A Guide To Understanding Private Equity

Some businesses have a great product but they lack the ability to scale their business model and really maximize their earning potential. That's where private equity can come in handy. Private equity investors scour the market for companies and products that need their help to grow. Partnering with the right investor can be a game changer for a small business. We’ll discuss how below.

What Is Private Equity?

Private equity (PE) is ownership or interest in an entity that is not publicly listed or traded. Private equity is considered an alternative asset class like real estate, venture capital, and distressed securities. Alternative asset classes are not easily accessible like stocks and bonds in the public market.

Private equity firms invest directly into mature or established companies to gain control over the company’s operations with the eventual goal of turning a profit. Most private equity firms will want large stakes of equity or ownership of the company to do so.

Funds with deep pockets dominate the industry because it takes a significant amount of capital to produce the kind of returns investors are looking for.

Private Equity Firms

A private equity firm is an investment firm that raises money from limited partners to form a fund. These funds often have a fundraising goal and once they’ve reached the amount of capital or number of limited partners allowed to invest, they close the fund and invest the capital.

Private equity firms prefer to take 50% ownership or greater, in the companies they invest in. The PE firm is taking a risk and investing in a company's future potential, they will want the ability to make decisions and change the course of business.

PE firms often own several companies at once, called a portfolio. The hope is that the companies will yield a hefty return when sold and the firm will be able to distribute proceeds to their limited partners.

Private Equity Investors

Private equity firms and investors come from a variety of backgrounds and each have their own unique approach to investing.

There are very hands-on PE firms that employ investor relationship managers, property managers, accountants and support staff to manage their portfolio and support the business in their growth.

Then there are passive investors who invest with no interest in managing or contributing to the day-to-day operation of a business. They’re strictly interested in the financial return.

Some PE investors have a specific area of expertise that they’re very familiar with. They may be able to use their experience and industry connections to improve the company’s performance. Private equity investors can wear many hats, acting as a business strategy consultant, leasing agent, etc.

As we stated before, private equity investment isn’t as easily accessible as stocks and bonds on the public market. Oftentimes funds are only accessible to accredited investors. The minimum investment varies by company and the rate of return is never guaranteed.

If you’re interested in becoming a private equity investor, speak with your financial advisor. They may have a firm or fund they can recommend. Remember though that private equity investment has little regulation or investor protections. Work with experienced financial professionals to ensure your investment strategy is strong.

Private Equity Funds

Private equity capital is raised from a pool of limited partners or investors to form a fund. Once the fund reaches the fundraising goal, the fund is closed and the capital invested into promising companies. Private equity funds operate differently from other investment vehicles like hedge funds and mutual funds.

Hedge funds differ from private equity funds in that they tend to operate in the public markets. Hedge funds invest in publicly traded companies, while private equity investors focus on investing directly into private companies.

Private equity raises capital from limited partners that are accredited. Mutual and Hedge funds raise capital from everyday investors and typically invest in publicly traded companies. Mutual funds are only allowed to collect management fees, while private equity funds can collect performance fees as well.

How Does Private Equity Work?

Private equity investors identify companies that are stagnant or potentially distressed but still show growth potential. They offer to purchase the business and offer their resources and expertise to grow the business. Along with the support and guidance comes an infusion of cash. That capital can help purchase inventory, innovate existing product offerings, upgrade equipment, etc.

The goal is to eventually sell the company for a profit once it has increased in value. The profits from the sale are then distributed to the limited partners. Many investors invest in multiple portfolios and asset types to ensure their investment is diversified.

Private Equity Is All Around Us

Private equity has quite the history. For a long time, these kinds of transactions went unnoticed but in 1901 Banking magnate JP Morgan conducted the first leveraged buyout of Carnegie Steel Corporation for $480 million. He merged Carnegie Steel Corporation, Federal Steel Company, and National Tube to create United States Steel. It had a market capitalization of $1.4 billion.

The 1933 Glass – Steagall Act drew the line in the sand between the banking and investment industry, forbidding a financial institution to be both a bank and a brokerage. Banks have a fiduciary duty to protect its members from risky activity, such as investing their hard-earned money without permission or input from them.

