What Is Private Equity?
A private equity definition sounds like a confusing concept. If you are familiar with trading, you know that equities are ownership stakes in a company that are bought and sold on the stock market.
Your first assumption may be that private equity is simply a stake held by a private citizen as opposed to a legal entity like a corporation. This is incorrect.
In order to define private equity, it is important to note the fact that there are different kinds of asset classes. An asset class is a category of securities that behave similarly and carry the same features. Asset classes are largely divided into two main groups:
- Equities (also known as stocks)
- Fixed-income (also known as bonds)
Other categories, like cash instruments and real estate, can be added to that list. Asset classes are balanced in a portfolio in varying ways depending on an investor’s strategy and risk tolerance. For the purpose of defining private equity, we will focus on stocks.
What Is Private Equity Versus Publicly-Traded Stocks?
The type of security most people are familiar with is the kind made available to the public and traded on stock exchanges. These become available when companies go public. The lesser known security is private equity.
Image source: Pixabay
What is private equity you ask? It is the money and debt invested in companies, and it is not publicly listed. A public company either becomes delisted by having most of its equity acquired by a firm or if it is bought out.
Sounds confusing, doesn’t it? Think about it like this: If Company A is doing poorly or hopes to grow, it needs more funds. Generally speaking, the obvious options are to:
- Get a loan from a financial institution
- Get a loan from the public through bonds
- Become a publicly-traded company and gain investors
There is another option that may not come to mind to some observers: private equity. What is private equity to a private company looking to grow? It is a way for it to gain investors without the complications of an initial public offering (IPO) and, in some cases, gain expert management advice.
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What Is a Private Equity Firm?
Keep in mind, in order for private equity to be effective, there needs to be a lot of it. This is where private equity firms come in. So, exactly what is a private equity firm? A private equity firm raises enough money to acquire a company, fatten it up, and then sell it for profit. It’s hard to define private equity without a private equity firm definition. These firms raise the capital that makes private equity possible.
What is a private equity firm to the individual investor? Not much. In fact, private equity firms almost exclusively raise money for their funds through what is known as institutional investors, such as pension funds, insurance companies, banks, and more. Any individual investors that are involved have a high net worth and a steep buy in price.
Individuals that are able to participate in private equity funds are known as accredited investors. Once upon a time, if you asked someone, “What do private equity firms do?” chances are, they shrugged and said that’s something only super wealthy people bother themselves with.
To an extent, this was true, and it’s why there has, traditionally, been little government protection. Unlike the everyday investors putting their money in the stock market, people investing in private equity have a lot of money and, therefore, a greater ability to absorb losses.
This has recently changed since pension funds – which affect the retirement of everyday people – are often put into private equity funds. However, the definition of private equity as a rich man’s game has remained. Therefore, in order to gain access to private equity investments, one has to become an accredited investor by demonstrating he/she has a certain income or net worth. The specifics are outlined in the Securities Act of 1933.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which was passed after the 2008 financial crisis, made a change that excluded a person’s primary residence from being included as part their net worth for these purposes.
While all private equity firms fall under our earlier private equity firm definition, different firms boast various specializations and expertise. They typically fall into one of two groups. They are either:
- Passive investors: the focus is on gaining returns for their clients, and they leave growth solely up to the company’s management
- Active investors: they provide management consulting and strategy for their clients to help grow the company
At the end of the day, what is a private equity firm without companies that are willing to use its services? Not much. As a result, firms have to build positive relationships with C-level executives and members of the financial industry that mediate mergers and acquisitions.
What private equity firms do is help finance or strengthen a company, so, on its face, it sounds like they hold all the power. On the contrary, it is ultimately up to the seller to determine who gets a claim to the company. This means firms must offer attractive perks in addition to their investment help, like operational or strategic advice.
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What Is a Private Equity Fund vs. a Private Equity Firm?
A private equity fund is the name of a particular investment scheme or strategy. A private equity firm may be responsible for a number of different private equity funds. Some of the largest U.S. firms based on private equity raised and managed include:
- The Carlyle Group
- Kohlberg Kravis Roberts
- Ares Management
- Apollo Global Management
- Clayton Dubilier & Rice
What Do Private Equity Firms Do to Raise Their Funds?
