Private equity used to be an investment mainly associated with pension funds, sovereign wealth funds, family offices and other large investors. Today, private-market investments are increasingly being made available to a wider group of investors.

The attraction is understandable. Private equity provides access to businesses outside the stock market, with the potential for attractive long-term returns and additional diversification.

But it also works very differently from buying listed shares, ETFs or unit trusts. One of the biggest differences is easy to overlook: you don't know the market price of a private investment every day.

What exactly is private equity?

Private equity simply means investing in companies whose shares are not publicly traded. Within private equity, there are several different strategies.

Venture capital typically invests in younger companies, often before they become profitable. Growth equity generally invests in more established businesses that need capital to expand. Buyout private equity usually acquires substantial or controlling stakes in mature companies, often using a combination of investors' money and debt.

The basic objective is straightforward: buy or invest in a business, increase its value over time, and eventually sell the investment at a profit.

How does that value increase? A private-equity owner may grow sales, improve operations, reduce unnecessary costs, enter new markets, make acquisitions or strengthen management. Returns can also come from paying down debt or selling the business later at a higher valuation.

Why private equity can look less volatile

This is one of the most important differences between public and private markets.

Suppose you own $100,000 of shares in a listed company. Markets fall sharply and, by the end of the day, those shares are worth $85,000. Your account immediately shows a 15% loss.

Now imagine that you own an investment in a private company facing the same difficult economy. There is no stock exchange continuously telling you what someone is prepared to pay for it. The fund therefore has to estimate its value using methods such as comparable companies, recent transactions or expected future cash flows. That valuation might only be updated periodically.

The private company could still be facing falling sales, higher financing costs and weaker profit margins. Its economic value may have declined, but you may not see that change immediately in the reported valuation.

This is why lower reported volatility does not necessarily mean lower investment risk.

A simple way to think about it is your home. Your house does not receive a new market price every day, but that does not mean its economic value never changes. You simply don't see a continuously updated price.

How borrowing can change the return

Private-equity buyouts often use debt, or leverage.

Suppose a company costs $100 million and later becomes worth $150 million. If investors funded the entire $100 million themselves, their investment has increased by 50%.

Now suppose they originally contributed only $50 million and another $50 million was borrowed. To keep the example simple, assume the debt is still $50 million when the company is worth $150 million. The investors' equity is now worth $100 million. Their $50 million has become $100 million — a 100% gain.

The company is exactly the same and its value increased by exactly the same amount. If the business performs badly, the debt does not disappear. This is one reason investors should look beyond a private-equity fund's headline return and understand how that return was generated.

Leverage can therefore magnify investment returns. It can also magnify losses.

Why investors need patience

Returns can also take time to emerge. Private equity is generally a long-term investment. Money can be committed for many years, and selling an investment before the fund matures may be difficult.

During the early years of a private-equity fund, investors may initially see weak or negative returns because fees and expenses are being incurred while newly acquired companies have not yet had enough time to increase in value.

Later, if those businesses perform well and are eventually sold, money starts flowing back to investors. When plotted over time, this pattern can resemble the letter J, which is why it is known as the J-Curve.

The practical lesson is more important than remembering the term: one or two years may be far too early to judge the success of a private-equity investment.

Understanding the return numbers

Two measures investors commonly encounter are IRR and MOIC. Neither number tells the complete story on its own.

Internal Rate of Return (IRR) considers both the amount of money earned and when money was invested and returned. Receiving money earlier can improve the IRR.

Multiple on Invested Capital (MOIC) is simpler. If $1 million invested eventually becomes $2 million, the MOIC is 2.0x.

They tell us different things. Turning $1 million into $2 million in three years is very different from doing it in ten years. MOIC tells us that the money doubled; IRR helps reflect the time it took.

There is another distinction investors should understand: realised versus unrealised returns.

If a fund bought a company for $100 million and now values it at $180 million, the reported gain is $80 million. But if the company has not been sold, that $180 million is still a valuation. The eventual selling price could be higher or lower.

So there is an important difference between value reported on paper and cash actually returned to investors.

Fees and liquidity also matter

Private-equity funds can have management fees, performance-related fees such as carried interest, and other expenses. This makes the distinction between gross and net returns particularly important.

A fund's underlying investments may perform very well before fees. What matters to the investor is how much remains after all the applicable fees and expenses.

With listed shares, investors can generally sell during market hours. They may not like the price available, but there is normally a market. With private equity, money can remain committed for years. Even where an investment can be sold on a secondary market, the investor may have to accept a discount.

Consider two investments expected to produce the same return. One can be sold tomorrow; the other locks up your money for ten years. Most investors would not consider them equally attractive. The potential return from an illiquid investment should therefore be considered together with what the investor is giving up in flexibility.

Is private equity really less risky?

Private equity can provide access to businesses that aren't available on stock exchanges. Long holding periods can also give managers more time to improve companies without having to respond to daily share-price movements.

But investors accept trade-offs: less liquidity, less frequent pricing, more judgement in valuations, potential leverage, higher or more complex fees and long investment periods. Results can also vary considerably between managers.

Ask: what risks am I taking, and am I being adequately compensated for them?

Public equities look volatile because markets constantly show us what buyers and sellers are willing to pay. Private equity removes much of that daily price movement from view, but it does not remove business risk, economic risk, interest-rate risk, leverage risk, valuation risk or the possibility of losing money.

Less visible volatility does not automatically mean less risk.

Money & Macro Takeaway

Private equity should not be viewed simply as an investment that may offer higher returns. It is better understood as a different set of trade-offs.

Investors give up some liquidity, continuous market pricing and transparency in exchange for access to private businesses, active ownership and potentially different sources of return.

Whether those trade-offs ultimately lead to better investment results is another question. That is what we examine in Part 2 — Does Private Equity Really Outperform Public Markets?

Research sources

Money & Macro by NorthAxis

This post is for general educational purposes only and does not constitute financial advice or a recommendation to buy or sell any investment product. Investors should consider their own objectives, financial situation, and risk tolerance before making any investment decision.