Private equity (PE) is stock in a private company that does not offer stock to the general public. Instead, it is offered to specialized investment funds and limited partnerships that take an active role in managing and structuring the companies. In colloquial usage, "private equity" can refer to these investment firms rather than the companies in which they invest.[1]
Private-equity capital is invested into a target company either by an investment management company (private equity firm), a venture capital fund, or an angel investor; each category of investor has specific financial goals, management preferences, and investment strategies for profiting from their investments. Private equity can provide working capital to finance a target company's expansion, including the development of new products and services, operational restructuring, management changes, and shifts in ownership and control.[2]
As a financial product, a private-equity fund is private capital for financing a long-term investment strategy in an illiquid business enterprise.[3] Private equity fund investing has been described by the financial press as the superficial rebranding of investment management companies who specialized in the leveraged buyout of financially weak companies.[4]
Evaluations of the returns of private equity are mixed: some find that it outperforms public equity, but others find otherwise.[5]
Key features
Some key features of private equity investment include:
- An investment manager (the private equity investor) raises money from institutional investors (e.g., hedge funds, pension funds, university endowments, and ultra-high-net-worth individuals) to pursue a particular investment strategy.
- The fund's raised proceeds are placed into an investment fund, of which the investment manager acts as a general partner (GP) and the institutional investors act as limited partners (LPs).[6]
- The investment manager then purchases equity ownership stakes in companies by using a combination of equity and debt financing, with the goal of generating returns on the equity invested, including any subsequent equity investments into the target companies, over a target horizon based on the particular investment fund and strategy (typically 4–7 years).[7]
- From a financial modeling perspective, the primary levers available to private equity investors to drive returns are:
- Revenue growth
Strategies
The strategies private-equity firms may use are as follows, leveraged buyout being the most common.
Leveraged buyout
Leveraged buyout (LBO) refers to a strategy of making equity investments as part of a transaction in which a company, business unit, or business asset is acquired from the current shareholders typically with the use of financial leverage.[13] The companies involved in these transactions are typically mature and generate operating cash flows.[14]
Private-equity firms view target companies as either Platform companies, which have sufficient scale and a successful business model to act as a stand-alone entity, or as add-on / tuck-in / bolt-on acquisitions, which would include companies with insufficient scale or other deficits.[15][16]
History and development
Early history and the development of venture capital
The seeds of the US private-equity industry were planted in 1946 with the founding of two venture capital firms: American Research and Development Corporation (ARDC) and J.H. Whitney & Company.[58] Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. In 1901 J.P. Morgan arguably managed the first leveraged buyout of the Carnegie Steel Company using private equity.[59] Modern era private equity, however, is credited to Georges Doriot, the "father of venture capitalism" with the founding of ARDC[60] and founder of INSEAD, with capital raised from institutional investors, to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in
Investments in private equity
Although the capital for private equity originally came from individual investors or corporations, in the 1970s, private equity became an asset class in which various institutional investors allocated capital in the hopes of achieving risk-adjusted returns that exceed those possible in the public equity markets. In the 1980s, insurers were major private-equity investors. Later, public pension funds and university and other endowments became more significant sources of capital.[110] For most institutional investors, private-equity investments are made as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds) and other alternative assets (e.g., hedge funds, real estate, collectables).
Investor categories
Public and private pension schemes in the United States, Canada, and Europe have invested in the asset class since the early 1980s as part of efforts to diversify away from traditional holdings such as public equities and fixed income.[111] These investments have been driven by the search for higher long-term returns, diversification benefits, and improved risk-adjusted performance.
Liquidity in the private-equity market
The private-equity secondary market (also often called private-equity secondaries) refers to the buying and selling of pre-existing investor commitments to private equity and other alternative investment funds. Sellers of private-equity investments sell not only the investments in the fund but also their remaining unfunded commitments to the funds. By its nature, the private-equity asset class is illiquid, intended to be a long-term investment for buy-and-hold investors. For the vast majority of private-equity investments, there is no listed public market; however, there is a robust and maturing secondary market available for sellers of private-equity assets.
Increasingly, secondaries are considered a distinct asset class with a cash flow profile that is not correlated with other private-equity investments. As a result, investors are allocating capital to secondary investments to diversify their private-equity programs. Driven by strong demand for private-equity exposure, a significant amount of capital has been committed to secondary investments from investors looking to increase and diversify their private-equity exposure.
Investors seeking access to private equity have been restricted to investments with structural impediments such as long lock-up periods, lack of transparency, unlimited leverage, concentrated holdings of illiquid securities and high investment minimums.
Secondary transactions can be generally divided into two primary categories:
LP Interest Secondaries (Sale of Fund Interests)
This is the most common type of secondary transaction, involving the sale of an investor's interest in a private-equity fund or a portfolio of multiple fund interests.
