Private Equity – Everything to Know

What is private equity?

Private equity is a type of investment that involves the funding of a company or enterprise by private investors, rather than through public markets.

These private investors can be either individuals (known as “angel investors”) or institutional investors, such as traditional leveraged buyout investors or venture capitalists.

What is a private equity firm?

A private equity firm is an investment firm that specializes in making private equity investments.

Private equity firms typically use a hands-on approach to their investments, and they often take an active role in running the companies they invest in.

What is a leveraged buyout (LBO)?

A leveraged buyout (LBO) is a type of private equity transaction in which a company is purchased with a combination of debt and equity financing.

In an LBO, the private equity firm provides a portion of the funding for the purchase, usually anywhere from 20 to 50 percent, while the rest is borrowed.

The origin of the leveraged buyout (LBO)

Leveraged buyouts gained popularity in the 1980s as a way to take companies private using smaller amounts of equity and larger amounts of debt to magnify investment returns.

Back then, it was more common for companies to be run inefficiently with lower regard for shareholder value, and private equity firms saw an opportunity to turn these businesses around by implementing more disciplined management practices.

What are the benefits of private equity?

There are a number of benefits that can be gained from private equity investments.

One benefit is that private equity firms tend to have a lot of experience and expertise in turning around underperforming companies.

This can result in significant improvements in profitability and shareholder value.

Another benefit is that private equity firms often invest for the long term, which gives them an incentive to make sure that the businesses they invest in are well-positioned for sustainable growth.

What are the risks of private equity?

Private equity investments are not without risk.

One of the biggest risks is that the private equity firm may not be able to successfully turn around the company, which can lead to substantial losses for investors.

Another risk is that private equity firms often use leverage to finance their investments, which can magnify both the potential upside and downside of an investment.

Types of private equity

Leveraged buyouts

Leveraged buyouts (LBO) involve the purchase of a company using a combination of debt and equity financing.

The private equity firm will typically put up a portion of the capital, and borrow the rest.

The goal of an LBO is to increase the value of the company so that it can be sold at a profit in the future.

Venture capital

Venture capital (VC) involves investing in early-stage companies that have high growth potential.

VC firms typically provide funding for startups in exchange for an equity stake in the business.

Growth equity

Growth equity is a type of private equity investment that focuses on investing in companies that are already profitable, but have potential for further growth.

Growth equity firms will typically provide funding in exchange for a minority stake in the company.

Distressed investing and special situations

Distressed investing involves investing in companies that are in financial distress, such as those that are facing bankruptcy.

The goal of distressed investing is to turn around the company and make it profitable again.

Special situations involve investing in companies that are going through a major change, such as an acquisition or a management shakeup.

The goal of special situations investing is to take advantage of the situation and make a profit.

Private equity fund of funds

Fund of funds invest in other private equity investment vehicles.

This type of private equity investment can provide access to a diversified portfolio of private equity investments.

Real estate private equity

Real estate private equity investing involves the purchase and ownership of real estate properties.

The goal of real estate private equity is to generate returns through appreciation and rental income.

Specialty funds

Like real estate, there are many types of specialty funds in private equity.

This might include tech-focused funds, which tend to be concentrated in the Bay Area in the United States rather than New York like traditional buyout funds.

Others include energy and power, which are more commonly concentrated in Houston in the US due to the region’s oil and gas industry.

Infrastructure is also popular as a private equity specialty.

Search fund

A search fund is when an entrepreneur is looking for a certain type of business to manage with the intent to take over as CEO or operator once acquired.

Royalty fund

A royalty fund buys companies with the intent of owning the royalties that these types of companies produce.

This might include owning drug patents, mineral rights, music royalties, and so on.

Private credit

Private credit is like private equity but operates in the credit market instead.

Private credit will often provide loans to corners of the market that traditionally have trouble accessing bank loans due to their risk, location, type of project, and so forth.

This might include loans to small businesses or private equity firms for their portfolio companies.

Merchant banking

Merchant banking is a private equity investment strategy that involves providing capital and financial services to companies.

This might include funding for expansion, mergers and acquisitions, or other strategic initiatives.

What is a private equity firm’s investment process?

The private equity firm’s investment process typically follows these steps:

#1 Screening

The private equity firm will screen companies to find those that meet its investment criteria.

