Private equity is money invested directly in a company by individuals or institutions.
Private equity firms pool money from investors, acquire controlling interest in a company, and then look to maximize the value of that investment.
Public vs. Private equity
The money a company earns from selling shares of stock to investors is called ”public equity.” ”Private equity,” therefore, is money that companies get from direct investments rather than selling shares of stock to the public.
Private equity firms
To increase buying power, private investors, including financial institutions and wealthy individuals, often pool their funds to increase the number of investment options available to them. The companies that manage these pooled funds are called ”private equity firms.”
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.
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.
Typical 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—$1 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.
- The firm uses this leverage to dictate hiring, firing, management, and operational choices aimed at increasing profitability as quickly as possible.
- 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.
- 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.
Companies that attract private equity
Two types of companies typically use 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.
Private equity vs. Mutual funds
Private equity firms operate much like a mutual fund, which pools contributions from many people and invests those funds in stocks, bonds, and other assets, but there are some very important differences:
|Mutual Funds||Private Equity Firm|
|Average Annual Management Fee||
|Amount of Profit to Investors||
Private equity vs. Venture capital
Private Equity and Venture Capital share many similarities, but they differ in many ways, including the size and structure of their investments. Here is a breakdown:
|Private Equity Firm||Venture Capital|
- Leveraged Buyout—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, 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.
- Venture Capital—When an investment firm uses funds to invest in a younger company with a lot of potential. Since most new businesses fail, there is a high risk of losing money, but since the firm is taking on such huge risks, the new company typically compensates the firm with an increased ownership stake, making the potential profit very high.
- Often confused with private equity, venture capitalists focus on a different kind of company for investment, though their end goal is the same.
- One of the most famous leveraged buyouts in history took place in 1989, when KKR (Kohlberg, Kravis, Roberts & Co.) bought out RJR Nabisco for $31 billion, the biggest deal of its time. This paved the way for modern private equity investing.
- In 2016 the total value of all private equity–backed buyouts was $319 billion.
- A job at a private equity firm could earn someone an annual salary of up to $350,000 after just three years.