Private Equity

What is Private Equity?

“Private equity” (or “P.E.”) is a type of alternative investment company that buys private companies, executes a plan to increase their profitability, and then either sells or takes them public with an Initial Public Offering (IPO). Today, private equity is a $26 trillion industry, drawing in wealthy investors with promises of yields that supposedly outpace the stock market. (While that may be the case for certain periods, it is difficult to discern whether those claims have consistently held true.)

Because private equity’s main goal is to make a profit, they have a reputation for making ruthless management decisions, sometimes to the detriment of the company’s employees and customers. Despite the growing number of critics and concerns over a lack of regulation, this asset class has thrived since the 1980s. Today, their appeal draws on the billion-dollar successes of private equity firms like Blackstone, Accel, KKR, and Apollo.  

Private Equity Investing

Private equity investments are not available to ordinary retail investors. Investors in private equity are typically institutional investors, like pension funds, college endowments, or insurance companies. These investors have enough money that they can afford to take on some risk and can afford to keep their money invested for a longer period – private equity funds typically have terms of ten to 12 years. Particularly wealthy investors, also known as accredited investors, may also participate in these types of private investments.

Firm Structures

Private equity firms usually choose a Delaware limited partnership. In a Delaware limited partnership, a General Partner controls the company. The Limited Partners are the investors. Under this structure, the General Partner has a fiduciary duty to act in the best interest of the fund. It is common for private equity funds to “specialize” in a particular type of investment. If the fund attempts to delve into a sector outside of their expertise, investors may file a lawsuit against the General Partner.

How Private Equity Funds Make Money

Private equity funds typically have a two-and-twenty fee structure. The fund charges an annual management fee of 2%, which is based on the total value of the fund’s assets. When a private equity fund sells the business, the General Partner earns another 20% performance fee based on the amount of the sale. The general managers can earn massive payments even if the companies they acquire do not benefit from the private equity fund’s management.

Types of Private Equity Funds

There are three main types of funds: Buyouts, carve-outs, and secondary buyouts.

• Buyout funds purchase entire companies.
• Leveraged buyouts borrow money to buy a company and use the company’s assets as collateral. These types of funds have a reputation for earning their General Partners billions of dollars.
• Carve-outs involve buying a division of a larger company.
• Secondary buyouts happen when a private equity firm buys a company from another private equity fund.

Leveraged Buyouts

The biggest P.E. funds – like Blackrock and Carlyle Group – are known for their leveraged buyouts.

In a leveraged buyout, a private equity fund acquires a company with borrowed money instead of cash or stocks. The company’s assets serve as assets for the loan. The use of leverage can increase the odds that the company will go bankrupt – the fate that befell Toys ‘R’ Us.

While these types of private equity deals drew lots of attention with their billion-dollar profits, they may be slowing down. In 2022, The Wall Street Journal reported that the enthusiasm for leveraged buyouts had waned as interest rates rose. Without low interest rates, it becomes difficult for private equity funds to find the cheap debt that finances these deals.

Leveraged buyouts do not always go as planned. Research from the California Polytechnic State University shows that approximately 20% of large companies acquired through leveraged buyouts go bankrupt within ten years. Out of the companies in the study’s control group, only 2% went bankrupt over the same period.

How to Invest in Private Equity

While this type of private investing is not available to ordinary investors, larger private equity funds do trade publicly. BlackRock made its stock market debut in 1999, and as of publishing trades for over $800 per share.

Investors may invest in private equity funds through a roundabout investment in a private placement. For instance, one broker had to settle with the Financial Industry Regulatory Authority (FINRA) after the regulator alleged that he had convinced investors to invest $2.2 million through two overly risky private placement offerings that had underlying private equity investments. (Risky investments often violate securities rules and regulations.) FINRA fined the broker $5,000 and suspended him for four months.

Investment Advisers and Private Equity Fund Disputes

Lack of transparency plagues the private equity sector and financial advisers have faced regulatory actions for their failure to make accurate disclosures to their investors.

$6.5 Million Fine for a Private Equity Fund’s Alleged Failure to Disclose a Conflict of Interest

In 2023, the SEC ordered a private equity fund to pay a $6.5 million civil penalty and to repay $14 million to its fund to settle charges that the firm failed to disclose the CEO’s relationship with an affiliate. The equity fund formed to purchase self-storage real estate properties and the order found that the fund paid brokerage fees to a real estate brokerage firm owned by the private equity fund’s CEO. According to the SEC, this relationship with an affiliate brokerage firm should have been disclosed in the fund’s prospectus.

Broker Faces $10,000 Fine Following Allegations of Providing Incorrect Information to Private Equity Investors

On February 1, 2024, Brian Shevland entered into an Acceptance, Waiver, and Consent agreement (AWC) with FINRA, in which he consented to the findings that he provided documents that contained materially inaccurate performance results to his investors. (AWCs allow financial professionals to settle with FINRA without admitting or denying their findings.) He allegedly did not ask the fund about these discrepancies, nor did he take any steps to investigate them.

