The Pros & Cons of Investing in Private Equity

By Managing Partner Christopher Warren and Partner Todd Kulkin

So you’re thinking of adding private equity to your investment portfolio. Rather than investing through a public exchange such as the stock market, private equity funds invest directly into private companies or buy out public companies, delisting them from the public market.

Capital raised by private equity can help companies and startups develop new technologies, acquire more assets, and strengthen their balance sheets – away from the public eye and quarterly pressures of the market. Meanwhile, successful private equity investments can pay off for investors through dividends and profits over time.

Private equity investments can take many forms, including venture capital and private equity funds run by private equity firms, which make money by charging investors for management and performance fees. Private equity funds are often split between limited partners (who have limited liability) and general partners (who take on full liability). General partners also take a greater role in managing the investment while limited partners do not.

While private equity has its advantages, it also comes with some drawbacks and complications. Before you invest, you should know exactly what you’re getting into.

Legal Issues to Watch for in Private Equity

Investment funds must be properly registered with the U.S. Securities Exchange Commission (SEC) as “investment companies” under the Investment Company Act of 1940. The SEC enforces strict standards for investment companies, with penalties for failing to comply.

Exceptions for Securities With More Than 100 Investors

Under Section 3(c)(1) of the Investment Company Act of 1940, a private equity fund does not have to register as an “investment company” if it sells its securities to more than 100 investors and does not offer any securities to the public.

If your private equity fund qualifies for this exception, you do not have to file a registration statement or register the fund’s securities with the SEC.

Regulation D Exceptions Under the SEC

Whenever an investor buys equity in a company, that ownership interest counts as a security regulated by the SEC. Under the U.S. Securities Act of 1933, all securities offerings and sales must be registered with the SEC. But filing for SEC registration can be pricey, especially for startups and small businesses with limited capital at their disposal.

Regulation D of the U.S. Code of Federal Regulations identifies exceptions to the SEC’s registration requirements. This allows smaller companies and businesses the ability to sell their securities without the inhibitive cost of registering under the SEC. Essentially, Regulation D lowers the barrier to entry for smaller companies to raise capital.

To qualify for Regulation D, companies must satisfy certain standards under the law. Once you’ve identified the company you wish to invest in, an experienced securities lawyer can identify whether a Regulation D exemption applies to your investment.

Fiduciary Duties and Handling Private Equity Revenue

Under the Investment Advisers Act of 1940, private equity fund managers and investment managers have a fiduciary duty of loyalty and care to their investors. This duty applies whether the private fund is registered with the SEC or not.

In fulfilling their fiduciary duties, private equity fund managers must perform proper due diligence on investments, manage the investments in the best interests of the fund, and carefully monitor the fund’s investments throughout their term. A fund advisor’s duty of loyalty requires them to serve the best interests of the private equity fund instead of their interests. A fund manager must also disclose and minimize any conflicts of interest that may exist.

If a private equity fund advisor or manager fails to live up to these standards, the fund’s investors could have a legal claim against them for breaching their fiduciary duty.

Pros: Benefits of Investing in Private Equity

Private equity presents several advantages over investing in publicly-traded companies.

• Private equity allows investors to invest in startups and small businesses without the quarterly performance pressures of the public market.
• Private equity investors can put their capital into entrepreneurial ventures that they believe will disrupt and improve industries with new technologies and innovations.
• Forms of private equity, like venture capital, allow investors to invest in ideas.
• Private equity financing could be the basis of a leveraged company takeover, where investors provide the capital and strategy to improve a company’s performance.
• Private investment allows investors and senior company management to experiment with dramatic or unorthodox actions to cut losses and improve sales.
• Successful and strategic private equity investments could result in significant increases in revenue, profits, and dividends for investors, especially over the long term.

Cons: Disadvantages of Investing in Private Equity

Although advantageous, private equity comes with its share of complications and drawbacks.

• With private equity, there’s no universal method to match buyers and sellers like the public stock exchange. As an investor, you will have to engage in market and industry research to find a promising investment opportunity with a high probability of success. This involves hiring professionals you trust to do the proper due diligence.
• The rights of private equity investors are decided through private negotiations between investors and the company receiving their capital. This is in contrast with the rights of public investors, which are determined by a governmental framework already in place.
• While the price of shares in publicly traded companies is determined by market forces, the price of shares in private equity is negotiated between the seller and buyer.
• Private equity investors may have to wait several years before they start seeing a return on their investment – especially when it comes to private equity funds that target distressed companies. The process of rehabilitating a company, making the necessary changes to its management and operations, and turning around a profit can take time.

In the right hands and with the proper due diligence, private equity investments could net you powerful returns. With so many options for private investment, the right advice, guidance, and management of available capital could pay off significant dividends.

Call the experienced legal team at Warren Law Group now at (866) WLGROUP or use our contact form to speak with a securities lawyer who can set up your investment for success.