Sometimes it’s just not enough to invest in the S&P 500 anymore. You’re burned out by public companies, hedge funds, and real estate. You’re looking for a return on your investment that isn’t as tied to the Dow as other investments. Naturally, you’re the type of person with plenty of money to invest. Private equity is right for you.
Private equity (PE) is actually a very broad term, as broad “mutual fund” or “debt”. Private equity is an asset class, just like a bond, or a stock, however it acts in a much different way. Bonds have principal payments and interest rates, while stocks are ownership rights in publicly traded companies. But what about private companies? Most companies in the US are private. Private equity firms are usually groups of people and/or institutional investors that have pooled their money together to make an investment in a private company. In exchange, they get partial or full ownership of that company.
Private equity firms will often purchase enough of a company to gain some type of managerial control of the company. This is because they intend to take the company in a different direction, or at least tweak the current business model. For example: the parent company of Dunkin’ Donuts was purchased by 3 PE firms in 2006. It was since that time that you’ve seen them really start to push coffee as a primary product.
There are a number of different ways a PE firm may invest their money (also called capital). Leveraged buyouts are one such strategy. This is often the case of the PE firm purchasing an entire company, but financing the bulk of the purchase with a bank. Venture capital (VC) is another, in which the funds invested go towards startup companies. Google, got their first break with VC funding. Growth capital is like VC, only the investment as a percentage of the company is very small and is designed to fund a new project or take the company in a different direction. There are still others, but they’re all designed to pool private money to make significant investments.
Unlike if you were to invest in your brother’s new gas station business, PE firms employ hundreds of experts. These experts could be economists, consultants, accountants, business analysts, and another other expert that is capable to deciding on what is a good investment and/or implementing the management to take the company in the desired direction. Each investment is highly calculated as the providers of the funding expect to be handsomely rewarded. This may come in the form of company profits with accompanying distributions or perhaps selling the company to new investors or taking it public to gain some capital appreciation. The difference between buying part of a private firm versus a public firm is that your money may be tied up for many years at a time. So this is often a big commitment with a long-term view of return on investment.
The reason you’ve heard of private equity before this course is because there’s been a massive increase in private equity funding over the last few years. A lot of that has to do with an accounting law known as Sarbanes-Oxley, or SOX. It is an accounting law passed in 2002 as a result of accounting failures like Enron. It was designed to protect investors from lying management however it added a significant amount of paperwork and double-checking on the corporation’s dime. This regulation eats into the profits of publicly traded companies and is a hassle for many. As a result, many companies went private. As they went private there needed to be a source of funding to purchase all those outstanding shares. Private equity firms raised the capital to do so and where there with a check to help take the companies private.
I’ll finish this course on private equity by talking a little bit about the private equity firms themselves. If you’re at all familiar with target retirement mutual funds you’ll know there is such a thing as a mutual fund that just invests in other mutual funds. Then you should not be surprised to learn there are PE firms that do nothing but provide capital to other PE firms. A bit surprising though is that a private equity firm can be a publicly traded company. Blackstone may be the most 
well-recognized name. They went public in 2007 to raise more money. One of their most well-known companies they own is the Hilton Hotel Corporation. Yes, that Hilton. There are others you may know as well that are still private. The Carlyle Group was one of the three that went in on Dunkin’, Bain 
Capital bought Burger King and helped take it public, Tommy Hilfiger went private in 2006 thanks to Apax Partners, and Cerberus Capital was the biggest investor in a takeover of Chrysler in 2007 and one of the biggest losers of the 2009 bankruptcy.
Private equity has always been around in some form or another. In its loosest of definitions it merely means private ownership. I technically have all the private equity in Weakonomics, though no formal value has been determined (I’d speculate its value to be similar to a peanut butter and jelly sandwich). Just in the last decade or so private equity has been formalized. If government regulation of public companies continues to tighten I have no doubt the growth of PE investing will increase.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
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