The Cons of Private Equity Firms: Risk, Illiquidity, and Cost

Private equity firms have become increasingly popular in recent years for their ability to invest in and support high-growth or turnaround companies. However, like any investment, private equity comes with its own set of potential cons. In this article, we will explore some of the key drawbacks associated with private equity firms, including their inherent risks, potential illiquidity, and high costs.

High Risk Inherent in Private Equity Investments

One of the most significant cons of private equity firms is the high level of risk involved. Private equity typically invests in companies experiencing high growth phases or turnaround situations, which can be more volatile and risky compared to other investment options. This increased risk can be attributed to several factors, such as the intense competition in these sectors and the uncertainty surrounding the company's future performance.

Illiquidity of Private Equity Investments

In addition to the high level of risk, private equity investments are often illiquid. Unlike stocks or bonds, private equity investments are typically made in companies that are not publicly traded. This lack of liquidity can be a significant drawback for investors, as it means that they may not be able to quickly sell their investments in case of an emergency or if they need to access their funds.

High Costs and Fees

Another major drawback of private equity firms is the high fees and costs associated with their services. Private equity firms charge significant fees, both on the management and performance side, which can make these investments quite expensive. These fees can take a significant portion of the returns generated by the investments, leaving less profit for the investors.

Private Equity as a Last Resort for Organizations

Many organizations see private equity as a last resort for financing, often as a result of a leveraged reverse buyout to restructure the company. For example, Twitter has not generally utilized private equity to a significant extent, considering it an option only under certain circumstances. This usually indicates that PE firms are often seen as a punitive measure for organizations in financial distress rather than a first-choice investment.

Pros and Cons of Private Equity

While private equity does come with its cons, it also offers several pros, such as access to a network that can support business development activities and the provision of experienced management teams. Additionally, private equity can provide the necessary liquidity to fund capital expenditures, sales, marketing, and other crucial business activities. However, these benefits must be weighed against the potential downsides, such as shareholder dilution, loss of control over management, alignment of exit expectations, and the significant time and effort required to secure investment from a private equity firm.

It's important for organizations and potential investors to carefully consider these cons before engaging with private equity firms. Understanding the risks, costs, and potential illiquidity of these investments is crucial in making informed decisions that align with their financial goals and strategies.