It wasn’t until the 1970s when venture capitalists began investing in America’s technology, that we really saw the power of private equity investment. Both Apple and Intel received venture capital funding. Private equity was gaining popularity and in 1988 RJR Nabisco purchased Kohlberg, Kravis & Roberts (KKR) for $25.1 billion, the largest transaction in private equity history up to that point.

In the years prior to the financial crash of 2008, private equity investment was booming. From 2006 to 2008 the private equity and alternative asset classes saw an incredible increase in activity. In 2007 before the major downturn of 2008 Goldman Sachs, TPG Capital, and KKR raised the required debt to buyout coal plant operator TXU Energy for $45 billion. Warren Buffett bought $2 billion worth of bonds from the new company. However, just seven years later, the purchase ended in bankruptcy.

A 2017 Harvard study reported global private equity groups raised $2 trillion between 2006 and 2008. According to the report, every dollar was leveraged by more than two dollars in debt. The study also found that companies backed by private equity performed better than their counterparts in the public markets.

Private Equity Investment Strategies

Private equity is a huge playing field and there are a lot of strategies investors use to make a profit. The following are a few strategies that are often used in private equity investment.

Leveraged Buyout (LBO)

A leveraged buyout (LBO) is when a PE firm purchases a company using financing, meaning the buyout is funded with debt. The PE firm may leverage the deal with their existing portfolio of companies and assets as collateral. This allows private equity firms to assume control of companies while only putting up a fraction of the purchase price, maximizing their potential return and creating wealth among their investors with less upfront cost.

Venture Capital

Venture Capital funding is a form of private equity that provides capital to entrepreneurs and small businesses. Many people associate venture capital with startups and young companies; while this is a common use for venture capital, this funding is not restricted to these companies. Private equity firms will often encounter these kinds of opportunities because they are actively seeking opportunities that are ready for growth or restructuring.

Many firms take advantage of some of these small companies' inexperience to gain control and earn significant profit later on with only a small initial investment. It can be very risky investing in a product or startup but the potential returns are worth the risk.

Distressed Financing

Distressed Financing is when a PE firm looks for assets and companies that are underperforming. Investors will seek out struggling companies to purchase, with the intention of changing the way they are currently doing business or to liquidate their assets for a profit.

Companies reporting poor sales or those that have filed Chapter 11 bankruptcy are prime candidates for private equity investment.

Real Estate Private Equity

Private equity investors typically invest in commercial real estate and real estate investment trusts (REIT). The minimum investment can be substantial and a real estate investor should anticipate those funds not being accessible for years at a time. Real estate investment became popular after the 2008 market crash when property prices were incredibly low. A lot of large underperforming portfolios were up for grabs.

Fund Of Funds

Just like it sounds, a fund of funds is simply investing in other funds, primarily mutual funds and hedge funds. Fund of funds allows investors that don’t have deep pockets access to investing in mutual funds and hedge funds. But be weary, many of these types of funds have a higher management fee rolled into the transaction.

Are Private Equity Firms Good Or Bad?

There are great advantages to private equity investment. Private equity provides an alternative to high interest loans or the tedious task of listing a company on public markets. Oftentimes the pressure to make enough money to stay afloat and turn a profit is too much to manage alone. Private equity investors can step in to provide the capital and expertise a company might need to become industry leaders and turn a profit for their investors.

There are disadvantages to private equity as well. Many firms are looking for a specific business with an expected return. It can be a challenge to find a firm or investor relationship that works for both the company and investor. There is little oversight of the private equity process and investor protections continue to be a major concern.

Many critics have concerns about PE firms backing certain types of business, healthcare systems being one example. A recent study examined private equity backed healthcare systems and showed a decrease in the quality of care and increased costs. Some critics question whether a for profit business model is a conflict of interest when dealing with human mortality.

The Bottom Line

Private equity investment is a great way to address the needs of a struggling business. The new business partnership can be beneficial for both parties. Having additional support can make room for innovation and take a business to the next level.

Be sure to discuss your investment strategy with a financial professional you feel comfortable with. If you’re ready to dip your toe in the investment pool, increase your knowledge of investment terminology and strategy by visiting the Rocket Money Learning Center.