What is private equity?

Firms seeking new capital will often turn to private equity to get it. Tim Bennett explains why, and also why the industry has taken such a battering in recent years.

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Transcript

In this video, I want to take on an important topic within financial markets, private equity. This will be an introduction to the topic, and if you'd like to know a bit more, do let us know at the end of the video.

Now, private equity is one of those buzz words bandied around – quite a few people have asked me, "What does it actually mean?" So, clearly, there's a little bit of confusion. So hopefully in this video, I'll cover the basics as to what private equity firms actually do.

They're certainly big enough. The top five firms have globally raised something like, $150bn worth of capital over the last five years. Names such as Blackstone, KKR, Carl L Group, TPG are the big players. So what are they all up to, and what are other private equity firms up to? That's the topic I'm going to cover today.

Now, private equity is basically a way of raising equity privately. So private equity investors tend to be looking to buy shares in certain types of firms, which I'll cover in a moment. They tend to be private companies, although they don't have to be. So it is private equity capital that's being supplied.

Now, there are three basic categories of private equity. Opinions divide a little bit on this, but, in my opinion, there are three routes.

First of all, you've got what's called venture capital. Venture capitalists are firms that specialise in investing in small, private startups, typically high risk, requiring what's sometimes called ‘seed funding’ to get going and expand. These are companies that are off the radar. They're not publicly traded – you and I can't buy shares in them, they're looking for venture capitalists to come in.

Those venture capitalists will supply equity, and they'll look, potentially, to cash in later when the company goes from being private to public. In the meantime, they'll look to take a seat or seats on the main board and have quite a say in how the business grows and develops. So, essentially, one goal is to move firms from private ownership, into public ownership [PLC] and typically then cash out their stake and move on, into the next company that requires investment. A good example of people in this space would be 3i.

Now, the second sort of private equity area is providing what I'd called growth capital for existing potentially quite large, quite public firms. So sometimes companies will look around at the options for growing and expanding. They're looking for something which is potentially relatively cheap and will achieve their aims, and they'll bring in a private equity firm, the experts if you'd like. Because private equity firms claim to be good at not only providing at both capital but also providing management expertise. They claim to be able to supply experienced professionals who can help the firm grow.

So sometimes you'll find that they're involved in bringing capital into an existing firm that maybe are already quite large or maybe a listed PLC, for example, that's looking for extra money and takes it from one of these big, private capital firms.

Perhaps the one that makes headlines the most often is what's often known as the ‘leveraged buy out’. That's a pretty broad category. Anyone who's read the famous book, Barbarians at the Gate, when a private equity firm called KKR got involved in the LBO leveraged buy out of RJR Nabisco, will have some idea of what's involved here. This is private equity firms sometimes coming in with a lot of money and saying, "Basically, what we can do is gobble up a firm".

So, here you might be taking a public firm private, almost the opposite of this route over here, taking a private firm public. What they're looking to do is gobble it up, make improvements, and then often reverse the process later. So they'll spot a target, buy it off its existing shareholders, look to make operational improvements. Then sometimes sell it back to the market at a higher price. So if you like, that's almost going public, private, public, if you want to see it that way.

Now, how do they do that, and what's the justification? How do you improve the way that a public company is being run, by taking it into private hands as a private equity firm? Well, what they claim to be able to do is bring in better management, make operational improvements, and make changes that these big stodgy public companies have failed to make over the years.

In truth, this can be quite controversial because, although some of the better private equity houses almost certainly do bring in improvements, and make changes in the way that a firm is managed or operated. Some private equity firms have been accused of simply cost-cutting, literally slashing costs, which in the short term will boost performance – firing staff, downsizing, and so on. Selling off financial assets, and on top of that funding what they've just bought with a mountain of cheap debt finance.

That's another little trick, ‘gearing’ as it's called. I cover it in another video.  It allows you to simply take a firm, stuff it full of debt, make a few operational improvements – quick and easy ones like cost-cutting and so on – and then get rid of it again at a higher price. During the boom years, before the financial crisis, quite a few private equity firms were accused of doing exactly that, riding the boom in cheap debt, taking out the fast costs and cashing in later at the expense of all sorts of stakeholders, including employees, former shareholders, and so on.

So there you have it. Essentially three ways that private equity firms can get involved in companies.

Now, who are these private equity firms?

Well, typically, they're run by so-called experts from various walks of industry, ex-CEOs, ex-investors, and so on. In terms of how the private equity firms themselves are financed, where do they raise the capital from to be able to go out and sort of gobble up other public companies?

It comes from one or two sources. Typically, it'll come from institutional investors, such as pension funds or life insurance companies, and/or, it'll come from whoever ultimately owns the private equity house. Because some of them are owned by big organisations such as some of the big investment banks, Goldman Sachs, for example.

What about you? I mean, there's all this action going on. There are firms sucking in venture capital, growth capital, going through the LBO [leveraged buyout] process, potentially. So how do you, the private investor, get involved in all this? There are two or three routes in.

There are one or two listed private equity firms around, 3i I mentioned earlier on, for example. So sometimes you'll find you can buy a share in a listed private equity company, a company that specialises in doing this kind of stuff.

Another common route in is a fund, which can spread your investment across different types of private equity, if you like, perhaps down at the venture capital end. And there's actually a vehicle called a venture capital trust in this country, in the UK that enables private investors to get into the venture capital space. I might do more on that in another video if I get requests for it.

There are one or two other routes. There is, for example, exchange-traded fund out there, LSE:IPRV is the code. That one attempts to track the listed private equity firms in the S&P 500, that's the US index. So it's not a desperately easy sector for a private retail investor to play. Private equity firms are not looking to you and me to provide them with the sort of the capital they need. The $150bn I mentioned earlier didn't come from the likes of you and me. It came from elsewhere, but there are one or two ways in, for a retail investor, if you want to get some sort of exposure to private equity.

As for the, "Are they good or bad?" it all depends on who you're talking about. Some of the top firms undoubtedly bring in expertise that small startups and existing large firms simply don't have, so they do offer genuine improvement. But the accusation, in the run up to the financial crisis, was that they were joined by lots and lots of slightly more Mickey Mouse outfits who just looked to make a quick buck by loading up their target firms with cheap debt finance.

So there you have it. If you'd like to know more about this topic, that was a very basic introduction, do let us know.

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