Private equity covers many different areas but is common in real estate, business startups, and acquisitions. It is called private because investors in these deals focus on private companies and generally don’t get involved with public markets (i.e., the stock market). There are a lot of pieces to private equity, and we’ll go over them in this article, along with an explanation of how private equity in real estate works.
Why Private Equity?
Investors can invest their money in public markets. So what is the draw to investing in private markets? Public markets mean buying stocks or investing in public companies. There can be more restrictions and public disclosures. However, private equity offers that opportunity if an investor wants to build a company from the ground up or get in at the ground level.
A Sponsor coordinates a private equity deal. Investors pool their money together, and the Sponsor allocates it to a real estate deal. Sometimes, the Sponsor may create a fund to hold investor capital.
Investors will know what they are investing in unless the deal is a SPAC (special-purpose acquisition company). The Sponsor will provide deal terms, risk assessments, expected return, and length of the investment.
Because these deals are in the private market, they are often illiquid. It’s not uncommon for private equity holding periods to range from a few years to over 10 years. This usually requires a special kind of investor called an accredited investor, many of whom are high-net-worth investors.
The valuation of a private equity deal is up to the Sponsor in most cases. Because it can be difficult to get comps, the Sponsor might use a model to determine the deal’s ongoing value. Unlike public markets where price discovery is near instant, a private equity deal may have a value quite different from an equivalent public real estate deal.
Components of Private Equity
Private equity deals are split amongst general partners (GPs) and limited partners (LPs). The GPs are those managing the deal. This can include the Sponsor. GPs collect fees for managing the investment. The GPs also create a management company or private equity firm. LPs are the investors.
Some private equity deals include share structures similar to what you might find in public markets. GPs will get common shares, while LPs will get preferred shares.
A big part of the Sponsor’s job is to analyze deals. The Sponsor might analyze 10s of deals before finding (i.e., closing) one that is viable. To compensate the Sponsor for this work, an acquisition fee is charged to the LPs. This fee can range from 0.5 to 4%.
The GPs/Sponsor must also manage the LPs’ funds, called assets under management (AUM). Responsibilities include managing the business, sending tax returns, keeping track of all transactions, etc. There is a fee charged for AUM responsibilities as well. Depending on the arrangement, the percentage can be based on the equity invested, effective gross revenue, or net gross asset value. AUM fees range from 0.5 to 2%.
There are other fees that the GPs may charge. A disposition fee is paid to the private equity (PE) firm for managing the sale of the property. This fee can range from 1 to 2%. Refinancing can fall under this fee as well.
Promoted interest is another fee that the PE firm may charge. If you’re familiar with hedge fund fee structures, promoted interest or promote is similar to a hedge fund’s performance fee. This is a percentage of returns beyond the preferred hurdle. A 50% promote means that 50% of profits over the preferred hurdle go to the GP. The other 50% goes to the LPs.
A fund might have a hurdle rate of 8%. This means there is no promote until the fund clears 8%. So if a fund returns 10%, the promote is 2%.
This article is only an overview of how private equity in real estate works. There are other deal structures, such as debt, where the LPs are paid a consistent cash flow and incur lower risk than an equity deal. Some deals may also be structured as equity and debt.
Private equity deals usually require more research than public stocks since there aren’t as many (if any) analysts providing additional information. Also, publicly available information about a PE deal isn’t as readily available, potentially increasing the risks associated with PE deals.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Hypothetical examples shown are for illustrative purposes only.