The movement away from a manufacturing economy to a service economy means money is going towards recruiting the best and brightest to work for financial institutions and consulting companies. Private equity firms are no exception. What private equity firms do is go on university campuses and recruit top talent to come work for them to help source and execute complex deals.
Even though what private equity firms do is related to investments, there are still a variety of professionals that occupy these firms, including lawyers and accountants. These are necessary to navigate all the complex regulations and details vital to these large-scale financial transactions.
Selling companies for a profit is ultimately what private equity firms do. The job leading up to that can be understood in three steps:
- Raising the funds
- Finding suitable companies and acquiring them
- Improving the company
This step-by-step breakdown provides a more operational private equity fund definition. It is basically a firm that sources, acquires, improves, and then sells a company.
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What Do Private Equity Firms Do to Raise Money?
Image source: Pixabay
Private equity firms acquire capital for the funds in a number of ways. They can get a portion of the money through commercial loans. They market the strategy of their fund on the strength of their managing investor or the reputation of the firm in order to attract institutional investors (and some accredited investors). What private equity firms also do is contribute some of their own capital. This is even more necessary if a firm is relatively newer.
What Do Private Equity Firms Do to Determine Which Companies They Want to Acquire?
However talented a private equity firm’s team may be, it is not interested in taking on companies that are destined to fail. Before investing so much capital in acquiring a company, what private equity firms will do is look at a company’s:
- Financial record
- Management team
- Products or services
- The state of its industry
These are important factors to consider. In some cases, improving a company may be as simple as investing money into developing a more sophisticated supply-chain management system. However, that will only work if there is demand for the product they are producing in the first place.
Once a company has been chosen, what do private equity firms do? For starters, they conduct thorough research to ensure the information they’ve gathered on the company checks out. They also consider possible exit strategies for eventually selling it for a profit.
Relationship management is also vital to what private equity firms do. The firm’s partners must develop and cultivate ties with investment professionals throughout the industry. These relationships make it easier to get a head start or preferential treatment over other potential private equity firms when a desirable company begins looking for private equity. When this is not the case, a private equity firm is chosen through an auction.
What Do Private Equity Firms Do to Improve the Company?
The level of involvement a private equity firm will take in the day-to-day operations of a company varies. As mentioned earlier, what some private equity firms do is take a passive approach, where they simply find investment for the company and leave management to the company leadership. Others take a more active, hands-on role because they have management experts on staff.
Sometimes, the level of involvement has less to do with the firm and more to do with the firm’s stake in the company. If it has a huge stake, then it will be more involved, perhaps by taking board seats and providing advice on operations. What private equity firms can also do is make changes to senior management and streamline processes to ensure the company is as profitable as possible when it is time for them to exit.
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What Do Private Equity Firms Do to Make Money?
The investment horizon of a private equity fund can be anywhere from a couple of years to seven years. This all depends on the investment strategy of the fund. This means that whatever profit they’re planning to make isn’t coming until several years after the initial investment. So what do private equity firms do to make money in the meantime?
They charge management fees, which some people refer to as private equity fees. These fees are charged annually and are normally about 2%. That may not sound like a lot, but when you consider that these funds being managed can total a couple billion dollars, that’s a lot of money. In this way, private equity fees ensure that firms make money even if they aren’t that successful in making the company profitable.
The private equity fee based on performance is also known as carried interest. This is a percentage based on the amount of profit made by the investments. Management fees are subject to income tax rates. Carried interest gets a lower tax rate because it falls under the category of long-term capital gains. Income that falls under this category isn’t taxed as heavily. This was originally implemented to encourage investment, but this loophole has come under much criticism in recent years for the huge tax break it affords the wealthy.
Private equity is one of the various assets available in the financial industry. Understanding exactly what private equity firms do can be challenging because of how exclusive it can be. Traditionally, it’s only been accessible to institutions or extremely wealthy individuals. However, learning even the basics of what private equity is can be helpful for understanding capital growth and how important investments, like your pension, are being managed.
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