What Is Private Equity?
Private equity describes investment partnerships that buy and manage companies before selling them. Private equity firms operate these investment funds on behalf of institutional and accredited investors.
Private equity funds may acquire private companies or public ones in their entirety, or invest in such buyouts as part of a consortium. They typically do not hold stakes in companies that remain listed on a stock exchange.
Private equity is often grouped with venture capital and hedge funds as an alternative investment. Investors in this asset class are usually required to commit significant capital for years, which is why access to such investments is limited to institutions and individuals with high net worth.
Key Takeaways
- Private equity firms buy companies and overhaul them to earn a profit when the business is sold again.
- Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.
- The private equity industry has grown rapidly; it tends to be most popular when stock prices are high and interest rates low.
- An acquisition by private equity can make a company more competitive or saddle it with unsustainable debt, depending on the private equity firm's skills and objectives.
Understanding Private Equity
In contrast with venture capital, most private equity firms and funds invest in mature companies rather than startups. They manage their portfolio companies to increase their worth or to extract value before exiting the investment years later.
The private equity industry has grown rapidly amid increased allocations to alternative investments and following private equity funds' relatively strong returns since 2000. In 2021, private equity buyouts totaled a record $1.1 trillion, doubling from 2020. Private equity investing tends to grow more lucrative and popular during periods when stock markets are riding high and interest rates are low and less so when those cyclical factors turn less favorable.
Private equity firms raise client capital to launch private equity funds, and operate them as general partners, managing fund investments in exchange for fees and a share of profits above a preset minimum known as the hurdle rate.
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Private equity funds have a finite term of 7 to 10 years, and the money invested in them isn't available for subsequent withdrawals. The funds do typically start to distribute profits to their investors after a number of years. The average holding period for a private equity portfolio company was about five years in 2021.
Several of the largest private equity firms are now publicly listed companies in the wake of the landmark initial public offering (IPO) by Blackstone Group Inc. (BX) in 2007. In addition to Blackstone, KKR & Co. Inc. (KKR), Carlyle Group Inc. (CG), and Apollo Global Management Inc. (APO) all have shares traded on U.S. exchanges. A number of smaller private equity firms have also gone public via IPOs, primarily in Europe.
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Private Equity Specialties
Some private equity firms and funds specialize in a particular category of private-equity deals. While venture capital is often listed as a subset of private equity, its distinct function and skillset set it apart, and have given rise to dedicated venture capital firms that dominate their sector. Other private equity specialties include:
- Distressed investing, specializing in struggling companies with critical financing needs
- Growth equity, funding expanding companies beyond their startup phase
- Sector specialists, with some private equity firms focusing solely on technology or energy deals, for example
- Secondary buyouts, involving the sale of a company owned by one private-equity firm to another such firm
- Carve-outs involving the purchase of corporate subsidiaries or units.
Private Equity Deal Types
The deals private equity firms make to buy and sell their portfolio companies can be divided into categories according to their circ*mstances.
The buyout remains a staple of private equity deals, involving the acquisition of an entire company, whether public, closely held or privately owned. Private equity investors acquiring an underperforming public company will often seek to cut costs, and may restructure its operations.
Another type of private equity acquisition is the carve-out, in which private equity investors buy a division of a larger company, typically a non-core business put up for sale by its parent corporation. Examples include Carlyle's acquisition of Tyco Fire & Security Services Korea Co. Ltd. from Tyco International Ltd. in 2014, and Francisco Partners' deal to acquire corporate training platform Litmos from German software giant SAP SE (SAP), announced in August 2022. Carve-outs tend to fetch lower valuation multiples than other private equity acquisitions, but can be more complex and riskier.
In a secondary buyout, a private equity firm buys a company from another private equity group rather than a listed company. Such deals were assumed to constitute a distress sale but have become more common amid increased specialization by private equity firms. For instance, one firm might buy a company to cut costs before selling it to another PE partnership seeking a platform for acquiring complementary businesses.
Other exit strategies for a private-equity investment include the sale of a portfolio company to one of its competitors as well as its IPO.
