Understanding Private Equity (PE)

You've probably heard of the term private equity (PE): investing in companies that are not publicly traded. About $11.7 trillion in assets were managed by private markets in 2022. PE firms seek opportunities to earn returns 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, why some private equity groups have garnered negative press attention, and how they create value through some of their key strategies.

Why Private Equity Firms Are Important

Private equity is ownership or interest in entities that aren’t publicly listed or traded. A source of investment capital, private equity comes from firms that buy stakes in private companies or take 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 eager to see outsized returns.

The private equity industry comprises institutional investors, such as pension funds, and large private equity firms funded by accredited investors. A significant capital outlay is needed because private equity invests directly—often to gain influence or control over a company’s operations—so deep-pocket funds dominate the industry.

The capital raised by PE funds annually almost tripled between 2013 and 2021, peaking at almost $2.2 trillion. That was down to 1.2 trillion in 2023 on the heels of fewer funds seeking out capital, with investors still skittish given higher interest rates.

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

The underlying reason for private equity investing is to achieve returns on investment that may not be achievable in the public market. Partners at PE firms raise and manage funds to yield favorable returns for shareholders, typically with an investment horizon of four to seven years.

This time horizon is often the focus of critiques of the industry, especially as it ballooned in size in the 2010s. Critics argue that PE firms, unlike founders or industry specialists, lack a deep emotional investment or specialized expertise in the businesses they acquire. To boost profitability, these firms often carry out drastic cost-cutting measures: layoffs, reductions in worker benefits, scaling back operations, and the like. Such strategies can profoundly affect employees and local communities. PE firms also frequently use leveraged buyouts, potentially burdening acquired companies with excessive debt and increasing the risk of future bankruptcies.

All this, coupled with ongoing debates in Congress over the preferential tax treatment of carried interest (a crucial part of PE fund managers’ compensation), has attracted significant media scrutiny. In recent years, the industry has taken the blame for why your kid’s toy store is closing (the Toys R Us bankruptcy of 2017), why Taylor Swift had to rerecord her albums (the album masters were part of a PE deal), why patients at your local hospital face higher bills and less care (a major 2023 Journal of the American Medical Association study showing a rise in complications at private-equity-owned hospitals), and even why your favorite sports magazine has laid off most of its staff (the 2024 layoffs at Sports Illustrated by a PE firm).

Supporters of the private equity industry argue that it plays a crucial role in the economy. They emphasize the ability of private equity firms to infuse capital into struggling companies, potentially saving them from bankruptcy and preserving jobs. These firms have the financial resources and strategic expertise to carry out changes needed by whoever owns them while streamlining operations and driving growth.

Defenders also note that private equity’s focus on maximizing returns aligns with the interests of investors, including pension funds and endowments, which in turn benefits retirees and beneficiaries. The UK-based researchers John Gilligan and Mike Wright, who have written a major textbook on the industry, which includes a summary of their problems with critics’ accounts, have argued that many of the concerns about PE are from cherry-picking specific cases or unrepresentative parts of the industry.

While not everyone will agree with every defense of PE they make, it’s hard to argue with their call for more “qualitative studies that take account of all relevant perspectives instead of relying only on a managerial, private equity firm, employee, or trade union perspectives."

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 chief financial officers 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 banks, such as Goldman Sachs (GS), JPMorgan Chase & Co. (JPM), and Citigroup (C), often facilitate the largest deals.

For PE firms, the funds they offer are only accessible to accredited investors and may only allow a few 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 serve three critical functions:

• Deal origination and transaction execution
• Portfolio oversight
• Cost cutting

Deal Origination and Execution

Deal origination involves creating, maintaining, and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks, and similar professionals. These relationships help for high-quantity and high-quality deal flow since these professionals can refer acquisition prospects to the PE firm for review. Some firms hire staff to search for and reach out to company owners to find transaction leads. In a competitive M&A landscape, finding such deals can help ensure that the money raised is heading to the most lucrative investment opportunities.

Firms that can find their own prospects can save money and cut their fees to intermediaries. When financial service professionals represent the seller, they usually run an auction that lowers the buyer's chance of acquiring a particular company. As such, deal origination staff work to build a strong rapport with transaction professionals so they are introduced to the deal early.

