How Does Private Equity Work?

Investment partnerships that acquire and run businesses before selling them are known as private equity. These investment funds are managed by Private Equity Firm Australia on behalf of accredited and institutional investors.

Private equity firms may invest in such buyouts as a consortium or may fully acquire private or public enterprises. They often don’t own shares of businesses that continue to be traded on stock exchanges.

As an alternative investment, private equity is frequently bundled with venture capital and hedge funds. Access to such assets is restricted to institutions and high net worth people because investors in this asset class typically need to devote large funds over years.

Investing in private equity

Contrary to venture capital, the majority of private equity firms and funds invest in established businesses as opposed to start-ups. Before exiting the investment years later, they manage their portfolio companies to boost their value or to extract value.

Since 2000, the private equity industry has expanded quickly due to greater allocations to alternative investments and very positive fund returns.

Private equity companies raise client money to start private equity funds, run them as general partners, and manage fund investments in return for fees and a cut of profits above a predetermined minimum, or the hurdle rate.

The money invested in private equity funds has a limited term of 7 to 10 years and cannot be withdrawn again after the initial investment. 8 After a few years, the funds do usually start paying out rewards to their investors. In 2021, a private equity portfolio company’s holding period was on average around five years.

Following the historic initial public offering (IPO) of Blackstone Group Inc. (BX) in 2007, a number of the biggest private equity firms are now publicly traded businesses. 10 Along with Blackstone, the following companies have shares that are traded on American exchanges: KKR & Co. Inc. (KKR), Carlyle Group Inc. (CG), and Apollo Global Management Inc. (APO). Smaller private equity firms have also issued initial public offerings (IPOs), mostly in Europe.

Specialties in private equity

Some private equity funds and firms focus exclusively on one type of private equity investment. Although venture capital is frequently referred to as a subset of private equity, its unique role and skill set set it apart and led to the emergence of specialised venture capital firms that now rule their industry. Other areas of expertise in private equity are:

• investing in distressed situations and focusing on financially troubled businesses
• Growth equity, which invests in growing businesses after they leave the startup stage
• sector experts, with some private equity companies specialising exclusively in energy or technology projects, for instance.
• Secondary buyouts, which entail the transfer of ownership of a company from one private equity group to another,
• Carve-outs involving the acquisition of business units or subsidiaries.

Types of private equity deals

According to their circumstances, private equity firms can categorize the deals they make to buy and sell portfolio companies.

The buyout, which entails the acquisition of an entire company, whether publicly traded, closely held, or privately held, continues to be a mainstay of private equity transactions. When buying a struggling public company, private equity investors will frequently look for cost-cutting opportunities and possibly restructure the business.

Carve-outs are a different kind of private equity acquisition in which investors buy a part of a bigger company, often a non-core business that its parent corporation has put up for sale. Examples include Francisco Partners’ deal to purchase corporate training platform Litmos from German software giant SAP SE (SAP), announced in August 2022, and Carlyle’s acquisition of Tyco Fire & Security Services Korea Co. Ltd. from Tyco International Ltd. in 2014. Compared to other private equity purchases, 1213 Carve-outs typically fetch lower valuation multiples but can also be more difficult and risky.

Instead of purchasing a publicly traded company, a private equity firm will purchase a business from another private equity group in a secondary buyout. Such transactions were once thought to be crisis sales, but because private equity firms are becoming more specialised, they are now increasingly typical. 1718 One company might purchase a business in order to reduce expenses before selling it to another PE partnership looking for a platform to buy comparable companies.

Additionally, a portfolio company can be sold to a competitor or listed on the stock exchange as an exit strategy.

Value Creation by Private Equity

A private equity firm will already have a strategy in place to raise the investment’s value by the time it buys a company. The company’s current management may have been unwilling to implement drastic cost reduction or a restructure. Private equity owners are more motivated to make significant improvements since they have a finite amount of time to add value before selling their investment.

