Table of Contents
What is a private equity firm?
What do private equity firms do?
Difference between active and passive investors
How do private equity firms make a profit?
What are the types of private equity investment?
The bottom line
What Are Private Equity Firms and How Do They Work?
What Are Private Equity Firms and How Do They Work?
Jun 2, 2022
6 min read
Learn all about how private equity continues to have the potential of being a highly profitable investment vehicle for wealthy investors and institutions.
When financier J.P.Morgan used his own money and that of his backers to do a series of mergers in the early 1900s to create U.S. Steel, the country’s first billion-dollar company, he was engaging in an early form of private equity. However, the term “private equity” would emerge after the end of World War II, and later become closely associated with industry giants like KKR (Kohlberg Kravis Roberts & Co.) and Blackstone.
Today, the private equity industry is made up of investment funds that raise billions of dollars every year from institutional investors and wealthy individuals. They use the money for everything from funding startups to buying big, established companies, which they then try to restructure and make more efficient, profiting when they are sold.
A private equity firm is a type of investment management company that is not listed on a public exchange and offers capital raised from limited partners to private or public companies. PE funds may invest in a startup company or in an established company that’s in need of cash. For instance, a business may be open to this option if under financial strain, seeking growth, or having concerns that a leadership transition (such as founder’s retirement) might impact the company’s value. Companies may turn to private equity as an alternative to high-interest bank loans or listing on stock exchanges.
Private equity investors are a mix of multiple individuals or institutional investors. Specifically, these investors are high-net-worth individuals or institutions that invest individually, in groups, or operate as venture capital companies. In a buyout, for example, a private equity firm adds a company to its portfolio of businesses and aims to increase its worth within a set period. Most of these are long-term investments, with holding periods of three to five years.
During that time, the fund manager increases the value of the portfolio company by improving its operations, deleveraging it (decreasing its debt to equity ratio), or expanding it with the goal of selling it at a profit and distributing the proceeds among investors. The holding period, or time from purchase to sale of the company, may exceed the five years it could take for a PE firm to turn around or ready a distressed company for an initial public offering (IPO), or sale.
Private equity firms bring together two groups of partners who work together to create a fund. The fund contains the capital the firm uses to invest in—and buy—companies. These two partner groups are:
. This is the partner that manages the fund. This partner, or group of partners, owns a minority share and has full liability.
. These investors—often high-net-worth individuals, public or corporate pension funds, endowments, or foundations—own the majority share and have limited liability.
Once the fund reaches its goal for raising capital, the partners close it and invest the capital into the portfolio companies. Investment structures vary, but they often take the form of leveraged buyouts, in which the private equity firm uses debt to make their equity investment go further.
To accomplish their investment goals, private equity firms complete five core operations:
Private equity firms join with limited partners or outside financial institutions to raise a substantial amount of capital to create the fund.
When PE firms are considering companies to add to their portfolio, they vet the company’s management, financial performance, as well as the services they provide. Then, after sourcing a deal, the investment team analyzes the company’s strategy, risk, business model, and management team, among other factors.
Private equity firms employ three key types of strategies for the companies in their portfolio: venture capital, growth equity, and buyouts. Each requires a different skill set and represents a strategy appropriate for companies at different stages of development. For instance, venture capital typically invests in start-ups while more established companies are candidates for a full buyout.
Private equity firms usually hold their assets for a certain period of time, and then exit and distribute profits to investors. An exit normally takes from three to five years, although holding times may vary. In the interim, the PE firm pays down the debt used to finance the company’s purchase, increases the business’s working capital, supports or installs new management and tries to boost profits. The goal of an exit is to sell a company or take it public through an IPO.
Private equity firms may have different levels of engagement with their portfolio companies. Some firms may be passive investors, meaning they are strictly making an investment and relying on the company’s management to generate returns.
Active private equity firms may be more involved in a portfolio company’s operations or management. For example, they may leverage relationships with industry executives to offer expertise on trimming company inefficiencies, or strategic support to help a company reach its performance goals.
Equity firms make a profit by collecting both management and performance fees, typically 2% of the assets under management (AUM) and a 20% performance fee charged on profits. This is known as the 2-and-20 rule.
A standard fee for a PE firm to charge to its limited partners— investors who usually own most of the private equity fund—is 2% of committed capital, or what the investor committed to the private fund. This fee is charged regardless of the fund’s performance. For instance, if a fund were valued as $3 billion, a fund charging a 2% fee would earn $60 million in revenue. These management fees are paid annually.
PE firms often charge a performance fee of up to 20% of an investment’s profits beyond a certain threshold, or hurdle rate. The typical hurdle rate is 8%.
Private equity firms raise money for various types of funding.
These firms make investments in startups or early stage companies. These businesses can be young, so they may not yet have revenue. Angel investors generally don’t take a controlling stake in the company. In exchange for money, the company may give the investor the right to buy shares in a future equity round—but most deals are simply cash for equity.
VC firms also invest in startups, but typically look for companies that have revenue but need resources to grow. The company may have a growing customer base and a plan to reach profitability. VC firms can receive equity, preferred shares, and convertible debt securities in companies.
These firms often look for companies that are generating profits but need an influx of cash to grow. The company will often have a stable cash flow and profit margins but be unable to draw down debt. Private equity firms often buy a controlling interest in the business but may take a minority position.
Firms that engage in distressed funding, sometimes called vulture funding, invest in underperforming businesses with the intention of turning them around or selling their assets for a profit. Companies that have filed for Chapter 11 bankruptcy protection are sometimes candidates for vulture funding.
Private equity is a form of financing that takes place outside public financial markets. Private equity firms and their limited partners invest directly in companies, with the goal of selling it at a profit and distributing the proceeds to investors. Although PE firms employ various strategies to accomplish this, their essential task is to seek out, acquire, and invest in portfolio companies that they can grow and create value in relatively quickly, then divest. Private equity continues to have the potential of being a highly profitable investment vehicle for wealthy investors and institutions, and a major growth engine for the companies in which they invest.
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