How Does Private Equity Actually Work

Summary

Private equity is a powerful financial strategy where firms buy companies, improve them, and sell for a profit. With a history spanning over a century, it has evolved from funding innovative startups to acquiring existing businesses and restructuring them. Major players like Blackstone, Apollo, and KKR manage trillions in assets. Private equity includes strategies like leveraged buyouts, growth equity, and distressed investing. While successful deals can create vast wealth, controversial failures like Toys R Us highlight the risks. The sector remains central in shaping industries and continues to grow, with investors reaping enormous rewards.

Takeaways

• 😀 Private equity firms like Blackstone, Hilton, and Ancestry.com share ownership under the same financial entity, demonstrating their immense influence in various industries.
• 😀 Private equity involves raising funds from investors, buying companies, improving their profitability, and selling them for a profit, often through a 4-step process.
• 😀 The 4 steps in private equity are: raising capital from investors, purchasing companies, restructuring them for profitability, and selling them for a return.
• 😀 Private equity has evolved from early 20th-century tycoons, like the Rockefellers, who focused on creating monopolies, to modern leveraged buyouts (LBOs) aimed at profit maximization.
• 😀 LBOs involve borrowing money from investors and using the target company’s assets to secure the debt, creating high-risk, high-reward financial scenarios.
• 😀 Successful private equity deals, such as Blackstone's Hilton Hotels acquisition, can generate massive returns, with Blackstone making $14 billion over 11 years from Hilton.
• 😀 Not all private equity deals are successful. The Toys R Us leveraged buyout is a notorious example of how excessive debt and management fees can lead to bankruptcy and company downfall.
• 😀 Growth equity is a more stable form of private equity, where firms invest in fast-growing, profitable companies like TikTok’s parent company ByteDance, aiming for scale without high-risk debt.
• 😀 Venture capital is a high-risk, high-reward investment strategy, betting on unproven startups like Airbnb and Facebook, with a chance for massive returns or total loss.
• 😀 Distressed investing involves buying struggling or bankrupt companies at a discount, aiming to either restructure for profit or strip assets, sometimes leading to company failure and bankruptcy.

Q & A

What is private equity and how does it work?

Private equity involves large investors buying companies to improve them and sell for a profit. The process typically follows four steps: raising money from outside investors, using that fund to buy companies, improving profitability by restructuring, and finally, selling the company for a profit.

What are the two main ways companies can raise money to grow?

Companies can raise money by either selling shares to the public (through an IPO) or selling parts of the company to private investors (private equity).

How do private equity firms make money from their deals?

Private equity firms earn money by charging management fees (typically 2% of the total assets managed) and performance fees (usually 20% of profits). They also structure deals to maximize profit during exits, often leveraging debt and restructuring companies to increase their value.

What is a leveraged buyout (LBO)?

A leveraged buyout (LBO) occurs when a private equity firm uses a combination of borrowed money and the target company's assets to finance the purchase. If successful, it allows the firm to generate massive returns on a relatively small initial investment.

What is the difference between a leveraged buyout (LBO) and growth equity?

In an LBO, a private equity firm takes control of a company using debt, often restructuring it for profit. In growth equity, the firm invests in an already established, profitable company to help it scale, typically without taking full control and with minimal use of debt.

Can you give an example of a successful leveraged buyout?

A notable example of a successful LBO is Blackstone's acquisition of Hilton Hotels in 2007. Blackstone injected $800 million, restructured the company, and focused on branding and franchising. When Hilton went public again in 2013, Blackstone made $14 billion in profit from the deal.

What went wrong with the Toys 'R' Us leveraged buyout?

The Toys 'R' Us buyout failed because the private equity firms involved took out debt but did not inject enough capital into the company. The company became burdened with debt and couldn't invest in store upgrades or e-commerce, leading to its bankruptcy in 2017.

What is distressed investing in private equity?

Distressed investing involves buying struggling or bankrupt companies at a discount, restructuring them, and aiming to turn them around for a profit. While some distressed deals result in major success, others lead to further company deterioration due to aggressive cost-cutting.

How do private equity firms structure their deals to maximize profit?

Private equity firms structure their deals by using debt (often secured by the acquired company’s assets), charging fees for managing the fund, and ensuring exits are timed for maximum value. These strategies allow them to make profits even if the company isn't fully sold yet.

How has private equity evolved over time?

Private equity has evolved from focusing on acquiring multiple companies in a single industry to buying and restructuring existing companies. The 1980s saw the rise of leveraged buyouts, and by the 2000s, private equity became more mainstream, with institutional investors like pension funds and governments getting involved.