When it comes to investing, many investors will go the traditional route by buying into stocks or bonds -- or maybe a mutual fund, or two. But for some, private equity holds an appeal as an investment option. But what is private equity anyway? And how do you invest in it?
What is Private Equity?
Put simply, private equity is just capital or shares of ownership that are not publicly traded or listed (unlike stocks, for example). For this reason, private equity is established through private equity firms or funds, and is often an investment in or buyout of a large public company that is then taken private. When creating private equity, investors will raise capital to invest in private companies -- to either facilitate mergers and acquisitions, stabilize the company's balance sheet, raise new working capital, or instigate new projects or developments -- and that capital is often contributed by accredited or institutional investors.
Some of the main operations of private equity firms include buying out financially struggling companies and turning them around through involvement in management and restructuring, or by directly investing in companies and facilitating mergers or initial public offerings (IPOs) once a healthy return has been established.
Additionally, pension funds and other organizations will often invest in private equity, and are typically putting up cash from substantial investors whose aim is to receive a positive return on their hefty investment. Because direct investment into a company or firm often requires large sums of cash, private equity investors generally have to shell out large minimum investments when going through a firm, which can range from the mid $200,000 range to several million dollars, depending on the firm or fund.
For this reason, private equity firms and funds are often the wealthiest and most powerful in the industry, and hold sway over the operations of many major private or formerly public companies. Investors in private equity often extend funds over a long holding period, during which the company's new found capital is used to improve operations and profits or to increase liquidity in preparation for an IPO. The benefit for private companies, in addition to the capital injection, is that they are not required to release quarterly earnings reports to investors, which can help the private equity firm work on more long-term projects that can increase the company's value and earnings -- without having to deal with external pressures like the impact of market forces on share price and the razor-sharp market focus on quarterly figures.
Because private equity is often exclusively invested in by accredited and institutional investors, private equity funds typically pool their money to privatize large companies or participate in leveraged buyouts (LBOs), which entail hefty amounts of capital put up to fund various purchases. Through the use of LBOs, mergers and acquisitions and the influx of working capital, the ultimate goals of private equity funds are often to either take the private company public (therefore cashing out the investments) or to sell to another company once the value of the investment has increased.
Private equity has done a pretty good job of creating value over the years.
According to Harvard Business Review (citing data from Dealogic), the total value of private equity buyouts with an individual ticket price over $1 billion increased from $28 billion to $502 billion from 2000 to 2006. And private equity capital raised has topped $3 trillion since 2012, according to this year's Bain & Company's Global Private Equity Report. So, private equity is an undeniably booming industry.
How is Private Equity Managed?
Because private equity is often managed by "active" firms that seek to fix, sell, or influence companies -- as opposed to just investing and holding -- private equity managers are in a valuable (and fiscally rewarding) position.
Much like other investment firms or funds, private equity is managed by managers or other associates that handle the assets under management (AMUs) within funds or firms. Private equity firms and funds use investors' money typically to invest in or buy out medium-to-large companies to maximize returns -- and they boast some of the top professionals in accounting, law and Fortune 500s among their ranks, promising formidable salaries. However, most private equity firms or funds have modest numbers of employees, with some even employing less than two dozen managers or associates.
And although the fee structure isn't necessarily uniform across the board, private equity funds have both a performance fee and management fee, both of which typically settle for around 20% of gross profits at sale and 2% on managed assets, respectively, at most firms.
Because private equity firms are generally smaller than investment banks or other investment funds, jobs at these firms are often especially lucrative and sought after. Associates or managers of private equity often work closely with the partners of the firm, and are typically tasked with managing the firm's portfolios, providing analytical modeling to help investors make business decisions, or examining confidential information memorandum documents (or CIMs).
A principal aim of private equity management is to invest in underperforming or failing companies and turn around their margins to become more profitable through increasing efficiency and earnings. However, much of a firm's value comes from its performance, thus a key goal of private equity firms is to make the most strategic and lucrative investments possible.
Because of the high-caliber nature of these firms and funds, starting salaries for associates and managers typically hit between $50,000 to $250,000 with additional bonuses, while vice presidents can earn upwards of $500,000 per year and principles can earn upwards of $1 million.
Private Equity and Job Creation or Loss
When it comes to job losses and job creation, private equity has been a controversial -- yet, hot -- topic. The common view of the inherently parasitic nature of private equity may not be the full story.
Many reports have claimed that private equity firms will often come into a company and slash jobs in order to increase returns for the wealthy few. However, CNBC reported last year that many private equity firms are actually increasing productivity through either helping develop new technologies or making existing companies more efficient. This, according to a commentary on CNBC, actually opens the gates for different positions, claiming that "creative destruction of antiquated jobs and invention of new forms of labor drives productivity growth, and [private equity] firms are integral to this process."
