Private equity refers to both the common stock of closely held companies and firms that invest primarily in the common stock of private or publicly traded companies on behalf of themselves and investors. When possible, private equity firms take controlling interests in target companies, because they are aware of the disadvantages to holding a minority interest in a privately held company. There are also advantages too, but the disadvantages generally outweigh the advantages.
The few recognizable advantages to investing in closely held minority interests generally are situational. One potential scenario is a target company that is well-managed and paying abnormally large cash dividends. In this case, an investor would not want to rock the boat and potentially would be able to participate in the investment, to some extent, with a lower cash outlay than would be required to purchase the entire company.
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Publicly traded companies must disclose quarterly and annual financial statements to investors and are subject to the rules of regulatory bodies ranging from the Securities and Exchange Commission to the Public Company Accounting Oversight Board. In addition, compliance costs related to the Sarbanes-Oxley Act of 2002, also known as the Company Accounting Reform and Investor Protection Act, are higher for public companies. According to a survey of 300 public companies performed by global consulting company, Protiviti, companies still are struggling to codify their internal control processes a decade after the Sarbanes-Oxley legislation. Another study, performed by William J. Carney of the Emory University School of Law, showed that annual compliance costs related to Sarbanes-Oxley are roughly $8 billion annually.
One of the major risks associated with minority private equity holdings concerns liquidity. A minority shareholder in a closely held company – particularly a small company – easily can find himself in a situation where no dividends to shareholders are paid and the stock holding is impossible to exit due to a lack of a market for the company's shares. This is a nightmare scenario for shareholders and it can be especially harmful to a portfolio in need of greater diversification.
Minority shareholders have little to no say in the corporate decision-making process. If at odds with the controlling shareholder, the minority shareholder usually has no realistic mechanism for enforcing his rights. Most states have minority dissent or minority oppression laws, but this is a costly alternative that will alienate controlling shareholders and management. And since private minority interests are illiquid, there usually is no way to get out of this situation except to sell your shares at a deep discount. Even obtaining a fair market value can be expensive, as closely held common stock appraisals typically are performed by financial experts.