Nepedia
Back to Discover
Advanced Reader
📖

Private equity

society Maturity 11-13 Next article →

Private equity refers to ownership in companies that are not listed on public stock exchanges. These companies do not offer shares to the general public. Instead, they work with specialized investment funds and limited partnerships. These funds take an active role in managing and structuring the businesses they own.

Private Equity Fund Diagram
Private Equity Fund Diagram

In common conversation, the term "private equity" often describes the investment firms themselves. These firms use private capital to fund long-term investment strategies in businesses that are illiquid. An illiquid business is one that cannot be easily or quickly converted into cash.

The mechanism of private equity involves several distinct groups of people. An investment manager, known as a general partner (GP), raises money from institutional investors. These investors include pension funds, university endowments, and hedge funds. They are also known as limited partners (LPs).

Secondary Diagram (LP Interest)
Secondary Diagram (LP Interest)

The GP uses these proceeds to purchase equity ownership stakes in target companies. This is done using a combination of equity and debt financing. The goal is to generate high returns on the invested money over a specific time horizon. This target horizon is typically between four and seven years.

Investors use several financial levers to drive these returns. One method is revenue growth, which involves increasing sales in new or existing markets. Another method is margin expansion, which often focuses on improving the EBITDA margin. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Investors may also focus on free cash flow generation to pay down debt. Finally, they may look for valuation multiple expansion. This happens when the company is sold for a higher multiple of its earnings than when it was bought.

There are many different types of private equity strategies. The most common is the leveraged buyout, or LBO. In an LBO, a firm acquires a company or a business unit using significant financial leverage.

Leveraged Buyout Diagram
Leveraged Buyout Diagram

These target companies are usually mature and generate steady operating cash flows. Another strategy is growth capital. This involves making minority investments in mature companies. These companies need money to expand, enter new markets, or restructure. Unlike buyouts, growth capital usually does not involve a change in control of the business.

Other specialized strategies include venture capital and mezzanine capital. Venture capital typically focuses on younger companies, while private equity often targets more mature enterprises. Some firms also deal in distressed securities. These are investments in companies facing financial difficulty. Some investors also use "add-on" or "bolt-on" acquisitions. They take a larger "platform company" and buy smaller companies to attach to it. This helps the larger company gain more scale and efficiency.

Debt financing plays a massive role in the history and structure of these deals. Using debt can increase the return on equity by reducing the amount of initial cash needed. Additionally, interest payments are often tax-deductible, which increases after-tax cash flows. However, the amount of debt used has changed over time. In 2005, debt represented about 70% of the average private equity acquisition. By 2020, this figure had decreased to approximately 50%. This shift occurred following several high-profile bankruptcies involving aggressive leverage.

The impact of these investments can be seen through the "J-curve."

The J-Curve PE
The J-Curve PE

This concept shows that net cash outlays are often high in the early years of a fund. In the later years, these are outstripped by large cash inflows. While some studies suggest private equity outperforms public equity, other evaluations are mixed. The success of a deal often depends on whether the company is a successful "turnaround." For large, complex deals, investors often form a syndicate. This allows them to share risks and combine different professional skills.

602 words

Where will your curiosity go next?

Keep exploring at your chosen reading level.

🖼️ Images & Media (5)
File:The J-Curve PE.png
The J-Curve PE.png
File:Leveraged Buyout Diagram.png
Leveraged Buyout Diagram.png
File:Private Equity Fund Diagram.png
Private Equity Fund Diagram.png
File:Secondary Diagram (LP Interest).png
Secondary Diagram (LP Interest).png
File:Secondary Diagram (Continuation Fund).png
Secondary Diagram (Continuation Fund).png
More to explore

🔬 Go deeper

More advanced topics to explore

🪜 Step back

Simpler topics to build understanding

What is Nepedia?

A free, ad-free encyclopedia for children. Every article is written at five reading levels, so the same page works for a five-year-old and a fifteen-year-old — use the level switcher above to see this one change. No account needed to read.