Understanding Private Equity (PE)

You've probably heard of the term private equity (PE): investing in companies that are not publicly traded. Roughly $11.7 trillion in assets were managed by private markets in 2022.

PE firms seek opportunities to earn returns that are better than what can be achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity firms and why they're important, including how they create value and some of their key strategies.

Why Private Equity Firms Are Important

Private equity is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity comes from firms that purchase stakes in private companies or acquire control of public companies with plans to take them private and delist them from stock exchanges. Private equity can also come from high-net-worth individuals (HNWI) who are eager to see outsized returns.

The private equity industry is comprised of institutional investors, such as pension funds, and large private equity firms funded by accredited investors. Because private equity entails direct investment—often to gain influence or control over a company's operations—a significant capital outlay is required, which is why funds with deep pockets dominate the industry.

The minimum amount of capital required for accredited investors can vary depending on the firm and fund. Some funds have a $250,000 minimum entry requirement, while others can require millions more.

The underlying motivation for such commitments is the pursuit of achieving a positive return on investment (ROI). Partners at PE firms raise funds and manage the money to yield favorable returns for shareholders, typically with an investment horizon of between four and seven years.

Types of PE Firms

Private equity firms have a range of investment preferences. Some are strict financiers or passive investors wholly dependent on management to grow the company and generate returns. Because sellers typically see this as a commoditized approach, other PE firms consider themselves active investors. That is, they provide operational support to management to help build and grow a better company.

Active private equity firms may have an extensive contact list and C-level relationships, such as CEOs and CFOs within a given industry, which can help increase revenue. They might also be experts in realizing operational efficiencies and synergies. If an investor can bring in something special to a deal that will enhance the company's value over time, they are more likely to be viewed favorably by sellers.

Investment banks compete with some private equity PE firms, also known as private equity funds, to buy good companies and finance nascent ones. Unsurprisingly, the largest investment-banking entities such as Goldman Sachs (GS), JPMorgan Chase (JPM), and Citigroup (C) often facilitate the largest deals.

In the case of PE firms, the funds they offer are only accessible to accredited investors and may only allow a limited number of investors, while the fund's founders will usually take a rather large stake in the firm as well.

That said, some of the largest and most prestigious private equity funds trade their shares publicly. For instance, the Blackstone Group (BX), which has been involved in the buyouts of companies such as Hilton Hotels and MagicLab, trades on the New York Stock Exchange (NYSE).

How PE Firms Create Value

Private equity (PE) firms perform two critical functions:

• Deal origination and transaction execution
• Portfolio oversight

Deal origination and execution

Deal origination involves creating, maintaining, and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks, and similar transaction professionals. These relationships secure both high-quantity and high-quality deal flow, referring prospective acquisition candidates to private equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that funds raised are successfully deployed and invested.

Additionally, internal sourcing efforts can reduce transaction-related costs by cutting out the investment banking middleman's fees. When financial services professionals represent the seller, they usually run a full auction process that can diminish the buyer's chances of successfully acquiring a particular company. As such, deal origination professionals attempt to establish a strong rapport with transaction professionals to get an early introduction to a deal.

It is important to note that investment banks often raise their own funds, and therefore may not only be a deal referral, but also a competing bidder. In other words, some investment banks compete with private equity firms to buy up good companies.

Transaction execution involves assessing management, the industry, historical financials and forecasts, and conducting valuation analyses. After the investment committee signs off to pursue a target acquisition candidate, the deal professionals submit an offer to the seller.

If both parties decide to move forward, the deal professionals work with various transaction advisors, including investment bankers, accountants, lawyers, and consultants, to execute the due diligence phase. Due diligence includes validating management's stated operational and financial figures. This part of the process is critical, as consultants can uncover deal-killers, such as significant and previously undisclosed liabilities and risks.

Portfolio oversight and management

Oversight and management make up the second important function of private equity professionals. Among other support work, they can walk a young company's executive staff through best practices in strategic planning and financial management. Additionally, they can help institutionalize new accounting, procurement, and IT systems to increase the value of their investment.

When it comes to more established companies, PE firms believe they have the ability and expertise to take underperforming businesses and turn them into stronger ones by increasing operational efficiencies, and with it earnings. This is the primary source of value creation in private equity, though PE firms also create value by aiming to align the interests of company management with those of the firm and its investors.

By taking public companies private, private equity firms remove the constant public scrutiny of quarterly earnings and reporting requirements, which then allows them and the acquired firm's management to take a longer-term approach to improve the fortunes of the company.

Management compensation is also frequently tied more closely to the firm's performance, thus adding accountability and incentive to management's efforts. This, along with other mechanisms popular in the private equity industry, eventually lead to the acquired company's valuation increasing substantially in value from the time it was purchased, creating a profitable exit strategy for the private equity firm—whether that's a resale, an initial public offering (IPO), or an alternative option.

Private Equity Investment Strategies

There are plenty of private equity investment strategies. Two of the most common are leveraged buyouts (LBOs) and venture capital (VC) investments.

Leveraged buyouts (LBOs)

LBOs are exactly how they sound. A company is bought out by a private equity firm, and the purchase is financed through debt, which is collateralized by the target’s operations and assets.

