How Private Equity Funds Work

Private equity investing involves making investments in privately held companies. Corporations provide investment opportunities in the form of stocks and bonds, but private companies do not have either of these fundraising methods at their disposal. Private equity investments generally take the form of business loans or acquisitions. Due to the nature of private equity, this type of investment is best suited to investors with longer time horizons. Rather than taking quick profits on trading securities, private equity investors generally have to wait for their investment to boost a company's performance and net income before they see a return.

Companies seek private equity investment for a number of reasons, including to fund expansion plans. Other common uses of private equity dollars include new product development and the acquisition of other companies. Private equity funds provide the money necessary to accomplish these objectives, and the company is able to acquire capital outside of traditional bank loans.

Put simply, private equity funds offer investors an opportunity to leave their money in the hands of an experienced fund manager, who pools the contributions of all fund members, invests the money according to the guidelines of the fund and distributes the profits among the members. Fund members can be individuals or institutions; institutional investors' contributions can often dwarf individuals' in scale, making them a valuable addition to a fund.

Private equity funds often pool resources to perform leveraged buyouts of distressed public companies. Funds use their own resources in addition to loans to purchase a majority of a company's stock, pay off its creditors and bondholders, then take the company private. The fund managers then have the option to turn the company around and cash out via a second initial public offering or to sell the company's assets at a profit.