Updated August 2018
Private equity simply refers to an ownership stake in a company that is not publicly listed. Private-equity investors (usually backed by big institutions, although there are also listed private-equity funds that small investors can buy easily) either invest in unlisted companies, or buy listed companies typically ones that are viewed to be underperforming with the goal of taking them private.
Private-equity managers aim to be very hands-on owners, unlike the traditional shareholder in a listed company. By working with unlisted (or delisted) companies, the private-equity owner escapes the short-term focus of the equity markets. In theory, this gives them the space and time necessary to make the companies more efficient.
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Having whipped the company into shape, the private-equity manager will then seek an "exit" generally by re-listing the company on public markets. This is a time-consuming process, so investors should expect to have to lock up their money for several years.
Tying up your cash in an asset whose true value is never entirely clear (much like a house, you only know what an unlisted company is really worth when you try to sell it) is, of course, risky. The reward investors expect to achieve for taking these extra risks is known as the "illiquidity premium".
The hype behind private equity implies that its highly-experienced practitioners take flabby, inefficient, poorly run firms that have lost their way, and then weed out the dead weight ("restructuring", as the euphemism has it) and set them back on a course for growth. The reality, according to hedge-fund manager Daniel Rasmussen, is that in most cases (70% of deals, according to his research) private-equity firms simply borrow lots of money, slash investment spending (which in turn, damages long-term growth prospects) to pay the interest bills, then sell for a higher price than they paid.
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