How Does Private Equity Work?
Private Equity is a vital part of the American economy, and it is a major driver of the economic growth. Private Equity, by using any one of several methods, makes major improvements in the quality of life for tens of millions of Americans. Private Equity is involved when the morning coffee is purchased at Dunkin Donuts, or the evening Pizza is delivered by Dominos. When pet food and supplies are purchased for the cherished household pet, the chances are that Petco is the source. Private Equity is currently involved in keeping these businesses working.
Private Equity involves the acquisition of a private company for the purpose of helping the company take its performance to the next level. Or, it may involve the purchase of a division of a large corporation for the purpose of providing an orientation for the division's mission as an independent operation. It may involve the purchase of a public company from the shareholders which would enable a restructuring out of the view and away from the critical comments of the public market. Shareholders are looking for short-term gains which a troubled company cannot deliver. A Private Equity structure can raise the corporate potential without the critical eye of short-sighted shareholders.
Private Equity works quite simply. A PE firm creates a fund of private capital for investing in companies that the PE firm believes could achieve much greater growth and profitability with an infusion of operating capital and improved management. The PE firm's goal is to implement strategies and management teams that will improve all aspects of the company's performance. The PE firm relies on private investment but may borrow money from banks and other lenders to make its investment work. It may seem like the PE firm is taking a risk, and it may be, but the experts that manage Private Equity funds know what they are doing and so they tend to be very successful.
The Private Equity Council offers an astonishing view of the success of PE firms. It reports that: "During the 25 years from 1980 to 2005, the top-quartile private equity firms generated annualized returns to investors of 39.1 percent, net of all fees and expenses. By contrast, the S&P 500 returned 12.3 percent." The math suggests that investing $1,000 annually during the 25 period would have generated a profit of nearly $4 million. If the $1,000 was invested annually in the S&P 500 public markets the return at best would be $18,000.
PE firms need more than capital and financial creativity to succeed. They must be active owners by bringing new techniques, new products, better marketing strategies, and the ability to reduce waste and grow revenue. PE firms do not take their eyes off of their investments.
Today, the top 11 PE firms have more than $7 billion in their funds. These funds are thought to be in the top-quartile of high-performing and stable funds. The point being that Private Equity capital saves the businesses upon which Americans rely, and the Equity Capital makes money for the investors while doing this.
