What is Private Equity? Understanding How it Works and It’s Impact on Business

What is private equity? Some people may think that because private equity is only accessible to the wealthy, there is no need to educate themselves on this topic. However, it’s essential to recognize that even average investors can have indirect exposure to private equity through pension plans or insurance policies, as these institutions often allocate portions of their portfolios to private equity funds. So what exactly is private equity and how can it affect your investments?

Private equity refers to capital investments made into companies that are not publicly traded on a stock exchange. The primary objective of private equity is to achieve high returns by actively managing a business. This article discusses the basic principles of private equity, how it works, the strategies involved, and its impact in the business world.

What is Private Equity?

Private equity firms pool funds from investors and use this capital to acquire stakes in companies to make them more profitable and later sell it at a higher value.

Private equity investments can take many forms, such as funding startups, growing companies, and buying out large, established businesses. Private equity focuses on active management, where the firm’s expertise and resources are used to improve the company’s operations and performance.

What’s the Difference Between Private Equity and Public Markets?

Private equity differs from public market investments like stocks traded on an exchange in several key ways:

Liquidity

Private equity investments are illiquid, meaning that investors cannot sell their stakes easily. By contrast, stocks in the public market can be bought or sold quickly.

Control and Influence

Private equity investors often have significant control over the companies in which they invest, influencing management decisions and strategic directions. Public shareholders typically have little direct influence. Also, private equity firms aren’t subject to the same disclosure requirements as public companies, so there is often limited information on their activities and financials.

Risk and Return

Private equity investments can offer higher returns, but they come with greater risk compared to more stable public investments.

High Fees

Private equity funds charge management and performance fees called carried interest. The fees can be substantial, reducing overall returns for investors. These fees, combined with large pay packages for private equity executives, can make the industry lucrative for managers, while not always delivering strong returns to investors.

How Private Equity Works

Private equity deals have different strategies, but the roadmap for setting up deals is generally the same.

Fundraising and Structure 

Private equity firms raise capital from institutional investors, such as pension funds, insurance companies, and endowments, and from individuals with high net worth. This capital is collected in a fund managed by a private equity firm. Investors in these funds are referred to as limited partners, while the private equity firm acts as the general partner responsible for making investment decisions and managing the fund.

Acquisition 

Private equity funds typically target companies that have potential for growth, operational improvements, or are undervalued. The acquisition can be a minority stake (partial ownership) or majority stake (complete ownership), depending on the strategy.

Creating Value 

Once the investment is made, private equity firms work to increase the value of the company. This might involve improving operations, streamlining management, expanding into new markets, or restructuring the company’s finances. The goal is to enhance the profitability and overall performance of the business.

Exit Strategy

After around three to five years, the private equity firm tries to exit the investment, ideally at a much higher valuation than the initial purchase. Common exit strategies include selling the company to another firm, going public through an initial public offering (IPO), or selling a stake in the company to another private equity fund.

Types of Private Equity Investments

Several types of private equity funds are available. The following are some of the more common examples:

Venture Capital

The focus of a venture capital private equity fund is typically on funding early stage startups such as tech and biotech companies and companies with high growth potential. These tend to be riskier investments; however, there is potential for substantial rewards. 

Growth Equity

The focus with the growth equity (or growth capital) strategy is established companies that need capital to expand or restructure operations or may be looking to enter new markets. 

The risk involved with these investments tends to be more moderate because they generally have more established revenue streams. But there is still risk associated with potential growth challenges.

Leveraged Buyouts 

A leveraged buyout fund strategy involves acquiring majority control or full ownership of established companies using borrowed funds combined with investors’ money. This strategy focuses on making a company more efficient and profitable.

The risk varies depending on the amount of debt used. 

Distressed Investments

Distressed funding involves investing in companies facing financial trouble but having the potential to turn around. Companies in this category include those that filed for Chapter 11 bankruptcy. 

These are considered high-risk investments because they involve restructuring companies with existing operational or financial issues.

Ways Private Equity Firms Improve Businesses

Companies acquired by private equity firms benefit by receiving substantial funding for growth, acquisitions, or other strategic initiatives. Private equity firms also bring industry knowledge, experienced management, and a network of connections to help improve business operations.

As the goal of a private equity firm is to improve a business and increase its value, the firm will implement a few different strategies to increase operational and financial efficiency.

Operational Improvements

Private equity firms often bring in new management teams or implement performance-enhancing measures such as automating processes or reorganizing company structures.

Industry Consolidation

Private equity firms may buy several smaller companies within an industry and merge them to create a more competitive and efficient business entity.

Growth and Expansion

Private equity firms often provide the necessary resources and expertise to help companies scale operations, enter new markets, or develop new products.

Employment Restructuring

While private equity investments can create new employment opportunities, they can also lead to job losses, especially if the firm cuts costs or restructures a business.

Criticism of Private Equity

The main criticism of private equity is that the sole focus is on financial gain with little regard for the long-term health of the company or their impact on the community. Oftentimes, cost-cutting measures result in layoffs, wage cuts, or reduced employee benefits.

For companies that were acquired as leveraged buyouts, the debt burden can weaken companies financially, and cause permanent damage while allowing private equity firms to walk away with their profits. 

Private equity firms have also been accused of “asset stripping,” selling off valuable parts of a business, such as real estate or valuable product lines, to generate quick returns, potentially leaving the core business weaker. Examples include the restaurant chain Red Lobster and retail chain Toys R Us. 

Another criticism is that as private equity firms grow and acquire more companies within the same industry, they could reduce competition, potentially driving up prices and reducing consumers’ choices.

Is Private Equity Worth investing in?

Private equity is a powerful tool that can transform companies. Private equity firms can drive business growth and generate high returns for investors by providing capital, strategic guidance, and operational expertise. 

Although private equity isn’t accessible to the general public, understanding private equity provides valuable insight into how capital markets work and the strategies used to create value in the business world.

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