Private Equity – Definition

Cite this article as:"Private Equity – Definition," in The Business Professor, updated June 2, 2019, last accessed October 1, 2020, https://thebusinessprofessor.com/lesson/private-equity-definition/.

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Private Equity Definition

Private equity is a substitute  investment class,composed of capital not listed on a public exchange. Private equity contains funds and investors who directly invest in the private companies, or who are involved in buyouts of the public companies, causing delisting of the public equity. Institutional as well as retail investors give capital for the private equity, which is used to make acquisitions,fund new technology, expand the working capital, and improve the balance sheet.

A private equity fund is held by Limited Partners (LP), who usually possess 99% of shares in a fund along with limited liability, and General Partners (GP), possessing 1% of shares with 100% liability. The latter investors have the responsibility for operating and executing the investment.

A Little More on What is Private Equity

Private equity investment usually comes mainly from the institutional investors and accredited investors, dedicating significant amount of money for extended time frames. In most of the cases, significantly long holding times are often needed for private equity investments to ensure a good turnaround for distressed businesses or to facilitate liquidity events like a sale to a public company or an initial public offering (IPO).

Private equity provides many benefits to startups and companies. Companies favor it since it enables them to have an access to liquidity as a substitute to conventional financial procedures, like high interest bank loans or the listing on public markets. Some types of private equity, like venture capital, also fund the ideas and developing companies. For de-listed businesses, the private equity funding helps them to try unorthodox growth strategies away from the public markets. Orelse, the pressure imposed by quarterly earnings radically decreases the timeframe available to the senior management to turn a business around or experiment with some new ways to make money or cut losses.

Private equity have its own riders. First, it might be hard to liquidate holdings in the private equity since, as opposed to public markets, a readymade order book matching buyers with sellers, is not available. A business must undertake a search for the buyer to make a sale of its company or investment. Second,shares pricing for a company in the private equity is decided by negotiations between sellers and buyers and not by the market forces. The same goes for for the publicly-listed businesses Third, the rights held by private equity shareholders are usually decided on a case-by-case basis via negotiations rather than a broad governance framework that usually dictates the rights for their counterparts in the public markets.

While private equity has been in the limelight just in the past three decades, techniques used in the industry have been there since last century. JP Morgan is believed to have aligned the first leveraged buyout of the Carnegie Steel Corporation, then among the biggest manufacturers of steel in the country, for $480 million in 1901. It led to several mergers and formation of Federal Steel Company and National Tube, to form United States Steel – the world’s largest company, with a market capitalization of $1.4 billion.

Private equity businesses usually at the sidelines of the economic and financial ecosystem after World War II till 1970s, when the venture capital started bankrolling technological revolution of America. Today’s the technology behemoths, including Intel and Apple, got the required funds to scale up their business from a Valley’s emerging venture capital ecosystem when founding. During the 1970s and 1980s, the private equity businesses became a good option for struggling companies to get funds away from the public markets. Their deals made headlines as well as scandals. With rising awareness of the industry, the capital available for funds also increased and the size of the average transaction in private equity as well.

When it happened in 1988, conglomerate RJR Nabisco’s acquisition by Kohlberg, Kravis & Roberts (KKR) for $25.1 billion became the biggest transaction in the history of private equity. The record was broken after 19 years when the 45 billion buyout of coal plant operator TXU Energy happened. Goldman Sachs and TPG Group joined KKR to get the needed debt to acquire the company during private equity’s peak years between 2005 and 2007. Even Warren Buffett purchased $2 billion worth of bonds from this new company. The project turned into a bankruptcy after 7 years and Buffett confessed his purchase “a big mistake.”

As per Harvard study, the global private equity groups got $2 trillion in the years between 2006 and 2008, leveraged by an extra two dollars in debt. But as revealed by the study, the companies backed by the private equity showed better performance than their counterparts in public markets. This was evident in businesses having limited capital at their disposal and businesses whose investors could access the networks and capital that grew their market share.

How Does Private Equity Work?

Private equity businesses raise funds money from accredited and institutional investors for to invest the raised funds in various kinds of assets. Following are some of the most common and popular  kinds of private equity funding:

Distressed funding: Also called vulture financing. Here the raised money is invested in troubled businesses with underperforming assets or units. The objective is to making important changes to their management or the operations or make a sale of their assets for the profit. Assets in the latter case include physical machinery, real estate,  intellectual property, like patents etc. Companies that are filed under Chapter 11 bankruptcy in the United States are usually opting for this financing.

Leveraged Buyouts: This is the most common kind of private equity funding that is revolved around buying out a business fully in an aim to improve its financial and business health and resell it at a profit to an interested party or via IPO.

Real Estate Private Equity: This kind of funding rose radically after the 2008 financial crisis that crashed the real estate prices. Typical cases where funds are used are commercial real estate and real estate investment trusts (REIT). Real estate funds need higher minimum capital for the investment unlike other funding categories in private equity. Prequin states that the real estate funds in private equity are projected to see 50 percent growth by 2023 with a market size of $1.2 trillion.

Fund of funds: This primarily focuses on the investing in other funds, usually the mutual funds and hedge funds. They provide an opportunity to the investor who may not meet the minimum capital requirements for such funds. But higher management fees is involved as they are rolled up from different funds) and also the unfettered diversification might not necessarily lead to optimal strategy to increase the returns.

Venture Capital: Venture capital funding is a kind of private equity, where investors called as angels, offer capital to the entrepreneurs. Based on the stage at it is given at, venture capital may have different forms. In seed financing, the capital is provided by an investor to turn the idea from a prototype to an actual product or service, while the early stage financing helps company’s growth. Lastly, a Series A financing helps them  actively create a market or compete within.

How Do Private Equity Firms Make Money?

The private equity firms primarily generate their money in terms of management fees, the structure of which usually differs but generally includes a management fee as well as a performance fee. Certain businesses charge a 2% management fee yearly or managed assets and demand 20% of the profits obtained from the sale of a company.

Concerns Around Private Equity

In the start of 2015, a call was raised for higher transparency in the private equity industry mainly because of the huge volume of income, earnings, and high salaries earned by the staff at almost all private equity firms. In 2016, few states pushed for bills and regulations opening a bigger window into the internal workings of the private equity firms. However, lawmakers on Capitol Hill are now pushing back, demanding limitations on the Securities and Exchange Commission’s (SEC) access to the information.

References for Private Equity

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-Jørgensen, 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

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