What is Private Equity?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

Private equity is a type of investment that involves purchasing shares in businesses that don’t trade on public stock exchanges.

🤔 Understanding Private Equity

Private equity is an alternative investment class that consists of buying shares in companies that do not trade on a public stock exchange. Many companies trade on the open market, and anyone can buy shares in them easily through a brokerage. Private companies are harder to purchase stakes in. Private equity also refers to groups that purchase controlling shares in public businesses and take them off public stock exchanges, making them private companies. Private equity most often involves institutional investors but can also include wealthy private investors as well.

Example

In 2005, facing declining prospects with the rise of ecommerce, Toys "R" Us — formerly a public company — was purchased and taken private by a consortium of private equity firms, including Bain Capital Partners LLC, Kohlberg Kravis Roberts (KKR), and Vornado Realty Trust. In 2017 and 2018, the company declared bankruptcy and closed and liquidated all of its remaining U.S. locations.

Takeaway

Private equity is like a secret club…

It’s easy to join most public clubs, like a school club. All you have to do is meet any eligibility requirements and submit an application. In the same way, buying public stocks is easy. Joining a private club is harder. You need to find out about the club and get an exclusive invite if you want to join. In the same way, private equity doesn’t trade on public stock exchanges. It deals with private businesses. When a private equity firm does buy a public company, it usually takes it private as quickly as it can.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What is Private Equity?

Private equity is a term that describes any strategy that relies on investing in businesses that don’t trade on the public market. Private equity groups and certain qualified investors can buy shares in these privately traded companies.

Private equity also refers to businesses, funds, and groups that purchase stakes in public companies. The private equity group then uses its influence to effect change in the company or even bring it private.

Venture capital and private equity share some similar aspects, but venture capital tends to focus on younger companies with the potential for explosive growth. Private equity groups usually invest in mature businesses that are struggling or that need an infusion of capital or to make significant changes to continue to grow.

Like most investors, the goal of the people involved in private equity is to make money. Because private equity usually involves large sums of money, private equity groups can gain a lot of influence in the operations of a business. Private equity firms use that influence to try to improve business performance.

Because private equity involves private companies, or taking public businesses private, it’s often easier to make decisions, such as replacing executives. A public business doing the same may result in a response from other investors or the general public, which can hurt the company’s share price.

Private equity companies ideally earn a profit by improving the businesses they purchase and selling them at a higher price than they paid — though, critics would argue that private equity firms often make money by saddling the acquired companies with debt, laying off workers, and selling off assets.

Partners that invest money in the private equity company also pay management fees to the company. Typically the charges are a combination of a flat percentage of invested assets and a performance-based fee.

What are some examples of private equity?

One well-known example of a private equity company is Blackstone. The business has a portfolio of 94 companies and manages more than $90 billion. Some of the firms that Blackstone owns include Renfinitiv, a financial market data service, and Change Healthcare, a health technology company. Blackstone states that its investment strategy revolves around purchasing a stake in businesses where its capital, experience, and network can improve the acquisition’s performance.

An example of a successful private equity investment is Bain Capital’s purchase of Accuride in 1986. Accuride began as a subunit of Bridgestone/Firestone, manufacturing truck wheels and rims.

Bain Capital’s purchase of Accuride gave it far more resources than it received from Bridgestone/Firestone. It also removed bureaucratic overhead from its activities. The company built a new, automated production facility to reduce its per-unit costs and let it undercut the competition. Many competitors could not react quickly because of their investors’ focus on quarterly results. Accuride, now a private company, did not have to appeal to short-term investors.

Within two years, Accuride’s market share doubled, and profits increased by two thirds. Bain Capital sold the business 18 months after purchasing it, earning nearly 25 times what it paid.

An example of a failed private equity investment is when TPG purchased a stake in Washington Mutual in the wake of the 2008 financial crisis. TPG and other private equity groups put $7 billion into the bank to help it recover from the mortgage default crisis.

Even with TPG’s assistance, Washington Mutual could not recover, and the federal government closed the bank in September of 2008, TPG lost the full amount of its investment.

What is the history of private equity?

Private equity is a relatively recent innovation. The first private equity firms, American Research and Development Corporation (ARDC) and J.H. Whitney & Co., both started in 1946, just after the end of World War II. The first significant success of private equity came when ARDC purchased a stake in a company named Digital Equipment for $70,000 in 1957. Eleven years later, it sold that stake for $355 million.

Despite private equity firms being relatively new, their strategies have existed for a long time. During the 1890s, businesses controlling a significant portion of the railroad infrastructure in the United States encountered financial difficulties. Large banks, such as JP Morgan, stepped in, purchasing the failing companies. The purchasers gave the railroads capital to repair and improve their lines and equipment and replaced poor managers with competent ones.

JP Morgan was also involved in what may be the first leveraged buyout, purchasing Carnegie Steel and merging it into a conglomerate of three steel companies called US Steel. He paid for the purchase in bonds issued by the new US Steel company.

