Learning About Private Equity (PE)
Investing in businesses that are not publicly listed is known as private equity, or PE. Private markets managed assets of over $11.7 trillion in 2022.1 PE businesses look for ways to generate returns that are higher than those found in the public stock markets. However, there can be certain aspects of the sector that you are ignorant about. Continue reading to learn more about private equity businesses and their significance, the reasons behind the unfavorable press that certain private equity organizations have received, and how some of their primary methods enable them to produce value.
Why Private Equity Firms Are Important
Ownership or interest in businesses that aren't listed or traded publicly is known as private equity. Private equity is a type of investment capital that is obtained by businesses that purchase shares in privately held corporations or acquire control of publicly traded companies with the intention of taking them private and delisting from stock markets. Rich people who are looking for huge profits may also contribute private equity.
Large private equity companies that are financed by accredited individuals and institutional investors, such pension funds, make up the private equity sector. Deep-pocket funds dominate the business because private equity makes direct investments, sometimes to obtain influence or control over a company's activities, necessitating a substantial cash outlay.
Between 2013 and 2021, the yearly capital raised by PE firms nearly quadrupled, reaching a peak of over $2.2 trillion. After fewer funds sought for capital, that dropped to 1.2 trillion in 2023, with investors being cautious in light of rising interest rates.
Depending on the company and fund, accredited investors may need to contribute a minimum amount of cash. A $250,000 minimum admission requirement is required for certain funds, while millions more may be needed for others.
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Types of PE Firms
Investment choices vary across private equity companies. Some investors are stern money managers, or they are passive investors that rely only on management to expand the business and make profits. As sellers generally view this as a commodity strategy, some private equity companies regard themselves as active investors. In other words, they assist management run the business so that it may develop into a stronger organization.11
In order to boost income, active private equity companies may have a large network of contacts and C-level connections with CEOs and CFOs in particular industries. They may also be specialists in achieving synergies and operational efficiency. An investor is more likely to be welcomed by sellers if they can provide something unique to the transaction that would eventually raise the company's worth.
To acquire strong businesses and provide funding for emerging ones, investment banks and some private equity PE firms—also referred to as private equity funds—compete. Not unexpectedly, the biggest acquisitions are frequently facilitated by the biggest investment banks, like Goldman Sachs, JPMorgan Chase & Co., and Citigroup.
How PE Firms Create Value
Private equity (PE) firms serve three critical functions:
- Deal origination and transaction execution
- Portfolio oversight
- Cost cutting
Deal Origination and Execution
Deal origination entails establishing, preserving, and growing connections with investment banks, mergers and acquisitions (M&A) intermediaries, and other related specialists. These connections facilitate the flow of high-quality and high-quantity deals since these experts may recommend acquisition candidates to the PE firm for evaluation. To discover transaction leads, some businesses employ personnel to look for and get in touch with business owners. Locating such transactions may assist guarantee that the capital obtained is going to the most profitable investment possibilities in a competitive M&A market.
Businesses may reduce their costs to middlemen and save money by finding their own prospects. Financial service providers typically conduct an auction to lessen the likelihood that a buyer would purchase a certain firm when they are the seller's representative. To ensure that transaction professionals are informed about the deal at an early stage, deal origination staff members strive to establish a good connection with them.
Tips: It is important to note that investment banks often raise their own funds, and therefore may not only be a deal referral, but also a competing bidder. In other words, some investment banks compete with private equity firms to buy up good prospects.
Portfolio Oversight and Management
Oversight and management make up the second most crucial function of private equity professionals. Among other support work, they can walk a young company's executive staff through the best strategic planning and financial management practices. Additionally, they can help institute new accounting, procurement, and IT systems to increase the value of their investment.
For more established companies, PE firms tend to think they have the ability and expertise to turn underperforming businesses into stronger ones by finding operational efficiencies and increasing earnings.11 This is the primary source of value creation in private equity. However, PE firms also create value by aligning the interests of company management with those of the firm and its investors.
By taking public companies private, private equity firms say they remove the public scrutiny of quarterly earnings and reporting requirements to allow them and the acquired firm's management to take a longer-term approach to improve the company's fortunes.
Read also: Understanding Funding Rounds: Series A, B, and C Explained
Cost Cutting and Liquidations
PE firms are driven by the goal of maximizing returns for their investors. This overarching goal, however, means using strategies that can have wider effects on different communities, some of which have garnered critical attention.
- Asset liquidation: Selling off assets or parts of the business to streamline operations or generate immediate cash flow.
- Cost reduction: Implementing stringent cost-cutting measures, which can lead to significant layoffs or downsizing.
- Imposing debt: Acquiring companies primarily through debt, which is later repaid using the company's cash flow or by selling its assets. This can put considerable financial pressure on the company.
Important: PE firms operate within complex legal and financial frameworks, often utilizing strategies to minimize tax payments. In the U.S., for instance, certain tax benefits, like the avoidance of corporate capital gains tax, have been a point of debate.14 These tax strategies are legal but contribute to the wider discussion about the economic role and impact of PE firms.
Private Equity Investment Firm Varieties
There are plenty of private equity investment strategies. Two of the most common are LBOs and VC investments.
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Leveraged Buyouts (LBOs)
LBOs are exactly how they sound. A company is bought out by a private equity firm, and the purchase is financed through debt, which is collateralized by the target’s operations and assets.
The PE firm buys the target company with funds from using the target as a sort of collateral. In an LBO, PE firms can assume control of companies while only putting up a fraction of the purchase price. By leveraging the investment, PE firms aim to maximize their potential return.
Venture Capital (VC)
VC is a more general term for an equity investment in a young company in a less mature industry think of the dot-com companies of the early- to mid-1990s. Private equity firms will often see potential in the industry and, more importantly, in the target firm itself, thinking a lack of revenue, cash flow, or debt financing is holding it back.
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