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Private equity

Private equity is an investing term that’s good to know. Bankrate explains it.

What is private equity?

Private equity is the term used to describe a situation in which an investor, or investors, pools money to acquire stakes in a company. Venture capital is technically PE, but it normally goes into startup companies with a great idea but an unproven track record. PE is most often used to buy part or all of older companies that may be making money but need help to achieve their full potential.

Deeper definition

Most of the companies targeted by PE are either not publicly traded on the stock market or have been delisted. Once a deal has been struck and PE investors make the business their own, the company can be listed again on the market. This time, it is listed as a way to make money for the PE firm.

PE groups commonly operate through a leveraged buyout (LBO). In an LBO, the PE investors use private funding as well as money they have borrowed from banks. They may use their funds to buy out a publicly traded company and take it private, or to buy a company owner out of his or her business. The money can also be used to pay off debt they inherited with the new business or to help the company make the changes it needs to grow.

Once PE investors take over, they regularly replace top management, reduce costs and structure smaller boards of directors. PE takeovers can be good for the original owner of a business and may benefit investors, but sometimes they come at the expense of current employees.

Like most business ventures, PE investing is about how much money the investors can make. PEs place a heavy emphasis on creating a more valuable company. Like anything, PE has its pros and cons. Among the pros:

  • A company may receive a large amount of funding, money it needs in order to change and grow.
  • PE can look at a business through fresh eyes in order to accentuate its most positive qualities and minimize others.
  • Companies tend to grow. More than 66 percent of companies grew by at least 20 percent after a PE group came in.

Among the cons of PE:

  • Many PEs essentially gut a company in the name of profits.
  • The role of founders, the value of the workforce and sentimentality can be secondary to PE goals.
  • PE firms look for a company big enough to offer large profit potential in a short period of time or one that’s in such dire financial straits as to be currently undervalued.

Example of private equity

Private equity firms normally achieve their return on investment in one of three ways:

  • Initial public offering (IPO). IPOs offer shares of the company to the public. Funds from the purchase of those shares immediately benefit the PE.
  • Acquisition or merger. PEs make their money back as soon as their company sells to another company.
  • Recapitalization. As changes are made and cash flow is generated, PE investors begin to see a return.

Anyone can indirectly take part in PE by buying shares of publicly traded PE firms. These include:

  • The Blackstone Group L.P.
  • Oaktree Capital Group
  • KKR & Co. L.P.
  • The Carlyle Group L.P.
  • Fifth Street Asset Management Inc.
  • Apollo Global Management LLC

As with any investment, you should begin by reading the firms’ most recent regulatory filings and making sure you understand their strategies and tactics.

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