Private equity - The Fiscal Forge

Overview

Private equity refers to investment partnerships (between a private equity firm and investors) that buy and manage companies before selling them. Investors that operate with private equity firms tend to be institutional or accredited (those with large amounts of money). Private equity, venture capital, and hedge funds tend to be grouped together as alternative forms of investment, and investors in these classes typically must commit a notable number of years before they can re-access their investments. As such, like hedge funds, investment into these asset classes is limited to institutions and high-net-worth individuals. Companies that are private or public can be acquired by private equity funds, but companies that are listed on the stock exchange market are usually not acquired.

Understanding private equity firms

Unlike venture capital, most private equity firms invest in mature companies rather than start-ups and manage their portfolio companies to extract value or improve their worth before exiting the investment years later. Private equity firms increase client capital to launch private equity funds, and operate these funds as partners, managing fund investments in exchange for fees and shares of profits above a minimum (known as the hurdle rate).

Examples

Blackstone: Blackstone is a private equity fund started in 1986. It is one of the industry leaders and has become the leading alternative asset manager. Blackstone had $1 trillion assets under management by the middle of 2023.
Brookfield Asset Management: Brookfield Asset Management in Canada is another leading private equity firm. The company had approximately $850 billion in assets under management as of 2023 (including $141 billion in private equity funds).

How are private equity funds managed?

A general partner (GP) manages a private equity fund. A GP is usually the private equity firm that established the fund, makes all the management decisions of the fund, and contributes 1% to 3% of the fund’s capital. The GP earns a management fee of 2% of fund assets and could potentially attain 20% of fund profits (above a certain level) which is known as incentive compensation.

What do private equity firms specialise in?

Some private equity firms or funds specialise in particular types of private equity deals. Although venture capital is often listed as a sub-group of private equity, its skillset and unique function have set it apart and have given rise to dedicated venture capital firms that dominate the sector.

Other private equity specialties include: distressed investing (speciality in companies with critical financing needs), growth equity (funding for business expansion past the start-up phase), sector specialists (technology or energy deals) and secondary buyouts (the sale of a company owned by one private equity firm to another firm).

Deal types

Deals undertaken by private equity firms to either purchase or sell companies are separated into groups according to their situation.

The buyout is a typical private equity deal and involves the acquisition of an entire company, whether public or private owned. Private equity investors acquiring an underperforming public company usually seek to limit costs and could restructure company operations.

Another kind of private equity acquisition is the carve-out, where private equity investors buy a division of a larger company (which tends to be a non-core business put up for sale by its parent company).A secondary buyout consists of a private equity firm purchasing a business from another private equity group as opposed to a listed company. Other alternative withdrawal methods for private equity investments include the sale of companies residing in their portfolio to competitors or an initial public offering.

How they can create value

Plans on how to increase a company’s worth tend to have already been made before a private equity firm chooses to acquire a company and usually includes drastic alterations such as cost cutting or management restructuring. Previous owners of a firm may have been unwilling to make these changes; private equity owners have large amounts of experience and are able to create value much more efficiently.
Private equity firms may also have a particular strength that can accommodate for an acquired company’s weakness. For example, a restaurant company that lacked the technological expertise to advertise digitally might benefit from private equity firms that have e-commerce experts who can fill this gap, improving value as a result.
Furthermore, acquisition by a private equity firm could reduce the burden of accomplishment (producing higher revenues and profits quarter on quarter) as it can enable management to take longer-term view on company operations, thus potentially producing greater results and thus value in the future.

Using debt to earn money

Debt is a vital component of private equity profits and is utilized for acquisitions to reduce how much capital a private equity fund has to commit. It also has the potential to increase return on that investment (although this comes with increased risk).
Debt also enables private equity managers to accelerate profits and returns through a process called dividend recapitalization, which provides the money for dividend distribution to owners with borrowed money.
However, these recapitalizations enable private equity firms to potentially benefit unfairly from firms as they can extract value swiftly while leaving the company with extra debt – this could lower a company’s perceived value when it is sold again.

How are they regulated?

Although private equity funds are exempt from certain regulations by the Securities and Exchange Commission (SEC), their owners and managers must still abide by anti-fraud provisions of federal securities laws and the Investment Advisers Act of 1940.
The SEC also proposed a new requirement for private fund advisers (which would include private equity managers) in February of 2022. This would require private fund advisers to provide quarterly statements detailing performance and annual fund audits to occur.

Criticism

Private equity firms were initially stereotyped as “strip miners of corporate assets” but have recently dismissed this more strongly as they highlight their managing expertise and successful portfolios.
There has also been a rising number of disputes regarding the commitment of private equity firms to ESG (environmental, social, and governance) standards, as they place much greater emphasis on their owners rather than stakeholders.
A further focal point of criticism are tax disputes. Private equity managers are able to use the carried interest provision to be taxed at the lower capital gains tax rate on most of their compensation, which is often criticized as tax avoidance.