How Private Equity Firms Operate
Typical private equity (PE) firms operate by creating private equity funds. These funds are used to make private equity investments in targeted companies.
The structure often involves general partners who manage the investments and limited partners, who are the primary investors.
Private Equity Firms vs. Funds
It's important to understand the distinction between private equity firms and private equity funds. The former is the entity that manages the investments, while the latter is the pool of capital used for investments.
Popular private equity firms include:
- Blackstone, Inc.
- The Carlyle Group Inc.
- KKR & Co. Inc.
- Vista Equity Partners
- Insight Partners
Recommended: Read our Private Equity vs. Venture Capital guide to learn the difference between private equity and venture capital.
Why Do Companies Seek Private Equity Investment?
Private companies, especially those in their early stage, might need funding but wish to avoid the public stock market. This is where private equity investments come in handy.
Established companies might also seek private equity for growth or restructuring.
The Private Equity Process: From Buyouts to Exits
A typical private equity firm buys companies through leveraged buyouts.
During ownership, they might restructure the portfolio company, streamline operations, or expand its reach.
Eventually, the private equity firm sells the company, either to another entity, back to public markets, or to another private equity group.
For instance, a notable private equity deal was when Silver Lake Partners and Michael Dell took Dell Inc. private in 2013, only to take it public again in 2018.
In 2007, in one of the largest private equity deals ever, a consortium led by TPG Capital, Kohlberg Kravis Roberts (KKR), and Goldman Sachs Capital Partners purchased the energy utility company TXU Corp. (later renamed Energy Future Holdings) for approximately $45 billion.
The deal, which took place during the height of the buyout boom, was notable for its size and complexity.
However, by 2014, Energy Future Holdings filed for bankruptcy due to falling natural gas prices and the significant debt accrued from the buyout.
This case serves as an illustrative example of both the ambitious scale of private equity deals and the potential risks associated with large leveraged buyouts.
Types of Private Equity
While many are familiar with the general concept of private equity, not all realize the diverse avenues within it.
Each type has its unique characteristics, risks, and potential rewards.
Below are some prominent types of private equity investments:
- Venture Capital: This focuses on younger, early-stage companies.
- Leveraged Buyouts (LBOs): These involve buying companies with significant borrowed money or debt financing.
- Growth Equity: Investments in more mature companies to fuel expansion.
Private equity offers a range of investment strategies catering to different stages of a company's lifecycle and various investor objectives. It is a subset of the broader private markets, which also include venture capital investments, private debt, and other alternative investments.
Private equity firms, particularly large private equity firms, often operate multiple funds simultaneously, each with a distinct strategy.
Private Equity vs. Other Investment Forms
Private equity stands distinct in the vast landscape of investment options available to investors. While it offers unique opportunities and returns, it's essential to understand how it compares to other prevalent investment forms.
Here's a brief overview of how private equity stacks up against some common investment alternatives:
- Mutual funds invest in publicly traded companies. Unlike mutual funds, which provide a diversified exposure to public markets, private equity firms have a concentrated focus. They zero in on individual private companies, infusing capital, expertise, and strategic oversight to create value.
- The investment horizon, risk profile, and hands-on approach distinctly set private equity apart from mutual funds.
- While hedge funds can invest anywhere, including in private equity, their strategies are more diverse.
- Contrary to private companies, publicly-traded companies are listed on stock markets and are open to investment from the general public.
How Do Private Equity Funds Work?
Private equity firms, utilizing their specialized funds, direct investments primarily towards private companies.
This approach underscores the primary objective of private equity, which is investing directly in non-publicly traded entities, leveraging their expertise and funds to drive growth and value.
These investors have a specified "fund's life" during which they make and exit investments.
These funds may use significant amounts of borrowed money to boost their purchasing power, known as leveraging.
Risks and Rewards
Like all investments, private equity has its risks. The lack of liquidity and long investment horizons can be challenging.
However, the potential rewards, including above-market returns, can be substantial, making private equity appealing to high-net-worth individuals and institutional investors.
Private equity is not without its challenges. Specific risks in the realm of private equity include:
- Lack of Transparency: Private companies do not have the same disclosure requirements as public ones, making detailed analysis and due diligence crucial.
- Capital Lock-up: Investments in private equity can often be illiquid, meaning the capital is locked for several years before an exit strategy can be implemented.
- Operational Risks: Many PE firms take an active role in the management of the companies they invest in, which means the success of the investment can be tied to the firm's ability to drive operational improvements.
On the flip side, the potential rewards can be substantial:
- Above-Average Returns: Historically, private equity investors have delivered strong returns compared to other asset classes, particularly when the firms can unlock value in the companies they invest in.
- Diversification: For investors, PE can serve as a way to diversify their portfolio beyond traditional equity and bond investments.
The Role of Private Equity in the Global Financial Landscape
Private equity plays an essential role in today's financial world. With its focus on long-term value creation, it offers companies a different path than traditional public markets.
As the private equity market evolves, so too does its impact on the global economy.
Private equity firms in many countries are subject to regulations set by bodies like the Securities and Exchange Commission (SEC).
These regulations ensure transparency, protect accredited investors and maintain market integrity.
It's also worth noting that private equity acquisitions might need approvals from regulatory bodies, depending on the industry and region.
In the U.S., the SEC is the primary regulatory body for private equity, ensuring investor protection and market integrity. However, around the globe, the regulatory landscape can vary significantly.
In Europe, the European Securities and Markets Authority (ESMA) plays a pivotal role, while in Asia, regulations might differ from one country to another. For instance, China's Securities Regulatory Commission and India's Securities and Exchange Board each have their unique sets of guidelines for private equity operations.
Moreover, it's essential to recognize that these regulatory bodies don't just oversee the firms but also the transactions they engage in. High-profile acquisitions, particularly cross-border ones, might require regulatory approvals, ensuring market competition isn't compromised and investor interests are safeguarded.
How is a private equity fund formed?
A private equity fund is formed when a private equity firm or PE firm gathers commitments from investors. These investors typically include institutional investors, pension funds, sovereign wealth funds, and high net worth individuals.
Once the committed capital is pooled, the fund then seeks out portfolio companies to invest in. The fund's life usually spans several years, during which it makes and exits its investments.
What is the difference between private equity and venture capital?
While both private equity and venture capital are subsets of the broader private markets, they differ in their investing strategies. Venture capital focuses primarily on early-stage companies, providing them with the necessary capital to grow. In contrast, private equity tends to target more established companies, looking for value creation opportunities.
How do private equity firms generate returns?
A private equity firm buys companies using its private equity funds. Over time, the firm will work to improve the company's operations, cash flows, and overall value. Eventually, the private equity firm sells the company, aiming for a return on its investment. These sales can be to other private equity firms, public markets, or other types of investors.
Why do companies partner with private equity firms?
Companies, especially privately owned ones, may seek private equity investments when they need capital for growth, restructuring, or other strategic initiatives. By partnering with a private equity group, they can access the funds they need without going public. Established companies might also seek private equity partnerships to tap into industry expertise, resources, and growth equity.
What role do limited partners play in private equity?
Limited partners are the main investors in a private equity fund. They provide the capital that the private equity firm uses to make its investments. While they do not typically engage in the day-to-day operations of portfolio companies, they do expect returns on their investments and may have a say in the fund's strategic decisions.
How does private equity differ from publicly-traded companies?
Private equity firms invest in private companies, while public companies are entities listed on the stock market, open for investment by the general public. The public stock market provides liquidity and transparency, while private equity offers potential for higher returns and a closer partnership between investors and companies.