Private equity is the pool of individual investors and investment funds that make certain types of investments. These investors are a major source of investment capital. The two general types of investments that they engage in are:
- Equity or debt investments in private companies. These investments are typically made to enhance the existing growth of a company, or to increase the value of its intellectual property by funding research and development activities.
- Buyouts of companies. The intent is to increase the value of the acquirees by improving their operational characteristics. These companies are frequently already experiencing financial difficulties, which allows private equity firms to buy them for a small amount. If the buyout is of a public firm, this usually results in the delisting of the acquiree as a public company.
A variation on the concept of buying out public companies is the leveraged buyout. This involves the use of very large amounts of debt and a small amount of equity to buy out a company, so that a private equity firm can potentially earn a massive return on its small initial investment if it can turn around a flagging business and sell it for a higher price.
In some cases, the intent of private equity firms is to eventually take a company public, so that they can have their shares registered with the Securities and Exchange Commission and can then sell the shares for a profit. However, it is extremely burdensome to take a company public, so another avenue that private equity firms follow to profit from their investments is to sell the entities in which they have invested to an acquirer that is already publicly held. The private equity firms then accept the shares of the acquirer in payment, and sell these share on the open market.
Those individual investors who are involved in private equity transactions are usually accredited investors, who are considered to be financially sophisticated and who have large amounts of capital available that they can invest. Since many private equity investments require anywhere from three to ten years before they can be sold off, investors must have deep reserves of cash.
Private equity firms are usually structured as funds, which take in large contributions from individual investors, select where to best employ the cash, and then eventually liquidate the funds and return principal and profits to the investors. In exchange, the operators of private equity firms typically charge an annual fee that is a percentage of the funds under management, as well as a share of the eventual profits (if any). The private equity business has the potential to be extraordinarily profitable, and so attracts some of the best business talent.
In order to be successful, the manager of a private equity fund should have all of the following characteristics:
- An excellent network to attract funding from investors
- The business acumen to decide where to place investments
- The negotiating skills to obtain the best deals for invested funds
- The operational skill to improve the performance of a business in which the fund has invested
- The sales and legal skills to either sell off the business or take it public to eventually realize a profit for the fund
It is difficult to find one person who possesses all of these skills, so a larger private equity firm employs a number of specialists who are experts in one or more of these fields.