How Private Equity Creates Value
By the time a private equity firm acquires a company, it will already have a plan in place to increase the investment's worth. That could include dramatic cost cuts or a restructuring, steps the company's incumbent management may have been reluctant to take. Private equity owners with a limited time to add value before exiting an investment have more of an incentive to make major changes.
The private equity firm may also have special expertise the company's prior management lacked. It may help the company develop an e-commerce strategy, adopt new technology, or enter additional markets. A private-equity firm acquiring a company may bring in its own management team to pursue such initiatives or retain prior managers to execute an agreed-upon plan.
The acquired company can make operational and financial changes without the pressure of having to meet analysts' earnings estimates or to please its public shareholders every quarter. Ownership by private equity may allow management to take a longer-term view, unless that conflicts with the new owners' goal of making the biggest possible return on investment.
Making Money the Old-Fashioned Way With Debt
Industry surveys suggest operational improvements have become private equity managers' main focus and source of added value.
But debt remains an important contributor to private equity returns, even as the increase in fundraising has made leverage less essential. Debt used to finance an acquisition reduces the size of the equity commitment and increases the potential return on that investment accordingly, albeit with increased risk.
Private equity managers can also cause the acquired company to take on more debt to accelerate their returns through a dividend recapitalization, which funds a dividend distribution to the private equity owners with borrowed money.
Dividend recaps are controversial because they allow a private equity firm to extract value quickly while saddling the portfolio company with extra debt. On the other hand, the increased debt presumably lowers the company's valuation when it is sold again, while lenders must agree with the owners that the company will be able to manage the resulting debt load.
Why Private Equity Draws Criticism
Private equity firms have pushed back against the stereotype depicting them as strip miners of corporate assets, stressing their management expertise and examples of successful transformations of portfolio companies.
Many are touting their commitment to environmental, social, and governance (ESG) standards directing companies to mind the interests of stakeholders other than their owners.
Still, rapid changes that often follow a private equity buyout can often be difficult for a company's employees and the communities where it has operations.
Another frequent focus of controversy is the carried interest provision allowing private equity managers to be taxed at the lower capital gains tax rate on the bulk of their compensation. Legislative attempts to tax that compensation as income have met with repeated defeat, notably when this change was dropped from the Inflation Reduction Act of 2022.
How Are Private Equity Funds Managed?
A private equity fund is managed by a general partner (GP), typically the private equity firm that established the fund. The GP makes all of the fund's management decisions. It also contributes 1% to 3% of the fund's capital to ensure it has skin in the game. In return, the GP earns a management fee often set at 2% of fund assets, and may be entitled to 20% of fund profits above a preset minimum as incentive compensation, known in private equity jargon as carried interest.Limited partners are clients of the private equity firm that invest in its fund; they have limited liability.
What Is the History of Private Equity Investments?
In 1901, J.P. Morgan bought Carnegie Steel Corp. for $480 million and merged it with Federal Steel Company and National Tube to create U.S. Steel in one of the earliest corporate buyouts and one of the largest relative to the size of the market and the economy. In 1919, Henry Ford used mostly borrowed money to buy out his partners, who had sued when he slashed dividends to build a new auto plant. In 1989, KKR engineered what is still the largest leveraged buyout in history after adjusting for inflation, buying RJR Nabisco for $25 billion.
Are Private Equity Firms Regulated?
While private equity funds are exempt from regulation by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 or the Securities Act of 1933, their managers remain subject to the Investment Advisers Act of 1940 as well as the anti-fraud provisions of federal securities laws. In February 2022, the SEC proposed extensive new reporting and client disclosure requirements for private fund advisers including private equity fund managers. The new rules would require private fund advisers registered with the SEC to provide clients with quarterly statements detailing fund performance, fees, and expenses, and to obtain annual fund audits. All fund advisors would be barred from providing preferential terms for one client in an investment vehicle without disclosing this to the other investors in the same fund.
The Bottom Line
For a large enough company, no form of ownership is free of the conflicts of interests arising from the agency problem. Like managers of public companies, private equity firms can at times pursue self-interest at odds with those of other stakeholders, including limited partners. Still, most private equity deals create value for the funds' investors, and many of them improve the acquired company. In a market economy, the owners of the company are entitled to choose the capital structure that works best for them, subject to sensible regulation.