The 1933 Glass-Steagall Act restricted banks from both accepting deposits and making these kinds of investments, slowing down these transactions. After World War II, private equity companies appeared to pick up where banks had left off.

In 1978, Kohlberg, Kravitz, and Roberts, founded by former partners at Bear Stearns, formed. It focused on purchasing family businesses and growing them to the national stage. One business it invested in is Orkin, a pest control company.

That year, 1978, saw a boom in private equity companies that has continued to modern days. In 1977, only $39 million entered the private equity market. In 1978, more than $570 million entered private equity. Relaxation of rules on pension fund investments freed large amounts of capital for investment in private equity.

How does private equity work?

Private equity companies are set up as limited partnerships between multiple people. Creating a limited partnership lets investors in the firm minimize their liability if the business performs poorly.

Typically, private equity firms approach large investors, such as university endowments, insurance companies, pension funds, and wealthy individuals, to secure funding. They explain their plans to the private equity investors and require that they commit their money to the firm for a set number of years. After that period ends, the fund returns the initial investment plus any profits to the investors. Private equity funds usually charge investors a percentage fee based on the amount invested, plus a cut of any profits.

While the private equity fund operates, it uses its investors’ funds to invest in private businesses or take over public ones. It then reorganizes those businesses or updates their ways of running to make them more profitable, selling them off at a higher price.

What are the types of private equity funding?

There are different strategies that private equity funds can use when purchasing companies.

Distressed funding

Distressed funding involves purchasing a struggling company’s debt at a low cost, aiming to convert that debt into an ownership stake in the business. This can happen as part of a restructuring that the company uses to settle its debt, often at the private equity firm’s encouragement.

With its new ownership stake in the company, the private equity company can adjust the failing company’s activities, aiming to make the business profitable. It then sells its shares at a profit. In some cases, the private equity firm sells its ownership shares as soon as the debt converts to equity.

Leveraged buyouts

A leveraged buyout involves borrowing large amounts of money to purchase a controlling stake in a business. The borrower secures the debt using the assets controlled by the company it buys.

For example, a private equity firm buying a business worth $50 million might only put up $5 million of its own funds. It borrows $45 million against the $50 million value of the company it purchases. After the purchase, the firm can take steps to improve the business it bought, increasing its value. The private equity company can then sell the shares at a profit.

Leveraged buyouts have gained popularity because they protect the private equity firm from danger. If the acquisition performs poorly, the acquired company’s assets are at risk rather than the private equity firm’s, because the debt is secured using the acquired business’s assets.

Venture capital

Venture capital is usually distinct from private equity, but it shares a few features. Private equity focuses on all types of businesses and usually involves buying majority stakes in the acquired companies. Venture capital normally involves small, new companies and purchasing less than a majority of the company’s shares.

Like private equity, venture capital involves funding from private firms and investment funds. The investor’s goal is to help the small business increase its value through a combination of funding and access to valuable connections.

Growth equity

Growth equity is a subset of private equity that usually focuses on acquiring less than a controlling stake in the target business. The goal for growth equity investors is to take maturing companies that make it out of the venture capital stage and to provide the last infusion of money that they need to succeed.

How do private equity firms make money?

Private equity firms usually make money in two ways.

The first is investment fees. The firms take money from investors and use that money to finance the purchase of private companies. The investors usually pay a percentage of the amount they invested each year.

If they meet a minimum return threshold, most private equity funds also take a cut of the investors’ returns. The cut can be as much as 20% of the profit if the fund earns returns higher than what’s called a hurdle rate, typically set around 8% per year.

What are the advantages and disadvantages of private equity?

The primary advantage of private equity is its potential for high returns. Most investors can’t purchase stakes in private businesses, and many private companies have significant potential for growth. Private equity firms can take those businesses public and make their investors substantial sums of cash.

Private equity firms can also take struggling public businesses private, buying shares at a low price. After reorganizing those firms, private equity brings them public again at a considerable profit.

The downside of private equity is that they usually charge high fees. The base fee can often reach 2%, and most firms also take a cut of investor profits. When compared to inexpensive index funds that charge as little as .1% or less, paying 2% of the invested assets each year can be difficult to justify.

Critics of private equity also argue that the funds do little to improve the firms they acquire. Instead, they take over the business, gut it by cutting costs and laying off workers, then sell it at a profit while its financials look good, only for the company to fail years down the road.

What is the difference between a private equity firm and a venture capital firm?

The difference between private equity firms and venture capital firms primarily lies in the investments they focus on.

Private equity focuses on larger, established companies, both private and public. When private equity acquires a public company, it takes it private. Private equity firms also usually use their control to affect the business’s activities, reduce costs, and work toward higher profits.

Venture capital usually focuses on young businesses in need of funds. Often, venture capitalists don’t acquire controlling shares in the young company. Instead, they provide money and connections but leave the founders and majority owners to control the daily operations of the business.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

1179875

Related Articles

What is Finance?
Updated June 17, 2020

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2021 Robinhood. All rights reserved.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. Robinhood U.K. Ltd (RHUK) provides brokerage services in the United Kingdom. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1476799