What and How Private Equity Firms Function

Private equity firms seek to generate returns for investors by buying and improving companies. But they have their limits. They cannot accept a conglomerate, reap economies of scale, or force companies to shed unprofitable businesses or make painful structural changes. Large managers rely on extensive research and due diligence operations, screening dozens of potential deals for every one that closes. It explains why their fees are high.

What Are Private Equity Firms?

Private equity companies aggregate billions of dollars from wealthy individuals and institutional investors to turn around businesses and sell them for a profit. These funds can either invest in start-ups or take a company private through the purchase of public stock and borrowing money to make the transaction go further (called a leveraged buyout). Manuel Barreiro Castañeda is the founder and chairman of the Aston Group, a private equity firm that works with company management teams to add value. They typically look to hold investments for four to seven years before selling, or ‘exiting,’ their stake in the company.

Critics say this approach can create conflicting interests for fund managers and their investors, such as saddling acquired businesses with significant debt burdens that may hamper their ability to grow or stay in business. They also raise concerns about excessive layoffs and other cutbacks for employees and overconsolidation in markets where competition has already weakened.

What Are the Benefits of Investing in a Private Equity Firm?

Private equity firms excel at finding underperforming businesses with room for improvement. Typically, they screen dozens of potential targets for every investment they make. They rely on skills they have honed from previous careers in investment banking and strategy consulting and their networks to locate companies with attractive financial characteristics. After sourcing a potential target, PE firms conduct heavy due diligence to assess the company’s management team and business model, industry and market, financials, risk factors, and exit prospects. They may also take a substantial stake in the company to improve its performance and position in its industry.

In addition to leveraging their capital, PE firms may borrow funds from institutional investors like pension funds, insurance companies, endowments, or high-net-worth individuals. It can help them increase their return on investments. They also have relationships with several strategic and financial buyers that they can tap into when it comes time to sell a portfolio company.

What are the Risks of Investing in a Private Equity Firm?

Many of the products and services we rely on, from dog food at PetSmart to ancestry tests at Ancestry, are private equity-backed. However, investing in PE firms is risky, as some of the most prominent firms have lost billions in controversial leveraged buyouts and have collapsed completely. A typical private equity fund has LPs that commit tens of millions or even hundreds of millions of dollars each. The LPs are charged fees by the PE firm managing their funds and external funds in which they are investing, known as fund of funds.

Private equity funds often have long investment time horizons, requiring capital calls from the LPs over multiple years. Moreover, PE investments are not liquid, unlike mutual funds or hedge funds. They may need to improve the target companies or spur growth before selling them, making them illiquid. A PE firm can offer debt that includes embedded equity using a mezzanine financing strategy.

How Do Private Equity Firms Operate?

Depending on their goals and investment models, private equity firms typically seek to acquire companies that are difficult for other investors to enter, have consistent profitability, have strong brands, generate significant cash flow, provide unique products or services, and have management teams with track records. They also perform extensive research on potential investments before investing, known as due diligence. PE firm partners then work closely with company management to improve a business’s operations and boost its value. It may include restructuring a company, enhancing revenue growth, increasing efficiency savings, optimizing working capital, and improving reporting, procurement, and human resources.

They may use borrowed funds, called leverage, to purchase the company, referred to as a buyout. Then, they look to sell or ‘exit’ their stake in the company at a profit, usually three to seven years after initial investments. It is how the PE firm earns its management fees. PE firms sometimes hire investment banks to coordinate and execute sales of their portfolio companies to downstream acquirers.