how does private equity work?

Lots and lots and lots of misinformation in here. The basic idea is this: private equity simply refers to firms that invest in private companies (i.e., not public). The goal of private equity funds is to purchase a company, make it more valuable, and then sell it at a later date to another buyer (like another PE firm or strategic corporate buyer) for a profit. In purchasing a company, most often PE firms will use debt to fund some of the purchase price (leveraged buyout or LBO). Think of it like a mortgage, but instead of an individual buying a house a PE firm gets to buy a business. If they put too much debt on the business and the business starts to do poorly, they might not be able to make their interest payments and default on that debt. That’s a really bad thing for all parties involved, including the PE firm. The PE firm owns the equity of the business, which is subordinated to the debt. So if the debt holders can’t be made whole, the equity holders lose all of their money. The way PE firms make money is to grow the business and sell at a higher price than they bought (while paying down debt and building equity like you would do in a house).

A bunch of people posting here only know what they read in the news about situations like Toys-R-Us and the like, but the truth is that in the vast majority of PE investments they want to make the business grow and be more valuable for the next owner. Bankruptcies and liquidations are not good for equity holders.

> How can you take out a loan to buy something and make that same thing pay it back?

Like buying a house — you can borrow money using the building you don’t yet own as collateral. I mean, you wouldn’t necessarily expect a house to generate enough income to pay for the mortgage, unless it’s an apartment building or something, but the principle is the same.

What are Private Equity firms?

I believe its important to understand what private equity (“PE”) firms are before diving in. Private Equity funds are professional investors. They raise money from rich people (their limited partners or LPs) and invest their money by buying companies; the investment professionals (general partners or GPs) in the PE funds charge a fee for their services and keep some profits from the companies they buy and sell.

The goal of the PE fund is to sell the company at a higher price than what it paid; no different than buying and selling in the stock market. It achieves this higher price pulling on several levers, a majority of which I think can be bypassed for an Spiegami question. The main lever a PE fund uses in our case is debt.

How does Private Equity work?

Leverage (debt) increases returns. Let’s say a company is worth $1,000 and generates $100 in cash flow (“CF”). Let’s also assume that a PE fund can purchase the company for $1,000 using $500 of its own cash and $500 of newly raised debt. If in 5 years the PE fund can sell the company for $1,100, it can generate 20% in returns.

Calculation: $1,100 – $500 (to repay debt) = $600 remaining cash for the PE fund. $600 – $500 (initial investment) = $100 gain. $100 (gain) / $500 (initial investment) = 20% return.

Contrast this with using no debt. If a PE fund uses its own cash for the whole purchase price of $1,000, returns are now a measly 10% when it sells the company for $1,100 ($100 (gain) / $1,000 (initial investment)).

Note: the industry looks at returns on an annualized basis (you might see “IRR” or Internal Rate of Return thrown around) so my above example isn’t exactly how a PE fund would go about assessing an investment.

Why can I put debt on the Company I’m buying?

Remember a basic principle, lenders want to lend money; interest payments are the main revenue driver for these firms. So long as the entity issuing the debt (the company responsible for paying it back) can service the obligation (fancy way of saying paying interest and principal on time), the lenders are perfectly fine with a PE fund buying a company using debt. Remember, in our above example, the company generates $100 in CF. This CF can be used to pay down debt. The PE fund has done a ton of work ahead of time to figure out if the company can pay its debt back and continue to operate.

Also remember, lending 101 dictates that a borrower put up collateral; at the risk of being pedantic, collateral is something that the lender can collect and sell to get their money back. What is the collateral in this case? The company. Any company has hard assets (inventory, warehouses, equipment, cash in bank accounts) that the lender can “take over” and sell if the company cannot pay back debt. Also, the company is generating CF in our example, which is being used to pay back debt in part. Put together, the lender also does its work to make sure the company can pay back the newly raised debt and lends it money.

To put it all together, the PE fund has its debt to buy the company and increase returns. The lender has lent money to a company that it thinks can service its debt. This is why debt can be placed on the company being acquired.