#2 Due diligence

Once a company has been identified, the private equity firm will conduct due diligence to assess the company’s financial condition, business prospects, and management team.

#3 Negotiation

If the private equity firm decides to move forward with an investment, it will negotiate the terms of the deal with the company.

#4 Closing

Once the terms have been agreed upon, the private equity firm will close the deal and take ownership of the company.

#5 Exit

The private equity firm will eventually exit the investment, typically through a sale of the company or an initial public offering.

Private equity vs. Hedge funds

Private equity firms typically take an active role in the companies they invest in, whereas hedge funds take a more hands-off approach.

Hedge funds also tend to be more liquid than private equity due to the nature of what they trade or invest in, meaning that investors can withdraw their money from a hedge fund more easily.

Finally, private equity firms typically invest in companies that are growing (especially in growth equity and venture capital), while hedge funds may invest in companies of all sizes.

The BEST Beginner’s Guide to Hedge Funds, Private Equity, and Venture Capital

How private equity firms are structured

Most private equity firms have a three-tier structure, with a team of partners at the top, followed by a group of directors and then a team of associates.

The partners are the decision-makers at the private equity firm, and they are responsible for making investment decisions, raising capital from investors, and managing the firm.

The directors are typically experienced professionals who work with the partners to identify and evaluate investment opportunities.

The associates are junior members of the team who support the partners and directors in their work.

Some private equity firms will also have analysts under the associates.

Some PE firms will also have interns from college or business schools, which feed into the analyst and associate programs, respectively.

Private equity firms also have a back office team that is responsible for support functions such as accounting, legal, and compliance.

Private equity fund structuring

For PE fund structuring, this video provides a good overview:

What private equity firms look for in an investment

When considering an investment, private equity firms will typically look for companies that have the following characteristics:

High growth potential and/or consistent income production

Private equity firms invest in companies that they believe have the potential to grow at a fast pace or have consistent cash flow.

A strong management team

Private equity firms want to invest in companies that have a management team in place that can execute on the business plan.

A niche market

Private equity firms typically invest in companies that serve a niche market as this can provide a competitive advantage.

A viable exit strategy

Private equity firms will typically only invest if there is a clear exit strategy in place, such as an IPO or a sale to another company.

How private equity firms are regulated

In the United States, private equity firms are regulated by the Securities and Exchange Commission (SEC).

Private equity firms must register with the SEC if they manage more than $150 million in assets by submitting a Form PF.

Private equity vs. Public equity

Private equity is different from public equity, which refers to stocks that are traded on the stock market.

Public companies are typically much larger than private companies and they are owned by a large number of shareholders.

Private equity firms tend to be much more hands-on with their investments than public equity firms.

PE firms will often take an active role in running the companies they invest in, while public equity firms usually take a more passive approach.

Private equity firms also tend to have a longer time horizon for their investments than public equity firms.

They will typically hold onto their investments for 5-10 years, while public equity firms typically have a holding period of shorter durations, partially attributed to the greater ease of selling liquid investments versus their private counterparts, which are naturally sold infrequently.

How do private equity firms make money?

Private equity firms typically make money in one of a few ways:

Cash flow from portfolio companies

Portfolio companies will generate cash flow can be held for longer durations rather than sold.

Recapitalization

PE firms may often perform what’s called a recapitalization to realize returns.

Cash is distributed to the shareholders (in this case the private equity firm) either from cash flow generated by the company or by raising debt or other forms of securities to fund the distribution.

Sell portfolio companies

Selling portfolio companies at a higher price than where they were acquired is a popular strategy, either to a secondary buyer (i.e., another private equity firm), through an IPO, or a merger or acquisition with another company.

Carried interest

Carried interest is a portion of the profits that private equity firms receive when they sell an investment.

This profit is typically 20 percent, which means that private equity firms only make money if their investments are successful.

Through management fees

Private equity firms charge their investors a management fee, which is used to cover the costs of running the business.

Criticism of carried interest

Carried interest is the portion of profits that private equity firms typically keep for themselves.

This has come under criticism from some quarters, who argue that private equity firms are essentially just managing other people’s money and should not be entitled to such a large share of the profits and essentially serves as a “tax loophole”.

Additionally, private equity firms have been criticized for their lack of transparency and for engaging in activities that may be harmful to the companies they invest in.

How to invest in private equity

There are several ways to invest in private equity:

– Directly: The most common way to invest in private equity is to do so directly, through a private equity firm.

