What is Private Equity?
Private equity is money invested directly in a company by individuals or institutions. This money, usually a combination of debt and equity, is pooled from investors to acquire controlling interest in a company, and to maximize the value of that investment.
Private equity invests in operating companies that are private and not publicly traded.
Private equity firms use a significant amount of debt along with equity to invest in companies. This enables the firm to maximize their returns and make large buyouts without investing a lot of their own money.
Private Equity Firms
A private equity firm is an investment management company that makes investments in companies through various strategies including leveraged buyouts (LBOs), venture capital, and growth capital. These firms often pool funds to increase buying power and the number of investment options available to them.
Private equity firms use various approaches to make investments, including buying out existing investors, buying out the founder, providing capital for expansion and growth or providing recapitalization for a struggling business.
Private Equity Funds
A private equity firm raises capital through a private equity fund. These funds are structured as limited partnerships, with the limited partners providing most of the capital, and with the general managers managing the fund.
The limited partners can include:
- Endowment Funds
- Insurance companies
- Wealthy individuals
- Sovereign wealth funds
- Large Corporations
- Fund of Funds
How it Works
Private equity firms use their capital to invest in, or purchase, companies that can be made more profitable. Once this is accomplished, the firm sells their stake for a profit.
The goal is to find a company that could be improved through increasing efficiency or altering operations and then cash out the investment once the company has been made profitable.
Companies That Attract Private Equity
- Private Companies—companies that do not sell shares of stock on a public exchange, such as the NYSE or NASDAQ.
- Struggling Companies—publicly listed companies that have fallen on hard times and need to be restructured to become profitable again.
Target Companies for Private Equity Investment
- Companies where costs can be cut and efficiencies introduced
- Companies with hard assets that can be used as collateral for future debt
- Companies with little or no debt and strong cash flows
- Companies whose stock is undervalued
- Companies in a proven and mature market and high margins
- Companies with good management
- Companies that have exit opportunities
- Companies that have assets that can be sold
Private equity firms typically cash out their investments in three ways:
- Initial Public Offering (IPO)—selling shares of stock to the public for the first time; the firm takes their profit from the funds raised.
- Merger or Acquisition—selling the controlled company to another company.
- Recapitalization—the controlled company uses revenue, debt, or equity capital to buy back the private equity firm’s stake, restoring control to the minority shareholders.
Leveraged Buyouts (LBOs)
A leveraged buyout is one way to take a public company private. However, instead of using investor funds just to acquire a stake in a target company, private equity firms can combine investments with loan financing to increase their buying power. Debt, or “leverage,” usually makes up about 70%–80% of the total investment, much like a homeowner financing the purchase of a house with a mortgage. This allows private equity firms to buy entire companies, maximizing control and potential profit. Because fewer investor dollars are used, potential returns are higher, but if the investment fails, the cost is much greater because the loan must still be repaid.
Leveraged buyouts can also be executed by wealthy individuals or corporations, not just private equity firms.
LBOs have a negative connotation due to the media’s coverage of some of the largest and most notorious deals over the years. However, they can also be beneficial to the the company that is being bought out both in increased cash flow and rise in productivity.
Example of a Private Equity Investment
- An existing company has fallen on hard times and is likely to go bankrupt.
- A private equity firm uses $500 million in pooled funds—$100 million each from five investors—to invest in the company in exchange for a 70% ownership interest.
- Because it owns most of the company, the private equity firm has control over management decisions.
- 1. The firm uses this leverage to dictate hiring, firing, management, and operational choices aimed at increasing profitability as quickly as possible.
- 2. The firm does not manage day-to-day operations, but partners in the firm, for example, may be on the company’s board of directors.
- Five years later the company is doing very well. The private equity firm sells its stake to a larger company in the same industry that wants to control the competition.
- The private equity firm’s 70% ownership interest is now worth $2 billion, meaning the investment has made a profit of $1.5 billion.
- The private equity firm gets 20% of the gross profit from this investment, or $300 million. This is called the carried interest, or “carry”.
- Each investor gets back their original $100 million investment.
- The remaining 80% of the profit is distributed among the five investors, netting each an additional $240 million.