By Harrison Heaton
The amount of confusion among a financial concept is obviously alarming. With that being said private equity is often something that everyone in the world of finance knows, but the definition, missions, and misconstrues to be something else. Therefore, for this article, I wanted to take a step back and give a higher level insight and deeper analysis into the world of private equity.
Private Equity is a differing type of investment class that has a heavy emphasis in the pursuit of private business transactions. However, even though this is what they focus on and specialize in, they are not limited to it and often dip their hand into business opportunities within the public market, or companies listed on the stock exchange. Private equity investments come mostly from some accredited investors and institutional investors that have dispensable amounts of money that they can devote towards long term investment opportunities. Longer-term holdings are often a requirement for most private equity to ensure liquidity and the financial sale of the company.
There are 4 major funding types within private equity. The first is distressed funding, which is also known as vulture financing. This is usually, like the name suggests, poorer quality companies that are underperforming. Private equity funds are used to try and turn around these companies and make them more profitable before later selling them. This type of funding increased after the 2008 market crash for obvious reasons. The second type of financing is leveraged buyouts. Leveraged buyouts are the most common and cleanest version of PE funding, which simply buys companies, makes them financially healthier and sells them for a gain. There are a variety of strategies to make these companies better, but for the most part it is executive changes. The third funding type is real estate private equity which invests large amounts of capital towards commercial real estate and REITS (Real Estate Investment trusts) which usually require a longer time horizon for investment. The last type of funding is venture capitalism, which emphasizes investment in start up or lower caliber companies with the hope of pursuing higher than average growth.
Structure is an important attribute to private equity and includes two types of partner classes. General partners and limited partners. General partners have a more hands-on role when it comes to the decision making surrounding the private equity fund, and their role often includes managing the fund and picking which investments they want to accumulate within their portfolio. Alongside making the investment decisions, general partners also are in charge of collected capital and financial commitments from the second type of partner, limited partners. Segwaying into limited partners and their role, LPs have the more relaxed position. LPs main role is to provide capital to these private equity funds to go towards a portfolio of different investments. Some LPs include institutional investors, high net worth individuals, insurance companies, university endowments, etc. and they all want to get a piece of the metaphorical “portfolio pie”. They have no say in the financial decision making the general partners undergo, but they do have the option to withhold funding if they are dissatisfied by the investment.
Marginal advantages are present through the utilization of private equity and is a favorable investment class among many major companies. There are several reasons for directly going to private equity funds instead of obtaining a traditional business/commercial loan, or listing the company on the public market through an IPO. Liquidity is a huge proponent of the favorable aspect of private equity due to the non-reliance of loans that may have interest rates attached to them. A company being able to rapidly access liquid cash to cover short term liabilities and debt payments is an essential operating factor, and is incredibly important to the security of the company due to them being backed by large sums of cash. Certain forms of private equity specialize in certain types of asset classes. For example, venture capitalism is under the umbrella of private equity and targets early stage startup companies with higher than average growth potential, yet has more risk correlated with this investing.
Private equity has the ability to create unorthodox strategies for growth through the target of certain assets like distressed companies that can be turned around for a profit, or early stage businesses that can be profitable with some management or technological advancements. The chart below shows a flow chart of the stages of private equity investments and some of the minimum requirements to get into it. Typically you have your limited partners as discussed above which accumulate large amounts of capital to dedicate towards the private equity fund. This fund is used to invest in all types of different asset and asset classes that may have the potential to be improved through some capital expenditures. They then hopefully make the company invested in more profitable and exit their position with a higher profit. This obviously has had its successes and failures just like everything in life, yet more often than not private equity firms are very successful.
Yet, when there are advantages they are yanged with disadvantages. Private equity is not for the average everyday investor due to the simple reasons that it requires a minimum investment threshold and usually has a longer term time horizon that individual investors don't feel comfortable giving their money for that long of time. Due to private equity dealing in the transactions of businesses, many of the issues arise when formulating and negotiating the investment purchases of these businesses. Negotiations are based on buyers and sellers values not market values as is typical with public transactions. This may result in disagreement or prolonged purchases. Additionally, negotiation between private shareholders is also an issue that will always be disputed, but has to be determined on a case by case basis.
Now that you know the definition, partners involved, advantages, disadvantages, how they make money and the type of investment assets they try to pursue, I want to provide some history and applicable examples of private equity firms and their funds used to purchase companies. Probably the biggest and most famous private equity transaction happened in the early 1900’s and was conducted by JP Morgan. JP Morgan had undergone their first leveraged buyout transaction with the acquisition of Carnegie Steel Corporation in 1901 for $480 million dollars. At this time Andrew Carnegie was congratulated on being the richest person in the world. JP Morgan then merged Carnegie’s Steel Corporation with other large steel companies to form the world’s largest company known as United States Steel. Ever since this merger, private equity has been increasingly popular and has had some serious transactions take place in the late 1900’s that have surpassed the $25 billion mark. With that being said, the glory years of private equity occurred right before the market crash of 2008/2009.
Work Cited
Chen, James. “Private Equity Definition.” Investopedia, Investopedia, 27 July 2021, https://www.investopedia.com/terms/p/privateequity.asp.
Segal, Troy. “Understanding Private Equity (PE).” Investopedia, Investopedia, 13 Nov. 2021, https://www.investopedia.com/articles/financial-careers/09/private-equity.asp.
“The Strategic Secret of Private Equity.” Harvard Business Review, 17 Sept. 2021, https://hbr.org/2007/09/the-strategic-secret-of-private-equity.
Gordon, John Steele. “A Short (Sometimes Profitable) History of Private Equity.” The Wall Street Journal, Dow Jones & Company, 17 Jan. 2012, https://www.wsj.com/articles/SB10001424052970204468004577166850222785654.
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