What is a Private Equity Firm?

Rather than selling shares on the stock market, a private equity firm raises money (usually millions or billions of dollars) from a group of investors.

Private Equity Firm’s #1 Goal = make a company worth more than it was before, in order to produce a very significant return for investors. A private equity firm’s targeted internal rate of return is between 20% and 25% 1

The private equity firm then uses the money to acquire an ownership position (usually a majority or substantial minority position) in a private company.

The private equity firm uses the money to grow the company, introduce new product lines, restructure its operations, management or ownership; to give the company a second wind and make a substantial return on its investment.

Why would a company relinquish some of itself to a private equity firm? They need the cash to grow bigger and be more successful. Why don’t they just get a loan from the bank? Because a bank loan must be paid back, while a private equity investment does not.

You may have heard these names – Blackstone, Carlyle Group, KKR, and Apollo - these are the biggest PE players in the world - and they have had some astounding performance.  

 

Blackstone’s first-quarter earnings doubled from 2014 to 2015 from $813 million to $1.62 billion 2

Why does the PE firm take an ownership position? So they can take control of the company, turn it around, and sell it for a large profit at a future date.
PE firms have a reputation for being ruthless. This is driven by their motivation to run the company well because they gain a big profit from doing so. And so do their investors.

 

How do PE firms make such huge returns?

1. They buy companies on the cheap

The average price-to-earnings paid for a private company in 2015 was 7.1. 3

Compare this to the public markets, where the historical average price-to-earnings ratio is between 15 and 25! 4 Relative to their earnings, private companies are bought at half to one-third the price of what would be paid for the same company if it were public, which creates a huge return potential in the case of a liquidity event.

2. There is a big cost to "going public."

For shareholders, it costs millions of dollars for audit requirements, financial disclosure requirements,and teams of lawyers:  A study of 360 venture-backed technology IPOs found that on average 8.8% of the money raised in the IPO was paid to investment banks, accountants and attorneys! 5

In comparison, a private company can grow without being burdened with the expenses of going public, which creates substantially more earnings for a private company.

 

Sources:

  1. http://www.hbs.edu/faculty/Publication%20Files/15-081_9baffe73-8ec2-404f-9d62-ee0d825ca5b5.pdf
  2. http://www.bloomberg.com/news/articles/2015-04-16/blackstone-first-quarter-earnings-double-as-assets-rise
  3. http://www.perda.co.uk/
  4. http://www.investopedia.com/university/peratio/peratio1.asp
  5. http://tomtunguz.com/how-much-does-it-cost-to-take-your-startup-public/