Private-equity firms
According to Private Equity International's latest PEI 300 ranking,[117] the largest private-equity firm in the world today is The Blackstone Group based on the amount of private-equity direct-investment capital raised over a five-year window.
As ranked by the PEI 300, the 15 largest private-equity firms in the world in 2024 were:
Because private-equity firms are continuously in the process of raising, investing and distributing their private equity funds, capital raised can often be the easiest to measure. Other metrics can include the total value of companies purchased by a firm or an estimate of the size of a firm's active portfolio plus capital available for new investments. As with any list that focuses on size, the list does not provide any indication as to relative investment performance of these funds or managers.
Preqin, an independent data provider, ranks the 25 largest private-equity investment managers. Among the larger firms in the 2017 ranking were AlpInvest Partners, Ardian (formerly AXA Private Equity), AIG Investments, and Goldman Sachs Alternatives
Private-equity funds
Private-equity fundraising refers to the action of private-equity firms seeking capital from investors for their funds. Typically an investor will invest in a specific fund managed by a firm, becoming a limited partner in the fund, rather than an investor in the firm itself. As a result, an investor will only benefit from investments made by a firm where the investment is made from the specific fund in which it has invested.
As fundraising has grown over the past few years, so too has the number of investors in the average fund. In 2004, there were 26 investors in the average private-equity fund, this figure has now grown to 42 according to Preqin ltd. (formerly known as Private Equity Intelligence).
The managers of private-equity funds will also invest in their own vehicles, typically providing between 1–5% of the overall capital.
Often private-equity fund managers will employ the services of external fundraising teams known as placement agents in order to raise capital for their vehicles. The use of placement agents has grown over the past few years, with 40% of funds closed in 2006 employing their services, according to Preqin ltd. Placement agents will approach potential investors on behalf of the fund manager, and will typically take a fee of around 1% of the commitments that they are able to garner.
The amount of time that a private-equity firm spends raising capital varies depending on the level of interest among investors, which is defined by current market conditions and also the track record of previous funds raised by the firm in question. Firms can spend as little as one or two months raising capital when they are able to reach the target that they set for their funds relatively easily, often through gaining commitments from existing investors in their previous funds, or where strong past performance leads to strong levels of investor interest. Other managers may find fundraising taking considerably longer, with managers of less popular fund types finding the fundraising process more tough.
List of private equity billionaires
Below is a partial list of billionaires who acquired their wealth through private equity.
Taxes
Income to private equity firms is primarily in the form of "carried interest", typically 20% of the profits generated by investments made by the firm, and a "management fee", often 2% of the principal invested in the firm by the outside investors whose money the firm holds. As a result of a tax loophole enshrined in the U.S. tax code, carried interest that accrues to private equity firms is treated as capital gains, which is taxed at a lower rate than is ordinary income. Currently, the long term capital gains tax rate is 20% compared with the 37% top ordinary income tax rate for individuals. This loophole has been estimated to cost the government $130 billion over the next decade in unrealized revenue. Armies of corporate lobbyists and huge private equity industry donations to political campaigns in the United States have ensured that this powerful industry receives this favorable tax treatment by the government. Private equity firms retain close to 200 lobbyists and over the last decade have made almost $600 million in political campaign contributions.[146]
In addition, through an accounting maneuver called "fee waiver", private equity firms often also treat management fee income as capital gains. The U.S. Internal Revenue Service (IRS) lacks the manpower and the expertise that would be necessary to track compliance with even these already quite favorable legal requirements. In fact, the IRS conducts nearly no income tax audits of the industry. As a result of the complexity of the accounting that arises from the fact that most private equity firms are organized as large partnerships, such that the firm's profits are apportioned to each of the many partners, a number of private equity firms fail to comply with tax laws, according to industry
Debate
Carried interest
Effects
PE's interest in short term profits without regard for the long term effects and the ability to "make money even if their companies blow up" can lead to job loss, raised prices, asset stripping and increased likelihood of bankruptcy for companies acquired.[147][148][149][150][151][152]
See also
- Common ordinary equity
- History of private equity and venture capital
- Holding company
- List of private equity owned companies that have filed for bankruptcy
- Private equity fund
- Private investment in public equity
- Publicly traded private equity
- Specialized investment fund
- Search fund
- Vulture capitalist
- Enshittification
Organizations
Further reading
- Private Inequity by James Surowiecki, The Financial Page, The New Yorker, 30 January 2012.
External links
- Archive of articles on private equity controversies in the 21-st century, Naked Capitalism.
References
- Investments in private equity An Introduction to Private Equity, including differences in terminology.^
- Venture Capital Investing PrivCo, retrieved 25 April 2022^
- Winning Strategy For Better Investment Decisions In Private Equity USPEC, 5 Nov 2019, retrieved 27 January 2020