An Introduction to Private Equity

by Derek Loosvelt | March 10, 2009

As its name implies, a private equity firm invests in assets not freely traded on public stock exchanges. Private equity investments can take many shapes; the most well-known is the buyout, a term popularized by Bryan Burroughs and John Helyar's 1989 book Barbarians at the Gate, later made into a television movie, following the battle for control of RJR Nabisco. The battle was ultimately won by legendary private equity firm Kohlbergh Kravis Roberts & Co., better known as KKR.

A buyout refers to the purchase of a controlling interest company unit. A leveraged buyout, commonly referred to as an LBO, which KKR implemented to acquire RJR, is a takeover that uses a significant amount of borrowed money. Other types of private equity investments include mezzanine financing and venture capital. Mezzanine financing uses subordinated debt along with equity to invest in a company, typically prior to an initial public offering. Venture capital, considered a subset of private equity (see the Vault Career Guide to Venture Capital), refers to investments in the launch or early development a company. As opposed to venture capital firms, private equity firms invest in later-stage companies.

Although private equity is a relatively young business -- the first of today's large private equity firms, Warburg Pincus, was founded in the late 1960s -- now there are more than 2,700 such companies worldwide. In addition to KKR and Warburg, other large players include the Blackstone Group, Texas Pacific Group and the Carlyle Group. (Like KKR, Carlyle was also featured in a mainstream film, receiving air time in Michael Moore's 2004 documentary Fahrenheit 9/11for its connections to former President George H. W. Bush and various Saudi investors, including the bin Laden family.) Leading investment banks such as Goldman Sachs, Lehman Brothers and JPMorgan Chase also have private equity units that are now huge players in the industry.

Private equity firms raise money for funds from entities such as pension funds, endowments, corporations and wealthy individuals. Funds are typically set up as limited partnership, thus the LP at the end of most of their names, as in JPMorgan Partners Global Investors, LP. Investors in the funds act as limited partners, a private equity firm as general partner. A private equity firm will first spend time raising money for a fund. Once it hits a certain amount, it will then announce a first "closing" and begin looking for deals. It could take several years to invest all the money in a fund, and a private equity firm might raise more money in a fund after the first closing. Only when a firm announces a fund's final closing is it no longer open to new investors.

The businesses that a private equity firm purchases with money from its funds are referred to as its "portfolio companies." The Blackstone Group has an equity stake in some 40 portfolio companies, which, according to The Economist, together have over 300,000 employees and annual revenue of more than $50 billion. If combined as a single entity, these companies would make Blackstone one of the top 20 Fortune 500 firms. In comparison, Texas Pacific Group's portfolio companies have over 255,000 employees and revenue of $41 billion, while Carlyle's portfolio companies have 150,000 employees and revenue of $31 billion.

Private equity firms make money two ways: either selling their stakes in portfolio companies to corporate buyers at higher prices, or floating their stakes on the public market through IPOs. These two avenues are commonly referred to as "exit strategies." As business owners, private equity firms can increase the value of their investments in several ways. One, and perhaps the most obvious way, is to increase a company's profitability. Another is simply holding onto a company until it falls back in favor with investors or the market. A third is to break up a company into separate units and sell them individually; often, the sum of the values of each unit of a firm is higher than its value as a whole.

Private equity firms also make money through annual management fees, commonly 1 to 2 percent of the total amount of a fund. Fees are charged to the fund's investors (the limited partners). So, for example, if a firm has raised a $1 billion fund, it might pocket $20 million in management fees each year from its limited partners.

Filed Under: Finance


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