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

If both parties agree, the deal professionals work with various transaction advisors, including investment bankers, accountants, lawyers, and consultants, to complete the due diligence phase. Due diligence includes reviewing 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 most crucial function of private equity professionals. Among other support work, they can walk a young company's executive staff through the best strategic planning and financial management practices. Additionally, they can help institute new accounting, procurement, and IT systems to increase the value of their investment.

For more established companies, PE firms tend to think they have the ability and expertise to turn underperforming businesses into stronger ones by finding operational efficiencies and increasing earnings. This is the primary source of value creation in private equity. However, PE firms also create value by aligning the interests of company management with those of the firm and its investors.

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

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

Cost Cutting and Liquidations

PE firms are driven by the goal of maximizing returns for their investors. This overarching goal, however, means using strategies that can have wider effects on different communities, some of which have garnered critical attention.

A key way to maximize returns is to increase the profitability and value its portfolio companies. This is often achieved by implementing operational improvements, expanding market reach, or innovating products and services. PE firms may also take more aggressive approaches that commonly include the following:

• Asset liquidation: Selling off assets or parts of the business to streamline operations or generate immediate cash flow.
• Cost reduction: Implementing stringent cost-cutting measures, which can lead to significant layoffs or downsizing.
• Imposing debt: Acquiring companies primarily through debt, which is later repaid using the company's cash flow or by selling its assets. This can put considerable financial pressure on the company.

These strategies can lead to substantial financial gains for investors but may also result in negative outcomes elsewhere, such as job losses or reduced investment in the company's long-term growth or vision.

Private Equity Investment Firm Varieties

There are plenty of private equity investment strategies. Two of the most common are LBOs and 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 PE firm buys the target company with funds from using the target as a sort of collateral. In an LBO, PE firms can 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 for an equity investment in a young company in a less mature industry—think of the dot-com companies of the early- to mid-1990s. Private equity firms will often see potential in the industry and, more importantly, in the target firm itself, thinking a lack of revenue, cash flow, or debt financing is holding it back.

PE firms can take significant stakes in such companies, hoping 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 could add value in less quantifiable ways.

How PE Firms Exit a Deal

A 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 significant investment banking professionals cited above typically focus their efforts on deals with enterprise values worth billions of dollars; the average deal size in 2022 was $964 million.

The middle market is significantly underserved because everyone tries to grab the larger deals. There are more sellers than highly seasoned and well-positioned finance professionals with extensive buyer networks and resources to manage a deal.

Flying below the radar of the more prominent multinational corporations, many small companies often provide higher-quality customer service and niche products and services that large conglomerates are not offering. Such upsides attract the interest of private equity firms, as they possess the insights and savvy to exploit these 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 metric for these investors is earnings before interest, taxes, depreciation, and amortization (EBITDA). When PE firms buy a company, they work with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically grow its EBITDA organically and through acquisitions.

PE 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. This 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 prospects require steep initial investments, there are still some ways for smaller, less wealthy players to get in on the action.

Publicly Traded Stock

Several private equity investment firms—also called business development companies—offer publicly traded stock, giving average investors the opportunity to own a slice of the PE pie. Along with the Blackstone Group, there are 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 can't invest in private equity because of Securities and Exchange Commission (SEC) rules concerning illiquid securities holdings, but they can invest indirectly by buying publicly listed private equity companies. These mutual funds are called funds of funds.

Exchange-Traded funds

Average investors can also buy shares in an exchange-traded fund 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. Investors are offered debt or equity in exchange for partial ownership of the business. Often, private equity crowdfunding is shortened to the term equity crowdfunding.

Companies can use crowdfunding 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 total amount of money invested and the number of nonaccredited investors.

Working at a Private Equity Firm

The private equity business attracts some of the best 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.

PE firms' fees vary but typically consist 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 standard, 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.

Those working at PE firms have had an upward trend in compensation despite a slowdown in deal-making and exits in recent years. According to a 2023 report by Odyssey Search Partners, analysts at private equity firms saw their average total compensation increase that year by 21% to $230,000. Associates and senior associates were receiving 11% and 14% raises over the previous year, respectively, bringing their salaries to about $300,000 and $400,000. For higher-ranking positions, vice presidents had a 14% increase to about $500,000, while principals had an 8% rise to about $700,000. However, compensation for the highest roles like managing directors and partners was about $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 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 in corporate America, the professionals at private equity firms are usually successful in deploying investment capital and 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, these firms must develop strong relationships with transaction and services professionals to secure a robust deal flow.

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