The acquirer (the PE firm) seeks to purchase the target with funds acquired through the use of the target as a sort of collateral. In an LBO, acquiring private equity firms are able to assume control of companies while only putting up a fraction of the purchase price. By leveraging the investment, PE firms aim to maximize their potential return.

Venture capital (VC)

VC is a more general term, frequently used in relation to taking an equity investment in a young company in a less mature industry—think Internet companies in the early- to mid-1990s. Private equity firms will often see that potential exists in the industry, and more importantly in the target firm itself, noting that it’s being held back, say, by a lack of revenues, cash flow, and debt financing.

PE firms are able to take significant stakes in such companies in the hopes that the target will evolve into a powerhouse in its growing industry. Additionally, by guiding the target’s often inexperienced management along the way, PE firms add value to the company in a less quantifiable manner as well.

How PE Firms Exit a Deal

One popular exit strategy for private equity firms involves growing and improving a middle-market company and selling it to a large corporation for a hefty profit. The big investment banking professionals cited above typically focus their efforts on deals with enterprise values (EVs) worth billions of dollars; the average deal size in 2022 was $964 million.

Because the best gravitate toward the larger deals, the middle market is a significantly underserved market. There are more sellers than there are highly seasoned and well-positioned finance professionals with extensive buyer networks and resources to manage a deal.

Flying below the radar of large multinational corporations, many of these small companies often provide higher-quality customer service and/or niche products and services that are not being offered by the large conglomerates. Such upsides attract the interest of private equity firms, as they possess the insights and savvy to exploit such opportunities and take the company to the next level.

For instance, a small company selling products within a particular region may grow significantly by cultivating international sales channels. Alternatively, a highly fragmented industry can undergo consolidation to create fewer, larger players—larger companies typically command higher valuations than smaller companies.

An important company metric for these investors is earnings before interest, taxes, depreciation, and amortization (EBITDA). When a private equity firm acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

Private equity investors must have reliable, capable, and dependable management in place. Most managers at portfolio companies are given equity and bonus compensation structures that reward them for hitting their financial targets. Such alignment of goals is typically required before a deal gets done.

How to Invest in Private Equity

Private equity opportunities are often out of reach for people who can't invest millions of dollars, but they shouldn't be. Though most PE investment opportunities require steep initial investments, there are still some ways for smaller, less wealthy players to get in on the action.

Publicly traded stock

There are several private equity investment firms—also called business development companies (BDCs)—that offer publicly traded stock, giving average investors the opportunity to own a slice of the PE pie. Along with the Blackstone Group, there is Apollo Global Management (APO), Carlyle Group (CG), and Kohlberg Kravis Roberts (KKR), best known for its massive leveraged buyout of RJR Nabisco in 1989.

Funds of funds

Mutual funds have restrictions in terms of buying private equity due to Securities and Exchange Commission (SEC) rules regarding illiquid securities holdings, but they can invest indirectly by buying these publicly-listed private equity companies. These mutual funds are typically referred to as funds of funds.

Exchange-traded funds

Average investors can also purchase units in an exchange-traded fund (ETF) that holds shares of private equity firms, such as ProShares Global Listed Private Equity ETF (PEX).

Crowdfunding

Private equity crowdfunding allows companies or entrepreneurs to obtain financing. The investor is offered debt or equity in exchange for partial ownership of the business. Oftentimes, private equity crowdfunding is shortened to the term equity crowdfunding.

Crowdfunding can be used by companies to raise money, similar to how individuals can raise money for causes via GoFundMe. Examples of online platforms for equity crowdfunding include Wefunder, AngelList, Crowdfunder, SeedInvest, and CircleUp. With private equity crowdfunding, however, entrepreneurs and businesses generally have to give up equity to get the investment.?

The Securities and Exchange Commission (SEC) has created regulations to allow companies to access capital. There are regulations, such as limits on the aggregate amount of money and on the number of non-accredited investors.

Working at a Private Equity Firm

The private equity business attracts some of the best and brightest in corporate America, including top performers from Fortune 500 companies and elite management consulting firms. Law firms can also be recruiting grounds for private equity hires, as accounting and legal skills are necessary to complete deals, and transactions are highly sought after.

The fee structure for PE firms varies but typically consists of a management and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale of the company is common, though incentive structures can differ considerably.

Given that a PE firm with $1 billion of assets under management (AUM) might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees, it is easy to see why the industry attracts top talent.

Compensation for PE jobs will vary depending on the company, title, and location. In North America, associates can make an average total compensation of $234,000; vice presidents, $392,000; principals, $608,000; and managing directors/partners, $1.1 million.

The Bottom Line

With funds under management already in the trillions, private equity firms have become attractive investment vehicles for wealthy individuals and institutions. Understanding what private equity exactly entails and how its value is created in such investments are the first steps in entering an asset class that is gradually becoming more accessible to individual investors.

As the industry attracts the best and brightest in corporate America, the professionals at private equity firms are usually successful in deploying investment capital and in increasing the values of their portfolio companies; however, there is also fierce competition in the M&A marketplace for good companies to buy. As such, it is imperative that these firms develop strong relationships with transaction and services professionals to secure a strong deal flow.

Correction—Nov. 15, 2023:?This article has been corrected to state that the average buyout deal size in 2022 was $964 million.?