variety of funds, bearing in mind the usual minimum commitment size, there are a variety of pooled vehicle types that may be offered. For example, dedicated feeder structures may provide specific single-fund exposure to private investors on a pooled basis. A variation of this model is a pooled vehicle that provides exposure to several pre-selected funds. Alternatively, investors can outsource their investment decision-making by investing in a fund of funds, such as a private bank.
Monitoring the Portfolio and Measuring Performance
Monitoring
An active approach to monitoring the activities of a fund holding can be a resource consuming exercise for an investor. Larger investors may be offered a place on the fund's Advisory Board, which generally focuses on investor and conflict issues. Some investors will review in detail the investment case for each of the fund's investments. In some instances the opportunity to co-invest may be available. Achieving a close working relationship with the fund manager is a long-term objective, which will promote a deeper understanding of the strengths and weaknesses of the manager and investment strategy. Investors that want to build a close relationship with their managers should ensure that they are able to dedicate an appropriate level of resource. For this reason, many investors will limit the number of private equity fund manager relationships that they maintain and to whom they commit funds.
Measuring performance
IRR and multiple Performance over time is typically measured as internal rate of return and absolute gains are measured as a multiple of the original cost. By using both measures simultaneously it is possible to illustrate the nature of returns. For example, a higher multiple combined with a lower IRR would indicate that the returns have been achieved over a longer period. Conversely, a higher IRR over a shorter period may be based on a small absolute gain. It is important for investors to be aware that anomalous and unsustainable IRRs are usually produced by uplifts in valuation that occur early in a fund's life. In addition, significant realizations achieved early in a fund's life will have a material impact on a fund's final IRR performance even though its aggregate multiple may not be equally impressive. Thus it is always preferable to look at both measures in tandem.The IRR is defined as the discount rate used to equate the cash outflows associated with an investment and each of the cash inflows from realizations, partial realizations or its mark-to market (the expected value of an investment at the end of a measurement period). The IRR calculation covers only the time when the capital is actually invested and is weighted by the amount invested at each moment.
Peer group benchmarking When comparing a fund's performance with that of other private equity funds, it is important to compare like with like. Comparing two mid-market pan-European buyout funds against each other would be appropriate. To compare sub-sector funds established during the same vintage year is also appropriate. As funds generally invest committed capital over a three-to-six year period and generally harvest investments in years three to ten, no meaning can be derived from comparing a fund in its first year to a fund in its sixth year. Also, funds with different vintage years may have experienced different economic and investment environments, which makes such comparisons inadvisable.Whilst private equity funds do not usually publish their return data, funds of funds and consultants maintain their own databases of return information and should be in a position to make comparisons. In addition, statistics are publicly available showing aggregate quartile performance by vintage year, geography and sector.
Benchmarking against different classes of assets The IRR computation is similar to that used to compute the yield-to-maturity on a fixed income investment. It is however different from the time weighted rate of return calculation that is standard for mutual funds and hedge funds as the variability of the timing and amounts of private equity fund cash inflows and outflows make it unsuitable. As a result, benchmarking against other assets is not a straightforward process. One method is to pick a benchmark index and to apply to a notional holding of that index the same cash flows that are experienced as a holder of an interest in the private equity fund. For example, when the fund draws down cash, it is treated as a purchase of the benchmark index of the same amount. When cash is returned, again it is treated as a realization of the same amount from the notional holding. If the fund out-performs the index, then the notional holding will have been reduced to nil before the fund finishes distributing. Benchmarking a portfolio in aggregate is also an option.

Private equity fund performance

In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments. In the majority of cases the only groups with knowledge of fund performance were investors in the funds, academic institutes (as CEPRES Center of Private Equity Research) and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.
The introduction of the Freedom of Information Act (FOIA) in the United States and other countries such as the UK in the early 21st Century, has led to performance data for the industry becoming more readily available. It is also possible to view private equity performance data directly on the websites of certain investors.
The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years in comparison with other asset classes such as public equities, certainly a factor in the bumper fundraising that both have enjoyed of late. In contrast other fund types such as venture have not shown such a strong overall performance. Manager selection in the private equity industry is definitely a vital factor for any investor seeking exposure to the market, with the performance of the top and bottom quartile managers varying dramatically, especially so in the high-risk venture capital world, and less so with real estate funds for example.
However, it is challenging to compare private equity performance to public equity performance. One method is the Long and Nickels excess IRR measure, which is not reliable. Another method which is gaining ground in academia is the public market equivalent or profitability index. The profitability index tells you how much you would have to invest in the public market (given its returns) to earn the same as you did from your private equity portfolio. See Phalippou and Gottschalg's 2007 paper, "The Performance of Private Equity" [1] for an overview of the profitability index.

[edit] Liquidity in the private equity market
The private equity secondary market (also often called private equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private equity assets.
Driven by strong demand for private equity exposure, a significant amount of capital has been committed to dedicated secondary market funds from investors looking to increase and diversify their private equity exposure.