According to the AWC, Brian Shevland managed two private equity funds. He allegedly caused the Funds to invest $20 million in a separate private equity fund that produced inaccurate performance results. Brian Shevland allegedly continued to direct others to use the materially inaccurate performance results.

The manager of the fund was arrested and charged with securities fraud. Shevland consented to pay FINRA a $10,000 fine.

Broker Allegedly Used Private Equity Fund to Defraud Investors of $13 Million

The New York Attorney General filed a lawsuit against a FINRA-registered broker following allegations that he defrauded investors of $13 million to “enrich himself and his companies.” The broker operated a private equity fund that he claimed would purchase discounted interests in other private equity funds on the secondary market. Instead, the broker allegedly misappropriated the investments for himself and injected funds into his failing brokerage firm, NYPPEX.

Criticisms of Private Equity

P.E. fund managers have a reputation for draconian business practices that can have ill effects on customers and employees. Their tactics may be ruthless and result in layoffs or fewer benefits for employees. Research from the  National Bureau of Economic Research pointed out that mortality rates increase by 11% in nursing homes following a private equity takeover. Another study by the National Bureau of Economic Research showed that private equity takeovers of nursing homes correlate with lower staffing levels.

Private equity funds have forayed into real estate, leading to complaints that buildings run by these companies impose sharp rent increases and fail to address maintenance issues. In New York City, critics of private equity claim that their business practices have made it even more difficult to find decent housing in an already overtaxed real estate market.

In medical practices, studies have shown private equity management corresponds with rising prices for customers. ProPublica reported that private equity management led to some profit-driven measures that potentially hurt patients, such as cutting emergency room doctors’ hours at the height of the COVID-19 pandemic.

What Are the Benefits of Private Equity Funds?

Conversely, proponents of private equity point out that these funds can save struggling companies. Companies that cannot pay their debts will most likely not qualify for a loan. Private equity wants to acquire companies for as little as possible, making them more likely to look for companies that have potential despite dire straits.

Increasing Transparency

Private equity became an attractive money-making proposition in part because of lax government regulation and favorable tax treatment. The 20% performance fee for General Partners is taxed as capital gains, which is a significantly lower rate than income. And while General Partners may earn billions of dollars, it is not clear how much value private equity funds actually provide to investors. Until now, private equity funds have not had to provide clear disclosures regarding their performance.

But that may be changing. In 2023, the SEC made moves to force p.e. funds to be more transparent, voting to prohibit hedge funds and private equity funds from offering better investment terms to bigger investors. Those better terms might allow the investor to withdraw early or give them a peek behind the curtain at the firm’s holdings. These new rules would also require private fund advisers to distribute annual financial statements that disclose fund fees, expenses, and performance.

P.E. funds have pushed back against the impending regulations, with lobbyists needling Congress to reject the SEC’s new proposed rules. Six private equity and hedge fund trade groups have filed a lawsuit against the SEC, saying that the new requirements are “arbitrary and capricious.” They further alleged that the new regulations would overstep the regulator’s purview.

The Treasury Department has also pushed for tighter regulations and now requires private equity funds to comply with anti-money laundering rules by reporting suspicious transactions. Six senators wrote a letter to the U.S. Treasury Secretary arguing in favor of the new anti-money laundering rules, stating that private equity funds are “particularly attractive for money launderers and sanctioned persons due to existing regulatory gaps.” Private equity also provides anonymity for investors, another possible boon for criminals. According to The Wall Street Journal, opponents of the new rule argue that private equity funds probably do not attract illicit transactions since they typically require at least a ten-year commitment.

Tax Loopholes for Fund Managers

The Biden administration has also pushed to reduce the tax benefits for general managers, including the “carried interest” that allows General Partners to defer paying taxes. Today, certain members of Congress argue in favor of closing the carried interest loophole and also state that fund managers should pay self-employment taxes.

Kurta Law Wants Investors to Know

Do not let the buzzword “private equity” persuade you to take on a risky investment. These investments are only available to the wealthiest of investors for good reason. Even if you can invest in a security that is linked to private equity, remember that the lack of transparency surrounding private equity investments makes it difficult for investors and financial professionals to independently evaluate. Furthermore, tightening regulations mean that the landscape for these investments is rapidly changing. More regulations and calls for closing tax loopholes might take down some of this industry’s top earners.

If a FINRA-registered broker recommends an overly risky investment, consider speaking with a securities attorney. Our attorneys provide free case evaluations and can tell you if you have a case for FINRA arbitration, the process most brokerage firms require investors to go through rather than suing in civil court. Call (877) 600-0098 or email info@kurtalawfirm.com.