Too embarrassed to ask: what is private equity?

When a company is listed on the stockmarket, it is described as being a public company. If you own shares in such a company, it means that you own some of its publicly-listed equity.

When a company is not listed on a stockmarket, it is described as being a private company. The term “private equity” simply describes an ownership stake in such a private company.

Private equity investors are usually backed by big institutions. They often invest in unlisted companies– companies that are already private.

They may invest in a promising young company which is at an early stage in its development and might struggle to raise money by more conventional means. This is more commonly described as venture capital funding and is something we’ll tackle in another video.

However, they also sometimes buy stock-exchange listed companies and then take them private.

The goal of these private equity investors is usually to buy the company, improve it in some way, and then sell it for multiples of the original purchase price. You can view them as the financial markets equivalent of someone who buys “do-er uppers” on the housing market at auction, gives them a lick of paint, then sells them on.

Such private equity managers are often attracted to “turnaround” situations, where a company has been struggling for some time. They aim to be very hands-on owners, unlike the traditional shareholder in a listed company.

By working closely 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 tough decisions needed to turn a company around.

Having whipped the company into shape, the private-equity manager will then seek an “exit” – generally by re-listing the company on public markets.

Private equity has a mixed reputation. Like the aforementioned specialist in “do-er uppers”, some can and do make genuine improvements. On the other hand, they sometimes just borrow lots of money against a company’s existing assets, pay themselves a hefty dividend, and then sell the company back to public shareholders again a few years later, in an even worse state.

To learn more about private equity, including how to invest in private equity funds and what to watch out for in private-equity owned companies, subscribe to MoneyWeek magazine.