Private equity and investment banking have much in common. Both businesses raise investment capital and work on transactions like mergers and acquisitions (M&A) and company restructurings.
But their structure, funding, and how they make money are different. Private equity firms invest money from their backers. Investment bankers don’t invest money directly and typically act as intermediaries and advisors to their clients. The two investment structures are regulated differently by the Securities and Exchange Commission (SEC).
Banking—where investment banking operations are often housed—is a heavily regulated industry. Private equity, on the other hand, is not subject to the same regulations since private equity deals are made with private funds furnished by accredited investors. In theory, these investors don’t need the same protections as banking customers.
What is private equity?
Private equity funds are formed when groups of investors join in a partnership to raise capital. The investors, or limited partners, take a majority share in the fund, have limited liability, and do not actively manage the investment. The fund managers, known as general partners, hold a minority interest in the fund, are exposed to full liability, and receive fees and a share of any profits for their work.
The fund takes a majority share in or buys out a private company, or it takes over a public company and delists it from the stock exchange. The goal is to restructure or improve the company’s operations, then either sell it to another company or do an initial public offering (IPO), distributing the profits to the investors. Private equity funds invest in companies at various stages of development and are directly involved in the management decisions of their portfolio companies.
Potential benefits and drawbacks of private equity
Private equity may offer several benefits to, and have potential drawbacks for, investors and companies.
Benefits of private equity to investors
- Passive income. Investors in private equity can reap the rewards of a company’s growth without actively managing their investment. They pay the general partner a management fee and receive a distribution upon the fund’s exit from the investment.
- Historically high performance. According to a study by management consulting firm McKinsey & Co., private equity has outperformed other asset classes since 2009.
- Tax benefits. PE funds are pass-through entities, meaning that income passes through the business and goes straight to investors, who pay taxes based on their own income tax rates.
Downsides of private equity for investors
- Loss of control. Limited partners don’t control or manage the investment.
- Qualifications. Investors must be accredited to invest in private equity, with a net worth of over $1 million or special employee certification.
- Liquidity lockup. Investors typically commit substantial capital to the fund and must wait until it exits its investment to make a profit—that can take a decade or more. They cannot pull capital out before the exit.
Benefits of private equity to companies
- Instant infusion of cash. Companies can benefit from a PE infusion whether they are startups or mature companies. Venture capital and angel investing, both types of private equity, can help fund early-stage companies.
- Privacy. For public companies that are bought and delisted from a stock exchange, a private-equity investment can be an attractive option because it happens outside public markets and isn’t subject to potentially burdensome reporting and disclosure requirements.
- Expertise of a fund manager. Companies can also benefit from fund managers’ expertise and connections. Because PE funds are investing their own capital, they have a vested interest in a company’s growth.
Downsides of private equity for companies
- Opaque pricing. Share prices for companies funded by private equity aren’t determined in the open public market but through private negotiations between buyers and sellers.
- Less transparency. Although PE is more tightly regulated now than it once was, it is still subject to less regulation and is less transparent than investments in publicly traded securities.
- Potential layoffs. PE funds often use leverage, or debt, to acquire companies and drive up their returns. They may seek to further increase their returns by cutting staff.
What is investment banking?
Investment banks manage the money of large companies. They underwrite debt, help companies issue stock, provide advisory services, and help identify and execute M&A deals.
Investment bankers act as a kind of intermediary for investors and companies. They work to sell companies by issuing and selling securities and identify investors who are willing to buy all or part of a company’s ownership interest. They employ people in various capacities to manage the sale, from researchers and analysts who work in financial modeling, to transaction specialists.
Investment banks are heavily regulated, including by the Dodd-Frank Act of 2010. Enacted in the wake of the Great Recession of 2008, the law protects investors and consumers from unethical practices in the financial-services industry. The Volcker Rule within the Dodd-Frank Act specifically bans banks from owning or trading funds for their own gain, including maintaining private-equity funds or hedge funds.
Advantages for companies that work with investment banks
- Resources and expertise. Investment banks come equipped with specialists for virtually every transaction. Companies that rely on an investment bank to sell their business avoid the distraction of finding a buyer and managing negotiations, and can focus on running the business.
- Advisory services. Investment banks can give companies impartial, outside recommendations on the best course for the business; company owners may be too close to a deal to be objective.
- Negotiation help. Investment banks can identify and negotiate with potential buyers, advise on alternatives to a sale, and determine the company’s valuation.
Disadvantages for companies that work with investment banks
- Large fees. Investment banks usually charge a retainer fee (a flat monthly fee) and a success fee based on the value of the company. Small companies or those that don’t need all the services of an investment bank to broker their sale may feel that the fees are excessive.
- Limited staffing. Since investment banks often work on multiple deals simultaneously and have limited staff, companies may retain a bank thinking that they’ll be working with the same managing directors they hired and end up with junior staff who may also be working on other transactions.
What are the key differences between private equity and investment banking?
While private equity and investment banking share some similarities, they differ in many core ways.
- Purpose and goals. Private equity is an investment business. Its goal is to restructure or improve a company, sell it, and collect a profit. Investment banks, on the other hand, are advisory businesses that work to raise capital, restructure, or act as intermediaries for the companies that hire them. An investment bank and a PE firm may do business together if a bank is able to, for example, sell a company to a PE firm.
- Business model and structure. PE firms are partnerships in which limited partners are high-net-worth individuals and institutional investors, and general partners actively manage the investment. Investment banks are staffed by researchers, analysts, associates, managing directors and many other types of specialists who do everything from seeking out takeover targets to executing transactions.
- Services offered. PE firms buy companies or majority shares in companies, restructure and make them more profitable with the goal of either taking them public via an IPO or selling them to a corporate buyer. Investment banks may be hired by a company to find investors, sell or merge the company, or to advise on restructuring or investments.
- Exit strategy. PE funds stay invested until the sale of the company or its IPO, when they divest their shares and distribute profits. Investment banks collect a retainer fee and then a fee based on the success of a transaction.
What are sell side vs. buy side firms?
Financial firms are typically categorized as “sell side” or “buy side.” Both types of businesses raise capital and execute transactions. The definitions are as follows:
- Sell-side. These are companies that seek to sell stocks, bonds and other assets (including entire companies) to investors. Investment banks are, for the most part, sell-side firms.
- Buy-side. Financial firms, including asset managers, pension funds and endowments, invest capital by buying stocks, bonds and other assets. Private equity funds fall into the buy-side category, even though many of their financial backers also are considered to be on the buy side.
The bottom line
Investment banks and private equity funds are both involved in raising capital, restructuring deals, and making sales, but they have different goals, structures, and regulations.
Investment bankers work on the sell-side, pitching and selling financial assets or entire companies to investors. They make their money as advisors from the fees they charge as a retainer and upon the successful execution of a deal. Government regulations prohibit them from investing bank funds for their own gain.
On the other hand, PE firms are investors. They work on the buy-side, raising capital to buy private companies or public ones which they then take private. PE firms make their money when they restructure or improve the target company and sell their investment.