Private Equity - Explained
What is Private Equity?
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Table of ContentsWhat is Private Equity?How Private Equity WorksAcademic Research on Private Equity
What is Private Equity?
Private equity is a broad term that refers to various classes of equity financing arrangements (such as venture capital investment). More specifically, however, private equity refers to the class of equity financing. Private equity refers to investments in mid-to-large companies by private equity firms. These firms often purchase a controlling or all of the interest in a company. The private equity firm holds the purchased company for an intended period of time (3 -7 years) and capitalize on the companys growth at the end of the term by selling the company. Private equity is a form of intermediate owner that comes after the early growth stage of the business. Private equity firms generally use a common practice known as leveraged financing to purchase the company.
- For more information, see Private Equity - Definition
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How Private Equity Works
Private equity firms form an investment fund and seek funds from any variety of investors. Investors generally commit funds for a period of 7-10 years. The fund managers select companies in which to invest the funds with the intention of selling the companies and recouping the investment and profit within 3-10 years of the investment. The investment is generally a purchase of all or a controlling share of the companys equity. In some cases, private equity firms and private investors or other private equity firms will join together to purchase larger companies.
Generally, there is insufficient investment cash in the private equity firm to complete the purchase. The PE firm has to employ various forms of debt financing to complete the purchase. The debt providers are banks or other private lenders. This is because loaning the entire amount may be too risky for a single lender. This structuring of debt gives rises to different classes of debt with different level of priority of repayment (e.g., senior debt, mezzanine debt, bridge debt, etc.).
A lender that has a lower priority for repayment bears a higher risk of loss. As such, the lower the level of priority, the higher the interest rate charged by the lender. The PE firm posts the shares of the acquired company as security for loans to purchase the acquired firm. The PE firm later makes money by exiting the venture at a far higher valuation.
PE firms either sell the company to other PE firms that believe the acquired company has additional growth potential, sells the firm to a larger company that gains some strategic advantage by purchasing the firm, or take the firm public through an initial public offering. We discuss the private equity process further in our other resources.
Academic Research on Private Equity
- Private equity performance: Returns, persistence, and capital flows, Kaplan, S. N., & Schoar, A. (2005). The journal of finance, 60(4), 1791-1823.
- The economics of the private equity market, Fenn, G. W., Liang, N., & Prowse, S. (1996). Fed. Res. Bull., 82, 26.
- Equity ownership concentration and firm value: Evidence from private equity financings, Wruck, K. H. (1989). Journal of Financial economics, 23(1), 3-28.
- Leveraged buyouts and private equity, Kaplan, S. N., & Stromberg, P. (2009). Journal of Economic Perspectives, 23(1), 121-46.
- The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle, Berger, A. N., & Udell, G. F. (1998). Journal of banking & finance, 22(6-8), 613-673.
- The performance of private equity funds, Phalippou, L., & Gottschalg, O. (2008). The Review of Financial Studies, 22(4), 1747-1776.
- The returns to entrepreneurial investment: A private equity premium puzzle?, Moskowitz, T. J., & Vissing-Jrgensen, A. (2002). American Economic Review, 92(4), 745-778.
- The economics of private equity funds, Metrick, A., & Yasuda, A. (2010). The Review of Financial Studies, 23(6), 2303-2341.
- Money chasing deals? The impact of fund inflows on private equity valuation, Gompers, P., & Lerner, J. (2000). Journal of financial economics, 55(2), 281-325.
- Private equity, leveraged buyouts and governance