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What’s it: Private equity is an investment vehicle focused on buying shares of prospective private companies to gain control over management and other operational changes to increase profitability. Thus, the target company can be sold profitably in the future.
Private equity is another vehicle for an alternative investment to hedge funds or assets in real estate and commodities. However, unlike hedge funds, they focus on direct investment to acquire control shares. Meanwhile, hedge funds focus on investing in securities issued by companies in the capital market, such as stocks and debentures, or other assets, such as commodities and real estate.
Private equity companies operate by relying on capital from accredited investors. Then, they use it to invest in private companies such as startups. They may also target public companies for privatization.
Obtaining higher returns and diversification are the reasons why investors invest in private equity. In addition, this investment vehicle allows private equity firms to work with target companies over the long term.
What are examples of private equity?
The Blackstone Group was the largest private equity firm in 2019, with $82.85 billion in funding. Here’s the complete list for the Top-20 (figures are in $ billions):
- The Blackstone Group: $82.85
- The Carlyle Group: $63.80
- KKR & Co.: $47.98
- CVC Capital Partners: $47.41
- Warburg Pincus: $36.56
- Bain Capital: $35.55
- EQT Infrastructure: $30.05
- Thoma Bravo: $29.88
- Apollo Global Management: $29.00
- Neuberger Berman: $28.88
- Hellman & Friedman: $26.90
- TPG Capital: $25.66
- EnCap Investments: $21.10
- Vista Equity Partners: $19.79
- Apax Partners: $18.62
- General Atlantic: $16.92
- Clayton, Dubilier & Rice: $16.51
- Permira: $16.39
- Advent International: $16.03
- Silver Lake: $15.00
How do private equity firms make money?
Private equity firms collect capital from investors and then manage it for investment. Some may take on debt to supplement capital. They then invest by buying the company. Their target is to get a controlling stake, so they have the power to influence management and operations. They may remodel significantly enough to have a high potential return when they sell, usually for three or five years.
The private equity firm then divests the target company when it has enough to sell. For example, they sell to outside investors like other private equity firms. Or, they divest their shares by selling the target company to the public through an initial public offering on the stock exchange. These two alternatives are common exit strategies for private equity.
In a specific case, the private equity firm makes a profit selling the target company’s securities. For example, under distressed investing, they acquire the target company’s debt securities at heavily discounted prices due to financial difficulties. And their prices go up once the target’s operations and finances are fixed.
Who is the target company in an acquisition by private equity?
Private equity buys private companies as targets. The target companies are usually young companies or startups with strong future growth potential. In other cases, the target is private companies with problems but have great potential to manage, for example, because they have a strong market position, strong brand equity, or a broad customer base.
However, in most cases, the target company is a public company. This is because their shares are listed on the stock exchange. And once purchased, the target company turns into a private company by obtaining a controlling interest.
How do private equity funds work?
Unlike most acquisitions, private equity firms usually seek to acquire a controlling interest. This is important because it smooths out their plans and programs to turn targets into profitable ones when sold.
Once holding a controlling interest, private equity firms generally adopt an aggressive strategy and develop ambitious but realistic growth plans. For example, they radically restructured finances and operations. Or they reorganize the target company and its management.
In fact, in some cases, private equity firms also lay off employees to support achieving targeted profits. They may also trim unprofitable divisions if needed.
This aggressive strategy aims to maximize profits as quickly as possible so they can be sold at a profit. Restructuring or reorganization allows the target company to regain its profits. Thus, their shares become more attractive when sold. If the company’s valuation is profitable enough to sell, the private equity firm will sell it to other investors. Or they sell them to the public via the stock exchange.
Involvement in operations
Private equity firms are usually not directly involved in running the target company’s business. And they take on a non-executive role. Instead, they contribute to the side where their skills as capital are required; for example, they help achieve a solid and efficient capital structure. In other cases, they facilitate strengthening governance or financial functions.
Private equity firms rely on key management to carry out their ambitious plans. Thus, they have a big hand in determining management or recruiting senior employees. They seek to place trustworthy professionals to run the business and execute their plans.
The key to successful private equity is ensuring the management team has the capability to execute their growth plans. They support the management team and ensure it is entirely focused on the plan.
Entrusting the business to the management team, of course, carries risks. For example, the old executive refused. Or the newly appointed executives are not acting in their best interests. In these cases, incentives are key. So, for example, old executives with heartfelt resign or new executives are motivated to run the business according to plan. Such incentives become the key to success for smooth operations.
Then, in some cases, private equity firms may become more deeply involved as venture capitalists do. And they take an active role in the operation.
What are the four types of strategies by private equity?
Private equity is divided into four based on their strategy. The four are:
- Leveraged buyouts (LBOs)
- venture capital
- Minority equity investing
- Distressed investing
Leveraged buyouts (LBOs)
Under leveraged buyouts (LBOs), private equity firms use debt to finance acquisitions. The target company is an established company or a public company. They use the target’s assets as collateral for the debt. And to repay the debt, they use the cash flow generated by the target company.
Venture capital
Unlike LBOs, venture capital targets companies with high growth potential. They are usually young companies or startups. Meanwhile, LBOs target established companies, which are identified as having an established market position rather than high growth potential.
Venture capital generally injects equity capital into the target company. In other cases, they may provide convertible preferred stock or convertible debt.
Venture capitalists are actively involved in running a business. They often hold positions on their boards of directors and assume key management roles.
Minority equity investing
Minority equity investing, also known as development capital, focuses on companies that are more mature than those run by venture capitalists. This strategy provides financing to help the target company grow. The capital they inject is vital for corporate actions such as financing strategic acquisitions or entering new markets. Under this strategy, private equity firms may also engage in operating restructuring.
Distressed investing
The distressed investing strategy targets companies in financial distress. Private equity firms assisted by purchasing the target company’s debt securities and obtaining the debt securities at a deep discount due to financial difficulties.
Under this strategy, private equity firms aim to profit when the price of the bonds rises after the target firms recover their finances. Restructuring the company operationally and financially is often a follow-up to a financing agreement. And they can play an active role in the health of the target company, although some may play a passive role.
Who invests in private equity firms?
Private equity is usually the investment vehicle for accredited investors such as insurance companies, pension funds, and endowments. In addition, some wealthy individuals may also be involved if they meet the conditions.
Private equity firms pool capital from these investors to invest. In some cases, they also raise capital from debt to fund acquisitions. Unlike hedge funds, they generally invest money directly into the company rather than in securities issued by the target company. They can take an active role in management or passive, depending on the strategy adopted.
What to read next
- Alternative Investment: Characteristics, Types, Investors, Pros, and Cons
- The Pros and Cons of Alternative Investment You Need To Know
- Hedge Funds: Examples And What Do They Do?
- Hedge Funds Strategy: Macro, event-driven, relative value, and equity hedge strategies
- Private Equity: Examples, Strategies, Targets, Its Ways To Make Money
- Private Equity Structure and Fee
- Venture Capital: How It Works, How It Makes Money, Investment Horizon
- What Are the 3 Stages of Venture Capital Financing?
- Leveraged Buyout (LBO): How it Works, Funding Sources, Criteria for Target
