I have received a lot of questions on private equity: what is it, and can an ordinary investor get involved? The answer to the second question is Yes, and I will return to it at the end of this post. As for the first question: Both private equity (PE) and its cousin venture capital (VC) are at base a lot more straightforward than they appear in the financial media.
How Do They Work?
Both PE and VC take a large enough stake in a company to run it and, presumably, use their expertise to make that company more profitable, all with an eye to selling it in the future at a substantial profit.
Venture capital firms usually focus on smaller startups in less mature industries. They help the operation prosper by bringing financial, administrative, and operational skills that the firm’s founders may lack. Once they have the fledgling firm operating properly, VC investors sell their stake at a profit, often when the firm lists itself on one of the world’s stock exchanges as a publicly traded company in what is called an initial public offering (IPO). Most VC firms work with their own capital and borrowed funds and do not take on outside investors
Private equity firms do essentially the same thing but on a bigger playing field. They take a large enough stake, often in a publicly traded firm, to bring the firm into private ownership, at which point they no longer have to make the public disclosures demanded by the organized stock exchanges. This, incidentally, is where the “private” in private equity comes from. It does not necessarily imply that the PE firms themselves are private or secretive or exclusive, though some of them are. They take their purchases off the public exchanges to make big changes over sometimes long periods while avoiding the questions and complaints that the management of a public company would have to endure. Once the improvements become evident and it is running smoothly and presumably now far more profitably, the PE company reintroduces it as a publicly traded firm, presumably at a substantial profit.
How Do They Do It?
Because PE firms, unlike VC operations, target established, publicly traded firms, you might wonder what special expertise they can add — after all, these targets have run their businesses more or less successfully for years. PE firms can improve profitability in four major ways:
- PE investors have experience with other firms that can bring new and useful practices to the management of the target.
- By aligning the interests of management with that of ownership, they can overcome institutional resistance to these supposedly more efficient and profitable practices.
- By taking companies private, they can focus on needed, longer-term projects by removing the scrutiny imposed on publicly traded companies, in particular the publication of their quarterly earnings.
- They can pare down bloated management compensation schemes.
Participation and Financing
Most PE firms only allow investors considered qualified by the Securities Exchange Commission (SEC). These are people with sufficient background or investment experience to, in the SEC’s estimation, make informed judgments on whether the firms involved and deals arranged are suitable for them. Even given these strictures and the big bucks involved, smaller investors can participate in private equity operations because several actually list as public companies. You can buy stock in them. Two of the most prominent are The Blackstone Group and Kohlberg Kravis Roberts.