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.
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.
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.
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