Private equity firms use a combination of money from investors (equity finance) and money borrowed from banks (debt finance) to acquire companies, often ones listed on the stock market, and sell them on at a profit. This process usually involves taking the acquired company private and stripping it of any inefficiencies, resulting in a smaller, leaner business with a higher value.
How do they operate?
The main way for private equity firms to raise profit is through leveraged buyouts. These involve purchasing a company using a high ratio of debt finance to equity finance, allowing the debt to act as a lever to increase the return on equity investment once the company is sold. This ratio is expressed as a loan-to-value (LTV) figure; for instance, 40 LTV means 40 per cent of the money used to purchase a company is debt finance. Before the financial crisis, it wasn't uncommon for private equity firms to purchase companies with LTV figures as high as 80 or 90.
Private equity firms may also invest in companies in other ways. For example, venture capital investments might be made in small start-up companies. As an alternative to buying the entire business, these deals are intended to help small entrepreneurs grow their businesses so that the private equity firm can make a profit from their part-investment on an eventual IPO or trade sale of the company.
Who are the clients?
Investors in private equity firms can range from big to small, encompassing both private and institutional investors. Any money placed in a private equity fund cannot be redeemed whenever the investor wants, so those wanting a quick return on their money are likely to invest it elsewhere. Private equity investors must wait until their fund is bought out or expires, with funds commonly having a lifespan of around ten years.
How do the firms make money?
Investors in private equity funds will pay the firm a periodic management fee in return for their handling of their investment. Once management fees have been paid, all money raised for the fund through selling acquired businesses at a profit is divided among investors according to the size of their investment in the fund. Due to the use of leverage, private equity investors are able to benefit proportionally more than they otherwise would from the increase in the value of a business when it's sold.
Why should I be interested in it?
Private equity is an ideal industry for anyone with an interest in both banking and consulting as it combines the deal-making culture of investment banking with the strategic analysis which is needed in consulting. Private equity work is suited to individuals with a good business brain, able to comprehend how large businesses operate and think of strategies to help make them more efficient and profitable.
Founded by financier Guy Hands, Terra Firma has invested over â‚¬14 billion (£11.9 billion) since its inception. Its focus tends to be on leverage buyouts of large, asset-backed businesses which require transformational change in their operations and management. Businesses acquired by Terra Firma over the years include Odeon Cinemas, William Hill and The Garden Centre Group.
This Washington DC-based private equity firm hasbeen one of the largest investors in leveraged buyout transactions over the last decade, with investments in such notable companies as Hertz and Getty Images. In 2011, the Private Equity International 300 ranking of the largest private equity firms listed Carlyle as the third largest worldwide.
Blackstone Group is the largest alternative investment firm in the world, specialising in a whole host of other services alongside private equity. Since being founded in 1985, the firm has completed investments in a wide range of companies including Hilton Worldwide and United Biscuits. In 2007, Blackstone completed a $4 billion initial public offering, making itone of the first major private equity firms to publicly list shares in its management company.
Used to describe a business in possession of tangible assets, such as real estate.
Buy, strip and flip
When a private equity firm buys a business, only to sell it via an IPO relatively quickly, as opposed to keeping it on its books for a few years.
An investor, or in this case a private equity firm, which targets assets that have been neglected by others, making them available for less than their true value.
In a private equity context, the collective pool of money from investors used by a private equity firm to invest in businesses.
In a private equity context, the use of borrowed money (debt) as well as investor funds (equity) to finance the purchase of a business.
In a private equity context, term given to the list of businesses a private equity firm has on its books at any one moment.
Trending issues in private equity
While the private equity model works brilliantly when firms are turning a profit, private equity firms which lose money often turn into troublesome "zombie firms". Knowing there are no future profits to look forward to, and aware their chances of raising future capital from investors is unlikely given their failure, unprofitable private equity firms instead eke out an existence on the fees they're able to continue to claim from investors. As investors are unable to withdraw their money until a fund expires, they can do little but helplessly watch their investment turn bad.
As well as investing in established, western businesses, private equity investors have been recently expanding into the emerging markets of India, China, Africa and Latin America with funds dedicated to these areas of the world. A recent *Wall Street Journal *article stated investors in Latin American private equity and venture capital funds had raised a total of $3.8 billion, with Brazil and Mexico the main recipients of investment.
Diversified income streams
In a move designed to increase their revenue, some of the world's largest private equity firms have begun to branch out and offer a wider range of financial services including advisory and asset management services. In a recent expansion, private equity firm Blackstone added an Innovations and Infrastructure division, with the goal of creating technology solutions to be used in the rest of their business.
Did you know...?
Guy Hands, Chairman and Chief Investment Officer of Terra Firma, moved to Guernsey in 2009 as an act of protest against the UK tax system. He hasn't set foot in the United Kingdom since.