What is Private Equity?
A beginner's guide to understanding the world of Private Equity (PE).
If you’re any bit familiar with the broad world of finance, you’ve likely heard of Private Equity. There’s lots of chatter swirling online about PE (some good and some bad), but what really goes on with these companies? How do they work?
The Basics of PE
At a broad level, private equity encompasses investment in companies that are not publicly traded, meaning that ownership in these companies cannot be purchased through the stock market.
Typically, private equity firms consist of a Private Equity Firm (“General Partner”) and investors (“Limited Partners”) who bring together capital and investment management expertise to form a Private Equity Fund (“Limited Partnership”), where the fund owns and manages a pool of portfolio companies. I borrowed a clean image of this dynamic from Moonfare, as shown below:
Private equity funds typically have lifespans with three main phases, as described below:
Formation/Fundraising: The period leading up to the launch of the fund where the partnership is created, strategy is determined, offering documentation is created, and initial target companies are identified.
Investment: Point in time where the fund makes investments in target companies, capital calls are made (asking investors to send money to the fund), and works with the target/purchased company to ensure smooth operation and drive potential returns to investors.
Harvesting: The period where the fund manager exits (sells off) the target companies and distributes capital back to the initial investors.
In short, these funds raise money from institutional and/or accredited investors, then buy out companies with the goal of increasing their value and selling them for a gain.
The Different Forms of PE
Private equity, as previously mentioned, involves just about any situation that has to do with the funding, ownership, and management of businesses that are not publicly available for investment. There are different types of PE firms and funds, simply explained right below:
Leveraged Buyout (LBO): This fund strategy combines investment funds with borrowed money. Typically, the PE firm will use investor funds and credit from banks to raise enough money to buy a company outright, or at least enough to gain controlling interest in a company. A PE fund might buy a business worth $400m by using $100m of equity (investor funds) and borrowing $300m from the bank, then try to sell the business for $600m a few years down the road.
Venture Capital (VC): This form of PE is concerned with buying stakes in early-stage startup companies that have high growth potential. Unlike LBOs, they typically take a minority stake in companies and leave company management to run the business. VC is a very high-risk strategy since most of the target companies are making little to no money at the time of investment, but the payoff can be tremendous if a business takes off. Success rates are low, but returns are massive for the few that make it.
Growth Equity: Growth equity funds invest in mature businesses with the goal of boosting expansion. Typically, these funds are looking for businesses that have proven to be profitable and sustainable, but are looking to work their way into new markets or purchase new companies. It’s a strategy that can allow for high returns with moderate levels of risk.
Real Estate Private Equity (REPE): These funds invest in properties, ranging from low-risk rental properties to speculative development deals that come with higher return potential and more risk.
Infrastructure: These funds are similar to REPE, but are focused on acquiring, operating, and selling assets that have to do with utilities, transportation, social infrastructure, energy, and renewable energy. These businesses are stable and offer relatively low risk.
Fund of Funds: These funds don’t invest directly in companies, but rather buy into a portfolio of various other types of PE funds (like the ones previously mentioned). This allows investors to diversify and gain access to other types of lucrative funds that they may not have had access to.
Mezzanine Capital: This is raised capital that has features of both debt and equity, and is typically raised for special projects, growth, acquisitions, and/or buyouts. It’s riskier than debt, but less risky than equity, and it offers returns in line with its risk profile. Mezzanine capital gets paid before preferred and common stock, but not before creditors.
Distressed PE: Also known as special situations, these funds lend money to companies in financial crises. They generally buy companies during bankruptcy or restructuring to get a lower purchase price, then work to “fix” the companies and sell them for a gain. On occasion, they’ll even take these companies to be listed on public exchanges.
Secondaries: These funds typically buy out the holdings of investors who are involved in limited partnerships (as described earlier in this writeup). If one of the limited partners needs or wants to sell their stake in a fund before the harvesting period, the only way to do so is through secondaries.
Why is There Controversy Around PE?
Private equity funds are beholden to their investors and creditors, and this sometimes incentivizes funds to prioritize short-term returns over all else. The type of PE fund that generally gets called out in the mainstream is the LBO, since the fund has a large debt obligation that must be paid off - even if it means job cuts and operational strain.
Critics argue that private equity funds are specifically engineered to benefit LPs and GPs at the expense of product quality, headcount, and long term sustainability. The carried interest loophole also gets a lot of negative press because it allows executives to pay lower taxes on payouts than they would on wage work of the same rate (I personally think we should all be taxed less for what we get in return at present - I’d happily pay more if funds weren’t misused by government entities). There is also criticism that the PE industry is opaque because of the way it operates, and that companies owned by PE are said to have higher risk for failure.
My personal opinion? PE is like anything else, where there are plenty of good, bad, and ugly outcomes across a broad spectrum of investments and operations. Many PE firms provide capital and expertise to companies that would otherwise stagnate or fail, so it’s not accurate to say that it’s a malicious industry that only causes harm and strife.
PE firms, like any other private enterprise, are only as successful as the market’s willingness to adopt their products and services at agreed-upon prices. It does model as the poster child for “the rich get richer” so I can definitely see why it’s not extremely popular with the public, especially during times of extreme wealth inequality.
Conclusion
I hope this was valuable learning! PE is a stimulating line of business to learn and can provide very lucrative opportunities, so it’s good to be knowledgeable about it (even if you have little interest in business).
Jared