The private equity firm can also possess specialised knowledge that the business’s previous management was lacking. It might aid the business in e-commerce strategy development, technology adoption, or market expansion. When buying a company, a private equity firm may use its own management team to pursue these goals or keep previous managers on to carry out a predetermined plan.

The acquired firm is free to make operational and financial adjustments without being under constant pressure to please its public shareholders or achieve analysts’ earnings projections. Private equity ownership may enable management to adopt a longer-term perspective, unless doing so interferes with the objective of the new owners to maximise return on investment.

Private equity managers are focusing on operational improvements as their main source of added value, according to industry surveys.

However, despite the fact that the rise in fundraising has made leverage less necessary, debt continues to play a significant role in private equity returns. When debt is used to finance an acquisition, the amount of equity required is reduced, which raises the potential return on investment—albeit at increased risk—correspondingly.

A dividend recapitalization, which uses borrowed funds to pay a dividend payout to the private equity owners, is another way for private equity managers to speed up their profits by getting the acquired company to take on more debt.

Dividend recaps are contentious because they enable a private equity company to quickly extract value while burdening the portfolio company with additional debt. On the other hand, the added debt may reduce the company’s value when it is resold, and lenders must concur with the owners that the business will be able to manage the added debt.

What Critics Say About Private Equity

Private equity firms have fought back against the perception that they are corporate asset strip miners by highlighting their management skills and providing examples of portfolio company transformations that have been successful.

The environmental, social, and governance (ESG) norms, which require businesses to consider the interests of stakeholders besides their owners, are being praised by many.

However, the quick changes that frequently follow a private equity buyout can be challenging for a company’s employees and the neighbourhoods where it operates.

The carried interest provision, which enables private equity managers to be taxed on the majority of their compensation at the lower capital gains tax rate, is another topic of frequent debate. It has been unsuccessful for lawmakers to tax that compensation as income on several occasions, most notably when this change was removed from the Inflation Reduction Act of 2022.

What is the management process for private equity funds?

A general partner (GP), often the private equity company that founded the fund, is responsible for managing a private equity fund. All management choices for the fund are made by the GP. In order to ensure that it has skin in the game, it also adds 1% to 3% of the fund’s capital. In exchange, the GP receives a management fee that is typically set at 2% of the fund’s assets as well as the possibility of incentive compensation in the form of carried interest, or 20% of fund profits over a predetermined minimum. Limited partners are the private equity firm’s clients who make investments in its fund; they are only partially liable.

Private Equity Investments: What Is Their History?

One of the first corporate buyouts and one of the biggest in terms of market and economic scale occurred in 1901 when J.P. Morgan paid $480 million for Carnegie Steel Corp. and combined it with Federal Steel Company and National Tube to become U.S. Steel. Henry Ford bought out his partners in 1919 using primarily borrowed funds after they had sued him for reducing dividends to fund the construction of a new auto plant. After accounting for inflation, KKR successfully executed the largest leveraged buyout in history in 1989 when it paid $25 billion to acquire RJR Nabisco.

What is the regulatory status of private equity firms?

While the Investment Company Act of 1940 and the Securities Act of 1933 exclude private equity funds from SEC oversight, their managers are nevertheless subject to the Investment Advisers Act of 1940 and the anti-fraud provisions of federal securities laws. For private fund advisers, including private equity fund managers, the SEC proposed comprehensive new reporting and customer transparency requirements in February 2022.

The new regulations would compel private fund advisers registered with the SEC to receive yearly fund audits and to give clients with quarterly statements outlining fund performance, fees, and expenditures. All fund advisors would be prohibited from offering special conditions to one customer in a financial vehicle without informing the other fund investors.

In a nutshell

No form of ownership is free from the conflicts of interest brought on by the agency problem for a large enough organization. Private equity firms, like management of publicly traded corporations, occasionally pursue interests that are at variance with those of other stakeholders, including limited partners. Even so, the majority of private equity transactions add value for the investors in the funds, and many of them enhance the acquired company. In a market economy, subject to reasonable regulation, the company’s owners are free to select the capital structure that best suits their needs.