What is Private Equity?
A private equity fund is a collection of investors that get together to essentially “flip” another company the same way people flip houses. Private equity funds are actually the same as LBO, or leveraged buyout funds. Sometimes a private equity firm will buy out a company outright and sometimes they will keep certain staff members.
The buyout process works using a model very similar to “Flip this House.” Imagine the investors on the show find a huge house that is worth ten million dollars. When the investors see the house and decide to buy it and flip it, but they still may not be able to come up with ten million dollars, so they go to the bank for the difference. They then get the money from the bank and make the purchase.
Next, they sell half the land off the property and get rid of the staff (just as would happen when a company gets bought out). They renovate the property in order to raise its value. Five years later, the investors flip it and sell it for twenty million dollars. At this point, all they have to do is pay the bank back and then divide the spoils amongst themselves.
This is exactly how private equity work in the business world. The private equity refers to the first one million dollars that was put into the purchase. The leverage comes from the bank which lends the money. The term ‘buyout’ refers to the house or company that the investors are buying. They then strip the company, streamline it, then turn it around years later and sell for much more, just like the house in the scenario.
What are Common Investment Strategies?
There are numerous investment strategies when it comes to private equity, but two of the most used are leveraged buyouts and venture capital investments. A leveraged buyout occurs when a firm is bought by a private equity firm then leveraged through debt. The private equity firm then attempts to buy the entire target with the money it raises by using the target as collateral.
The other common investment strategy is venture capitalism. Venture capitalism usually occurs in industries that have not yet matured, like a start up or internet company. Private equity firms will see that potential exists in the industry and more importantly the target firm itself, and often due to the lack of revenue available to the target, PE firms are able to take stakes in such companies. With this stake, they are hoping to further the company’s growth and be a part of its success, taking some of their earnings as well.