Matter & Substance
  February 13, 2024

What Is Private Equity & How Does It Work?

Private equity is a crucial aspect of modern finance, driving significant changes in the business world through investing in privately held companies to spur growth and generate returns. Understanding how it works is essential for investors and entrepreneurs alike. In this article, we'll delve into the fundamentals of private equity, exploring its strategies and machinations as well as what it means to be a private equity firm.

What Is Private Equity? 

Private equity refers to investments made into private companies or the acquisition of public companies that result in the company becoming private. This involves the pooling of capital from various investors to acquire equity ownership in companies.

How Does Private Equity Work?

Private equity firms raise funds from institutional investors and high-net-worth individuals. Then, these funds are used to acquire equity stakes in target companies. From there, private equity firms work closely with the management of these companies to improve operational efficiency, increase profitability, and ultimately drive value. This may involve restructuring, implementing new strategies, or facilitating mergers and acquisitions.

Types of Private Equity Investments

Private equity investments come in various shapes and sizes, each tailored to different stages of a company's lifecycle and investment objectives. Understanding these types is crucial for investors navigating the complex landscape of private equity. From venture capital fueling early-stage startups to leveraged buyouts restructuring mature companies, the spectrum of private equity investments offers diverse opportunities and risks.

  • Leveraged Buyout (LBO)

    A leveraged buyout, or LBO, involves using a significant amount of borrowed funds to finance the acquisition of a company. The acquired company's assets are often used as collateral for the loans. The goal is to use the company's cash flow to repay the debt and ultimately generate a return for the investors. For example, a private equity firm might acquire a mature company with steady cash flows, take it private through an LBO, implement operational improvements to increase its value, and then sell it at a profit.

  • Venture Capital (VC)

    Venture capital involves investing in early-stage or startup companies with high growth potential. VC firms provide capital to these companies in exchange for equity ownership. They typically take an active role in mentoring and guiding the management team to help the company grow rapidly. For instance, a VC firm might invest in a tech startup with innovative technology, provide funding for product development and market expansion, and eventually exit the investment through an IPO or acquisition by a larger company.

  • Growth Equity

    Growth equity investments are made in established companies that are experiencing rapid growth but may not yet be profitable. Unlike VC firms, growth equity investors focus on companies that have already proven their business model and are seeking capital to accelerate their expansion. For example, a growth equity firm might invest in a mid-sized company looking to expand into new markets or develop new products. The investment would help fuel the company's growth without diluting existing ownership stakes.



What Are Private Equity Firms?

Private equity firms are investment management companies that specialize in making investments in privately held companies. These firms raise capital from institutional investors, such as pension funds and endowments, as well as high-net-worth individuals, to invest in various private equity opportunities.

Why Are Private Equity Firms Important?

Private equity firms play a crucial role in the economy by providing capital to companies that may not have access to traditional forms of financing. They also help improve the operational performance of the companies they invest in, leading to job creation, innovation, and economic growth.

How Do Private Equity Firms Make Money?

Understanding the mechanisms behind how private equity firms generate returns is essential for investors navigating this sophisticated sector. Private equity firms employ strategic methodologies to capitalize on investment opportunities and maximize profits. From identifying undervalued assets and implementing operational enhancements to executing successful exits, these firms employ rigorous financial practices to drive returns for their stakeholders.

  • Management Fees

    Private equity firms typically charge their investors management fees, which are calculated as a percentage of the total assets under management. These fees cover the operational expenses of the firm, such as salaries, office space, and travel costs.

  • Carried Interest

    In addition to management fees, private equity firms also earn carried interest, which is a share of the profits generated from the investments. Carried interest is usually calculated as a percentage of the profits above a certain threshold, known as the hurdle rate. This incentivizes the private equity firm to maximize returns for its investors.

  • Investment Profits (Exits)

    The primary source of profits for private equity firms comes from successful exits, where they sell their ownership stakes in portfolio companies at a higher valuation than the initial investment. Exits can occur through various means, including IPOs, strategic acquisitions, or secondary sales to other investors.

  • Dividend Distributions

    In some cases, private equity firms may also receive dividend distributions from portfolio companies during the holding period. These distributions are typically funded by the company's cash flow and can provide a steady stream of income to the firm and its investors.

What Is a Private Equity Investor? 

A private equity investor is an individual or institution that invests capital in private equity funds or directly in private companies. These investors seek to earn attractive returns by taking on the risk associated with investing in privately held businesses.

What Is a Private Equity Fund?

A private equity fund is a collective investment vehicle that pools capital from multiple investors to make investments in private companies. These funds are managed by private equity firms, which are responsible for sourcing investment opportunities, conducting due diligence, and managing the portfolio of investments.

  • Private Equity Funds vs Hedge Funds

    Private equity funds typically invest in privately held companies with the goal of driving operational improvements and long-term value creation. Hedge funds, on the other hand, often employ more diverse investment strategies, including both long and short positions in public markets, with a focus on generating alpha or absolute returns.

  • Private Equity Funds vs Mutual Funds

    Private equity funds invest in illiquid assets, such as private companies, and typically have longer investment horizons compared to mutual funds, which invest in publicly traded securities and offer daily liquidity to investors. Additionally, private equity funds often charge higher fees due to the specialized nature of their investments and the active management involved.

  • Private Equity vs Venture Capital

    While both private equity and venture capital involve investing in privately held companies, they differ in terms of the stage of the companies they invest in and their investment strategies. Venture capital focuses on early-stage startups with high growth potential, whereas private equity often targets more mature companies with established business models. Additionally, venture capital investments tend to be higher risk but offer the potential for significant returns, while private equity investments typically involve lower risk but may offer more modest returns.

Contact Mowery & Schoenfeld for Expert Guidance in Private Equity

If you're interested in understanding more about private equity opportunities, contact Mowery & Schoenfeld. Our team of experienced professionals can provide personalized advice and support to help you achieve your investment objectives. Reach out to us today to learn more and schedule a consultation.

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