Private equity is the equity in an asset that is not freely tradable on the public share markets. In today’s market, ‘private equity’ refers to any money invested with non-public companies which expects a yield for the use of the capital. Also, private equity can refer to buying public companies with the intention of making them private in the future. With either definition the idea is simple, private equity provides funding to companies that do not want to go public.
A private equity firm is the controlling partner in a collection of partnerships that have come together to pool their capital and invest in a particular opportunity.
Private equity firms constitute a pool of private investors, referred to ‘limited partners’, who enter into a partnership with the general partner – the managing principals of the private equity firm, in anticipation of generating very significant returns on their investment. The limited partners are usually large institutional investors with an overabundance of money to invest, such as pension funds, university endowment funds, insurance companies and large money management funds.
Because of the outsized return on investment, private equity firms might be considered extremely attractive for high-net-worth individuals and institutional investors having a fiduciary responsibility to their constituents, such as pensioners. They provide investment opportunities that otherwise would be unavailable to most institutions.
While private equity firms may focus on a variety of investment strategies, including drumming up venture capital, they often buy undervalued or under-appreciated companies, improve them and then sell them for a profit. After buying a company, a private equity firm removes it from the stock market. This allows the private equity firm to make tough or controversial decisions without having to answer to or release sensitive information to shareholders or the public generally. By making the company private, the private equity firm is basically only accountable to its smaller group of investors.
In order to turn the company around, a private equity firm often replaces or controls the management team of the company. It is not unusual, however, for the private equity firm to keep existing employees of an existing company. While the private equity firm is controlling the company, its goal is usually to determine how it can improve the company’s performance or projected future performance so that potential investors will buy the company at a profit.
Private equity firms invest in every major industry, assisting both small and big corporations. Private equity firms though do help many small companies; the real economic impact comes from their assistance in ‘ate-stage venture capital’ opportunities, which means companies which possess strong growth but not enough liquidity to reach their bigger goals. In many cases, you can have a company with huge potential, but not enough money to meet their product demand. By giving these companies the funds to invest, it allows them to grow to their potential, adding money, ideas and jobs into the economy. The great thing is, private equity creates a positive economic cycle, keeping new companies flowing into the market at all times. In addition, private equity firms provide seed capital for new innovations. If you take a good look around, many of the big companies in the world have been funded through private equity.
Private equity funding can come from a variety of sources. Most often, the funds come from pension funds, financial institutions or individual investors with a substantial net worth. By being able to pool such large amounts of investment capital, the private equity firm expands its reach to, and power over potential investment opportunities.
Typically, private equity firms are on the hunt for underperforming companies within their respective industries that have terrific underlying value in terms of increased valuation potential with an improvement in the firm’s operating performance.
Increased valuation potential might be a function of strategic positioning regarding market potential, product uniqueness or patents, generous management incentives, or financial enhancements to optimize cash flow. Or it can be divestment potential, if the value of parts of the acquired company is greater than the value of the company itself. These and other factors can make a firm an ideal candidate for a leveraged buyout.
Once the work of improving the company has been done and its value increased, the private equity firm takes the company public again. If it all works out, the private equity firm sells the company for a nice profit for all original investors. The private equity firm itself, also often draws additional fees, including management and performance fees, for the legwork involved in the endeavour, including advertising, accounting etc.
Private equity firms earn their money as a function of capital gains, the increase in the value of the acquired firm. They realize their profit on the back end in fulfilment of their exit strategy, either through the sale of the acquired company to another private party or through an initial public offering.
Private equity firms buy companies using very little of their own money, by borrowing large amounts. They improve the operations of the acquired firm, pay down the debt and then exit within a few years with a hefty profit.
Despite their status as ‘investors’, they actually act like owners by becoming proactively involved in management. They are typically nimble in rapidly responding to problems and changes in the competitive environment. Their driving mantra is to rapidly and aggressively improve the performance of the firms they acquire so they can execute their exit strategy as quickly as possible, usually within three to five years.
If there weren’t private equity firms around, the markets would be a very scary place. Companies would either have to go public or bang their heads again the glass ceilings forever. With private equity funding now available to many businesses, this option has removed the pressure to go public. As most eventually learn, being in the spotlight isn’t the best choice for some products. With stock markets now recovering, it has become a perfect environment for private equity firms to profit. Hopefully this trend continues, because we know that the private equity is a market that can make or break any economy.