Still, many critics have expressed concerns over the private equity industry's reputation for laying off workers once acquisitions are made -- prompting venture capitalist Michael Moritz to write an op-ed for The New York Times last year accusing private equity firms of profiting off of laying off workers at companies bought with leverage, according to Fortune. Additionally, several high-profile examples have given private equity firms a bad reputation in this respect. In fact, according to a 2017 Newsday analysis, around 40% of the 43 big supermarket or retail companies that filed for bankruptcy in 2015 were owned by private equity firms.
But although the jury is still out on whether private equity does more harm than good for employment, it has been noted that, while firms may cause loss of existing jobs, they also create new jobs, through growth, that often reflect more-specialized and productive work.
What Is a Private Equity Firm?
Private equity firms are fairly similar to venture capital funds (and are, in fact, pretty much the same thing) in that investors give their money to the firm to invest in a company, or, in some cases, to buy out a company. In most cases, private equity firms will buy 100% of the company and thus have total control. But private equity differs in that private equity firms often have high minimum investments and therefore mostly attract a high-net-worth group of investors who can afford to directly invest in a company.
And, while some firms are more passive in their investment, leaving the management to increase earnings or improve returns, many private equity firms play a more-active role in growing the company and getting good returns for their investors by either restructuring the company's management, acquiring new companies or merging.
Different Types of Private Equity Firms
Some private equity firms that are more active in their role as investor in companies have "C-level" relationships -- that is, contacts with CEOs and CFOs that often contribute to increased business and growth. These funds will often scope out contacts to partner with or invest in in the future.
However, other firms are more passive in their approach, taking what many call a commoditized approach to investment. These private equity firms typically buy and hold their investments instead of getting involved in growing or fixing the company.
Still, another kind of equity fund, called a search fund, has become increasingly popular, according to Forbes. A search fund essentially invests a small amount in an entrepreneur who then seeks out a company or investment to run -- to then put more money behind.
How Does Private Equity Make Money?
Essentially, the private equity firm makes money for its investors by buying out or directly investing in companies and helping increase their earnings so as to increase the company's value (and thus returns). Private equity firms will often help or send in management to restructure or improve the company's efficiency and to stimulate growth, often cutting costs or jobs in order to streamline the company.
Occasionally, a private equity firm will buy out a large public company and delist it from the stock exchange. But, many private equity firms will stick to buying private companies and, once the company has sufficiently grown and improved margins, will take it public with an IPO and allow investors to cash out.
But since the private equity firm often uses borrowed money for buyouts (called leverage), leveraged buyouts can be risky and don't always pay off for investors.
Still, the private equity market is robust, with over $621 billion raised for private equity in 2017, according to Forbes earlier this year.
Private Equity Investment Strategies
The two principal strategies private investment firms utilize are venture capital investments and leveraged buyouts.
With leveraged buyouts, the private equity firm uses debt (leverage) to buy out a company -- with the debt used to finance the buyout becoming collateral. In this way, the firm buying out the company doesn't have to shell out the whole purchase price at once, and can use the investment from the various investors to increase the company's earnings or growth in order to create a higher return.
Venture capital investment is essentially a subset of private equity, in that it focuses more on investing in small or newer companies that are typically on the cutting edge of developing new technologies or industries. By investing in these smaller companies, private equity firms utilize venture capital in the hopes of bolstering the company into becoming a big staple of that burgeoning industry.
But while these two staples of private equity firms are overarching strategies, the means by which firms grow or improve their investments varies. Many private equity firms focus on cutting costs and jobs in order to improve efficiency, while others attempt to grow their companies by expansion -- a shift that has allegedly been seen in recent years.
According to a Forbes report earlier this year, the recent shift in private equity toward growth and away from mere cost-cutting has helped increase many companies' top lines, noting that "in a business-to-business (B2B) setting, we typically see a 10% to 20% top-line acceleration, and a 10% to 15% uptick in earnings before interest, taxes, depreciation and amortization (EBITDA), when companies target multiple commercial capabilities -- and even bigger benefits when they infuse digital."
Private Equity and Transparency Concerns
Coming out of the Obama-era, which, thanks to Dodd Frank, increased regulations on private equity, recent reports suggest transparency in private equity will continue to increase. According to Forbes this year, 2018 will see an increase in transparency, brought on largely by fund managers and investors, whose primary goal is to attract new investors and individuals into private equity.
In fact, according to Forbes, many managers are seeking to target the mass retail market in 2018, and feel that increased transparency is necessary to attract the necessary investors.
Private Equity vs. Other Kinds of Equity
Still, as mentioned earlier, private equity is different than the kind of equity obtained through stocks, mainly because it is private and not traded on public exchanges, whereas equity through stocks is publicly traded.
Additionally, private equity firms often invest in large companies that may or may not be in need of improvements to increase margins or efficiency, whereas other investment vehicles like venture capitalists tend to invest in newer, riskier companies that often are in the business of technology or development creation, according to Entrepreneur.