– Funds of funds: Another way to invest in private equity is through a fund of funds. This is an investment fund that invests in other private equity funds.

– Secondary market: The secondary market is a market for private equity investments that have already been made. Investors can buy and sell these investments on the secondary market.

– Public markets: There are also a number of public companies that invest in private equity, such as KKR (KKR), Blackstone Group (BX), and Carlyle Group (CG).

How to get into private equity

For those looking at how to get a job in private equity, the traditional path is to get an investment banking internship in college, parlay that into a full-time job as an investment banking analyst, then use that as a stepping stone to private equity after two years in the i-banking analyst role.

Some larger buyout firms also accept applicants right out of college, though these spots are competitive and applicants tend to disproportionately be from schools such as Wharton and Harvard.

How to Get Into Private Equity ($300K+ 2 years out of college) | Process & Study

Private equity firms and taxes

Private equity firms have come under scrutiny in recent years for their use of tax-advantaged structures, such as carried interest.

These structures allow private equity firms to pay a lower tax rate on their profits than they would if they were taxed at the corporate rate.

The private equity industry has also been criticized for its lack of transparency.

Private equity firms are not required to disclose their investments or performance publicly, which makes it difficult for outsiders to assess their performance.

Private Equity – FAQs

How do private equity firms make money?

Private equity firms typically make money via the following tactics:

• By selling the company for more than they paid for it
• By taking the company public through an initial public offering (IPO)
• Merging it with another company
• Performing a recapitalization to distribute a dividend to shareholders (i.e., the private equity firm)

Private equity firms will also charge fees for their services, which are typically a percentage of the funds invested (i.e., management fees).

How do private equity firms handle their investments?

Private equity firms typically have a hands-on approach to their investments.

They will often take an active role in running the companies they invest in, while public equity firms usually take a more passive approach.

Private equity firms also tend to have a longer time horizon for their investments than public equity firms.

What is a private equity fund?

Private equity funds are investment vehicles that pool together capital from multiple investors. These funds are then used to invest in private companies.

Private equity funds are typically structured as either limited partnerships or limited liability companies.

What are the benefits of private equity?

There are a number of benefits of private equity:

– Private equity firms can provide capital to help companies grow and expand.

– Private equity firms can help turn around struggling companies.

– Private equity firms can bring operational and managerial expertise to their portfolio companies.

What are the risks of private equity?

There are also a number of risks associated with private equity:

– Private equity firms may take on too much debt in their leveraged buyouts, which can lead to financial distress for the companies they invest in.

– Private equity firms tend to lack transparency due to their mostly private nature (though more have gone public over time).

– Private equity firms may have a conflict of interest, as they are typically more interested in making a profit for themselves rather than maximizing the value for all stakeholders.

What are private equity firms looking for in their investments?

When considering investments, private equity firms will typically look for companies that fit the following criteria:

• Companies that are undervalued by the market
• Companies with high potential for growth
• Companies that are going through a major change
• Companies in financial distress
• Real estate properties with high potential for appreciation or rental income
• Companies with cash flow and low debt so they can be leveraged up and have cash flow to pay the debt down over time
• Synergies with other portfolio companies of the private equity firm, which can lead to cross-selling opportunities, mergers, and potential scale

Summary – Private Equity

Private equity is a type of investment that is made into private companies.

Private equity firms typically make money by either selling the company for more than they paid for it or by taking the company public through an IPO.

They may also simply hold a company and collect its cash flow.

Private equity can provide capital to help companies grow and expand, turn around struggling companies, and bring operational and managerial expertise to their portfolio companies.

However, private equity firms may also take on too much debt in their leveraged buyouts, which can lead to financial distress for the companies they invest in.

When considering investments, private equity firms will typically look for companies that are undervalued by the market, have high potential for growth, or are going through a major change.

Private equity can be a risky investment, but it can also lead to high returns if done correctly.

Private equity firms typically have a hands-on approach to their investments and a longer time horizon than public equity firms.

Private equity funds are investment vehicles that pool together capital from multiple investors, which is then used to invest in private companies.

Private equity funds are typically structured as either limited partnerships (LP) or limited liability companies (LLC).

There are a number of benefits and risks associated with private equity investments.

When making investment decisions, private equity firms typically look for companies that are undervalued by the market, have high potential for growth, or are going through a major change.