A Guide to Private Equity
What is “private equity”? Technically, it just means ownership of a company by a private party, instead of by shareholders who can buy and sell their shares in the public stock market. Venture capital, for instance, is a form of private equity. Buying your friend’s restaurant because he wants to retire would be private equity.
But when people say “private equity” (PE), they are usually talking about leveraged buyouts. That’s when a group of partners put in some money of their own and then borrow a lot more, and use the total amount to take over a company. The goal is to pocket the company’s profits while also making it more valuable, then resell it to someone else—the profits plus the sale price can be used to pay back what was borrowed at the beginning, and hopefully there’s a lot left over for the partners themselves.
Using this strategy, partners can use relatively little of their own money to buy very large companies and, if they sell for more than they paid, generate huge profits relative to what they put in. Partners who want to use this strategy repeatedly create PE firms, like Bain Capital and Blackstone, which raise even more money from limited partners (LPs) who also put up money but have no say in how the target companies are bought or run. Most often, these LPs are large institutional investors like pensions, endowments, and sovereign wealth funds. The PE firms charge these LPs large fees to manage the money and do the deals, ensuring that the PE firms profit regardless of how their investments perform.
In the industry’s early years (the 1980s–90s), PE firms achieved extraordinary returns on their investments. A story emerged that they were savvy managers of the companies they bought and created enormous value not only for themselves but for the broader economy. But as more and more firms and investors piled into the industry, the bargains disappeared, and so did the results. It’s been more than a decade since LPs saw better returns than they would have achieved by just putting money in a basic public index fund. PE firms eager to justify their existence are placing ever-riskier bets at ever-higher prices. More often than not, they now sell their companies to each other, or even to themselves. This is unlikely to end well, either for their investors (often the taxpayers behind public pension funds) or workers at the targeted companies. The PE firms, of course, will still collect their fees.
“The more leveraged takeovers and buyouts today, the more bankruptcies tomorrow.”
—John Shad, SEC Chairman, 1984