Why sell to Private Equity / do Private Equity firms signal the death of a company?

The easy question to answer is why sell? Simple, if I’m an owner of a company and I want out, a PE firm will give me cash. I no longer have to worry about employees, payroll taxes, purchasing inventory, paying my vendors, etc.

Or, if the current owner of a company is another PE fund, it may be time to sell to return some returns to its investors. As such, PE funds create a market of buyers and sellers of companies that allow these transactions to take place.

As to PE funds signaling the “death” of the company, I believe it is a discussion best had outside of Spiegami. The question begs a more nuanced answer touching on various aspects of the industry.

Optimistic: The private equity firm can run the failing company better, and lenders believe them. E.g. You’re a successful farmer where a neighboring farm has been mismanaged for the last few years. You have a successful track record. It’s neighboring land, so you might have economies of scale. You can probably convince someone to lend you the money that can buy it and pay it back with the money you make off the farm.

Cynical: The private equity firm can liquidate the failing company for more than the current market value of the company, and lenders believe them. E.g. A tractor salesman wants to buy that same farm, because he can resell that used equipment for more than the current owners.

It seems odd that this would be true. Why couldn’t the current ownership liquidate the company on their own? If the company is running out of money, they might not have enough time to sell everything for full-market value before bankruptcy, and their current lenders might not trust them with more money. Or the private equity firm might have better connections than the old ownership. Or perhaps the old ownership doesn’t to liquidate the company that they built and make all the awful decisions on the way.

Often times, part of the failing company can still be successful as a going concern, but everyone else has to be fired, and everything else has to be sold. It’s tough to do that if you built/managed the whole company for years.

There are a few different things at work here.

Public companies are traded on the stock market, anyone can buy shares, their stockholders elect their Board of Directors, and the companies have to give the public tons of information about the company on a regular basis (and if it’s false or you fail to disclose problems, the executives can go to jail or the company can be sued massively).

Private companies only have one owner or a small number of owners, not huge numbers of random people, there’s no issue with losing control of the company or the board, and they don’t have to give out much information, and for the information they do give they can only be sued for outright fraud or lying.

There are two main ways to fund a company – debt (sell bonds) and equity (sell stocks). The drawback to equity is you lose some control and some profits – the new stockholders get to vote, and they can share in the profits. The drawback to debt is you have to make regular payments on the bonds and if you can’t make them, the bondholders can force you into bankruptcy, and you lose the entire company.

Generally it’s easier to raise money when you’re a public company. Investors know they’re getting truthful information, and they can easily sell their stocks in the stock market at any time. It’s much harder to sell a stake in a private company, and you also don’t always have reliable information.

But there can be advantages to being private also. A company with a long-term plan that won’t be profitable overnight can pursue it without worrying about stockholders getting angry, and either dumping their stock or voting out the board of directors. Startups especially don’t necessarily want to give out lots of information that might make someone question their business model – better to raise money privately based on your idea.

Private equity firms have a business model of buying entire public companies that they believe are undervalued or poorly managed, making them private, turning them around over a 3-7 year period, and then cashing out by making them go public again. Then you get a reformed and more successful version of the initial company. This is the optimistic case; the pessimistic case is that they look for companies to exploit, and simply extract as much value as possible and then if the company fails, it fails, leaving workers and communities out of luck. Often they buy a company, load it up with debt, pay themselves a “management fee”, and sell off any assets or business lines that are not immediately profitable, and then after a few years of this, they’ve made a good return on their initial investment and don’t care if the company fails.

Why sell to private equity? Because they offer you a higher price than the stock market does. If your company is trading for $20/share, and private equity offers you $25, either a majority of the stockholders will gladly sell out (this is called a tender offer) or management and the Board of Directors will agree to sell the entire company (this is called an acquisition). The Board can refuse to sell, and has some ways to defend against an offer it believes isn’t in the long-term interest of the company even if stockholders want it, but usually there’s a price for everything and if private equity is willing to pay enough they will get control.