Private Equity Fundraising

Private equity fundraising refers to the action of private equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund that they have invested in.
The majority of investment into private equity funds comes from institutional investors. The most prolific investors into private equity funds in 2006 were public pension funds and banks and financial institutions, which together provided 40% of all commitments made globally according to data from London-based Private Equity IntelligenceLtd. Other prominent groups investing in private equity include corporate pension plans, insurance companies, endowments, family offices and foundations.
Another large investor group in private equity funds are so-called fund of funds, which are private equity funds that invest in other private equity funds in order to provide investors with a lower risk product through exposure to a large number of vehicles often of different type and regional focus. Fund of funds accounted for 14% of global commitments made to private equity funds in 2006 according to Private Equity Intelligence Ltd.
As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004 there were 26 investors in the average private equity fund, this figure has now grown to 42 according to Private Equity Intelligence Ltd.
It is also worth noting that the managers of private equity funds themselves will also invest in their own vehicles, typically providing between 1–5% of the overall capital.
Often private equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles. The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services according to Private Equity Intelligence Ltd. Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner.
The amount of time that a private equity firm spends raising capital varies depending on the level of interest amongst investors for the fund, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital where they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerably longer, with managers of less popular fund types (such as European venture fund managers in the current climate) finding the fundraising process more tough. It is not unheard of for funds to spend as long as two years on the road seeking capital, although the majority of fund managers will complete fundraising within nine months to fifteen months.
Once a fund has reached its fundraising target, it will have a final close. After this point it is not normally possible for a new investor to invest in the fund, unless they were to purchase an interest in the fund on the secondary market.

[edit] Size of industry
Nearly $135 billion of private equity was invested globally in 2005, up a fifth on the previous year due to a rise in buyouts as market confidence and trading conditions improved. Buyouts have generated a growing portion of private equity investments by value, and increased their share of investments from a fifth to more than two-thirds between 2000 and 2005. By contrast, the share of early stage or venture capital investment has declined during this period. Private equity fund raising also surpassed prior years in 2005 and totaled $232 billion, up three-quarters on 2004.
Prior to this, after reaching a peak in 2000, private equity investments and funds raised fell in the next couple of years due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The fall in funds raised between 2001 and 2003 was also due to a large excess created by the end of 2000 of funds raised over funds invested.
The regional breakdown of private equity activity shows that in 2005, North America accounted for 40% of global private equity investments (down from 68% in 2000) and 52% of funds raised (down from 69%). Between 2000 and 2005, Europe increased its share of investments (from 17% to 43%) and funds raised (from 17% to 38%). This was largely a result of strong buyout market activity in Europe. Asia-Pacific region’s share of investments increased from 6% to 11% during this period while its share of funds raised remained unchanged at around 8%. [4]
The biggest fund type in terms of commitments garnered was buyout, with 188 funds raising an aggregate $212 billion. So-called mega buyout funds contributed a significant proportion of this amount, with the ten largest funds of 2006 raising $101 billion alone—23% of the global total for 2006. Other strong performers included real estate funds, which grew 30% from already strong 2005 levels, raising an aggregate $63 billion globally. The only fund type to not perform so well was venture, which saw a drop of 10% from 2005 levels.
In terms of the regional split of fundraising, the majority of funds raised in 2006 were focusing on the American market, with 62% of capital raised in 2006 focusing on the US. European focused funds account for 26% of the global total, whilst funds focusing on Asia and the Rest of World account for the remaining 11%.
Venture Capital is considered a subset of private equity focused on investments in new and maturing companies.
Mezzanine capital is similar class of alternative investment focused on structured debt securities in private companies.

Private Equity

The Private Equity sector is broadly defined as investing in a company through a negotiated process. Investments typically involve a transformational, value-added, active management strategy. Private Equity investments can be divided into the following categories:
Venture capital: an investment to create a new company, or expand a smaller company that has undeveloped or developing revenues
Buy-out: acquisition of a significant portion or a majority control in a more mature company. The acquisition normally entails a change of ownership
Special situation: investments in a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (Changing industry trends, government regulations etc.)
Private equity firms generally receive a return on their investments through one of three ways: an IPO, a sale or merger of the company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.
Considerations for investing in private equity funds relative to other forms of investment include:
Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $1,000,000) plus further investment for the first few years of the fund.
Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
If a private equity firm can't find good investment opportunities, it will not draw on an investor's commitment. Given the risks associated with private equity investments, an investor can lose all of its investment if the fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.
The seeds of the private equity industry were planted in 1946 when the American Research and Development Corporation (ARD) decided to form to encourage private sector institutions to help provide funding for soldiers that were returning from World War II. While the ARD had difficulty stimulating any private interest in the enterprise and ended up disbanding, they are significant because this marked the first recognized time in financial history that an enterprise of this type had been formed. In addition, they had an operating philosophy that was to become significant in the development of both private equity and venture capital: they believed that by providing management with skills and funding, they could encourage companies to succeed and in doing so, make a profit themselves. During the course of their unsuccessful journey, ARD did succeed in raising approximately $7.4 million, and they did have one rousing success; they funded Digital Equipment Corporation (DEC). By the 1970s such private participation had permeated into the the private enterprise formation, but till in the late 1970s, the task was being largely carried out by investment arms of a few wealthy families, such as the Rockefellers and Whitneys..[1] In the 1980’s, FedEx and Apple were able to grow because of private equity or venture funding, as were Cisco, Genentech, Microsoft, Avis, Beatrice Foods, Dr. Pepper, Gibson Greetings, and McCall Patterns.[2]. Despite these successes, through a series of "debt-financed leveraged buy-outs(LBOs)" of established firms, the PE firms were being seen with acrimony and being casted as irresponsible corporate raiders- as a threat to the free capitalist structure. The extreme example of this phenomenon is described in the bestselling book [3], where the two PE firms Forstmann Little and Kohlberg Kravis Roberts, were described as "Barbarians at the Gate" for their aggressive $25 billion pursuit for RJR Nabisco.
Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.
Some examples of private equity owned organisations are The Automobile Association, Jimmy Choo Ltd and Boots the Chemist.