History and evolution of Private equity as an asset class

The seeds of the private equity industry were planted in 1946 when the American Research and Development Corporation (ARD) decided to encourage private sector institutions to help provide funding for soldiers who 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 private enterprise formation, but until 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.

 Types

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.);
• Merchant banking: negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.^[4]

[edit] Features

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 suitable 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.

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