You've probably heard the term private equity (PE) quite a bit in recent years. But it's not exactly a new idea. In fact, investments in private equity as we know them today go as far back as the 1940s. But it wasn't until the 1980s to 1990s that the industry began to see a boom thanks, in part, to the availability of credit—including private credit—as well as debt with high yields. But there may be a few things you don't understand about the industry. Let’s see...
Private equity is a general term used to describe all kinds of funds that pool money from a bunch of investors in order to amass millions or even billions of dollars that are then used to acquire stakes in companies.
Technically, venture capital is private equity. But "PE" is often associated with the funds trolling for mature, revenue-generating companies in need of some revitalization -- maybe even some tough choices -- in order to become worth much more. While venture capital often goes into younger companies involved in unproven, cutting-edge technologies, funds described as private equity are more attracted to established businesses. Think manufacturing, service businesses and franchise companies.
In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever-larger acquisition targets. The global value of private equity buyouts is bigger than $1 billion. Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth. Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public company regulations.
Working: Sometimes a private equity firm will buy out a company outright. Maybe the founder will stay on to run the business -- but maybe not. Other private equity strategies include buying out the founder, cashing out existing investors, providing expansion capital or providing recapitalization for a struggling business. Private equity is also associated with the leveraged buyout, in which the fund borrow additional money to enhance its buying power -- using the assets of the acquisition target as collateral.
Advantage: Is the founder becoming too crotchety? Are the original investors begging for a payday? Is the business losing its mojo and in need of a serious cash infusion and/or overhaul? Private equity might be the way to go. The private equity fund will also likely come in with new ideas and perhaps even new managers who might give the business a second wind.
Disadvantage: Younger companies in the early stages don't fit well into the private equity investment strategy. Also, remember that a private equity fund's ultimate goal is to make the company worth more than it was before in order to produce a return for investors. Sentimentality, the workforce, the role of the founders in the business, even the business' long-term success -- they can all be secondary to this goal. So be prepared for some ruthlessness.
A type of private equity fund called a search fund has been gaining popularity recently. Instead of pooling money to invest in a business, the investors throw a few hundred thousand dollars behind a would-be entrepreneur who searches for the best business to acquire and run. If the future CEO finds a suitable target, the investors then pitch in the millions needed to make the purchase. This could be the perfect answer for a business that is not only in need of an investment but also a new top executive to turn things around.
With funds under management already in the trillions, private-equity firms have become attractive investment vehicles for wealthy individuals and institutions. Understanding what private equity exactly entails and how its value is created in such investments are the first steps in entering an asset class that is gradually becoming more accessible to individual investors.
As the industry attracts the best and brightest in corporate America, the professionals at private-equity firms are usually successful in deploying investment capital and in increasing the values of their portfolio companies. However, there is also fierce competition in the M&A marketplace for good companies to buy. As such, it is imperative that these firms develop strong relationships with transaction and services professionals to secure a strong deal flow.
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