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Understanding Private Equity: What It Is and How It Works

Understanding Private Equity


Even if you already work in finance, the concept of what private equity actually is can be confusing. High-level private equity investors use a mix of debt and equity to acquire companies (either with a minority or majority ownership stake), make operational improvements to make the company more profitable, and exit the investment in a few years in order to make a large return on their initial investment.


Private equity has been around for decades but has grown exponentially over the last two decades in particular. Even with the dip in activity after the crash in 2008, private equity investments rebounded, growing quickly in its legacy markets of North America and Europe and expanding into Asia and Africa. In fact, several studies estimate that private capital will continue to grow at an exponential rate, making it a key resource for growth.


Why is private equity so attractive? There are a few key reasons why private equity has survived several market cycles and doesn’t quite face the same swings in performance as other investment types (i.e., venture capital, hedge funds, etc.). First, private equity requires aggressive use of debt to finance transactions, which provides financing and tax advantages that other investors don’t have access to. Second, private equity firms focus on cash and margin improvement, which in turn makes the company as a whole more profitable and leads to a greater return on investment for the firm. Lastly, private equity firms are not subject to restrictive public company regulations (unless the firm itself is public, in which case it does have obligations to its investors and reporting agency) in the same way that hedge funds and other public investment vehicles are. These advantages allow private equity firms to employ a combination of business and investment management to earn returns on their investments. This allows them to continue raising larger funds and making investments to earn returns for investors as well as for employees of the firm (who can invest alongside larger investors).


So where do private equity firms get the capital to invest in, and how do they deploy the capital? In order to understand this, we should look at the structure of a private equity fund. A private equity fund (or the “General Partner”) is funded by investors who are called “Limited Partners.” Limited Partners, more commonly referred to as LPs, can be entities like public pension funds, endowments, foundations, insurance companies, family offices, high-net-worth individuals, fund-of-funds, sovereign wealth funds, and a variety of other sources. The job of the investor relations team at a private equity firm is to reach out to potential LPs and secure financial commitments from them in order to meet the fund’s fundraising target. Once commitments are finalized, all of the LPs pool their money together, and this is the money used for the private equity firm’s fund (also called a “Limited Partnership”). From the fund, the investment team at the firm will make a series of investments in companies that will become the fund’s portfolio companies. Once the entire fund’s capital is deployed, firms will raise the next fund, which will usually have a larger size and/or a different strategy. LPs in one fund can also be LPs in additional funds, particularly if they like the performance they’ve seen so far from the private equity firm.


Once a private equity firm makes an investment, they will typically hold onto it for 5+ years. The exit year can depend on a variety of factors, including macroeconomic trends and market conditions, company initiatives that have a specific execution timeline, or the ability to find a new buyer (whether that be another financial sponsor, a strategic buyer, or another exit method like taking the company public). During what is known as the “hold period,” the private equity firm will make operational improvements to the company in order to boost profits. One common way to do this that has gotten significant press is by cutting jobs that are redundant within the company. While this practice was very common in the beginning days of private equity, firms like the one I work at try to invest in companies with a very strong management team in order to avoid key executives leaving or having to be laid off. Other improvements may include introducing new products or services, bolt-on acquisitions of smaller companies or products, or a variety of creative solutions that may not have even been a possibility when the company was initially acquired.


Some of the largest private equity firms in the world are actually public companies. These include firms like KKR, Blackstone, Apollo, Carlyle, and many others. In addition to having LPs and the fund structure discussed above, these firms have the extra component of having public investors in their stock. These firms must follow all the reporting standards of regular public companies, including audited financials, earnings calls every quarter, and hosting investor days, to name a few. Being a public company can also influence the types of investments the firm is willing to have in their portfolio. For example, public companies might be less willing to invest in companies that aren’t ESG friendly or have had management issues since public investors may have negative reactions, causing the firm’s equity value to fall.


Private equity firms can also specialize in a specific type of investment, and many of the larger firms have several subgroups that invest in specific industries or asset classes. For example, a firm like KKR has many subgroups with investment professionals in the U.S. who specialize in consumer, healthcare, industrials, TMT, and financial services. Each subgroup will have its own funds to deploy and its own investments to manage in their individual portfolios. Other firms might have the entire firm focused on one type of investment. For example, infrastructure funds focus on investing only in infrastructure but might invest across a variety of industries (telecommunications, energy, environment, healthcare, transportation, etc.). Firm and fund structure vary wildly across different firms, which is why it’s important to read about a specific firm’s strategy and how they invest capital contributed by their LPs.


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