Demystifying Private Equity

You’ve probably heard it before: wealthy people grow even wealthier by letting their money work for them. But have you ever asked yourself how exactly they manage to do that? The answer is simple. They have access to investment opportunities that most people don’t, and that 99 percent of society likely doesn’t even know exist. One of those opportunities is called Private Equity. The term is self-explanatory. It refers to investing in equity, or ownership, of private companies. It’s similar to buying stocks, except those represent public equity. Since it’s nearly impossible for individuals to casually acquire stakes in private companies, an entire industry of private equity funds has emerged, where professional investors manage and deploy their clients’ capital. Given that this sector plays such a major role in our economy and yet remains largely invisible to the public, let’s explore how these funds work, how they generate returns, and how they influence the world around us.

To start things off, let’s take a closer look at the term Private Equity. As mentioned, it refers to investing in private companies, but that alone is still quite vague, given the millions of different businesses out there. To make sense of it, the industry is usually broken down based on the stage of a company’s development. That means whether it is a startup, a mature conglomerate, or something in between. Investing in startups still falls under the umbrella of private equity, but it is more specifically referred to as Venture Capital. The next stage is called Growth Equity, which focuses on young companies that have outgrown their startup phase and are no longer in immediate danger of failing. Everything that comes after, investments in mature companies of all sizes, is what people typically mean when they talk about Private Equity.

Now that we have finally narrowed down what Private Equity actually means, let’s look at how these funds operate. There are countless PE firms active today, managing anything from a few million to over one trillion (!!!) USD each. They differ not only in size but also in their focus on specific industries, geographic regions, and the value creation strategies they apply. Exploring all the different types of funds would be worth an article of its own. For now, just know that there are a lot of them. So where does all this money come from? Mainly from institutional investors such as pension funds, insurance companies, endowments like university funds, and government funds. On top of that, only the wealthiest individuals can afford to invest in private equity, since the minimum capital commitment usually starts at around five to ten million USD.

Each PE firm usually manages several independent funds. The lifecycle of a single fund is typically around ten years. It begins with the firm deciding to raise a new fund, promoting their strategy and collecting fresh capital from their investors. These investors, known as Limited Partners in the industry, commit their money for the entire duration of the fund, with very limited options to withdraw it early. Once fundraising is complete, the PE firm starts searching for suitable investment targets. The kinds of companies they acquire depend heavily on the fund’s specific strategy, and there are many different investment rationales. PE firms generally aim to invest all the capital within the first three to five years of the fund’s life. After acquiring a company, they begin working closely with what are now called Portfolio Companies, improving efficiency or driving growth, depending on the overall approach of the fund. After about five to seven years, these companies are either sold or taken public on the stock exchange, ideally generating a profit for the investors.

And unsurprisingly, this business model is highly lucrative. PE firms aim for annual returns of around 20 percent, which is exceptionally high compared to the average returns in public markets. In fact, private equity is among the most profitable forms of investment in today’s economies. Naturally, the firms are paid generously for this performance. They typically claim 20 percent of the profits their investors earn, along with a fixed two percent management fee per year. Investors usually accept these fees without hesitation, given the strong overall returns. One major reason for these high returns is the use of debt. By leveraging their investments, PE firms can significantly boost their gains. It works much like buying a house. You finance part of it with your own money and borrow the rest from a bank. But once the loan is paid off, you own the entire property, even though your initial contribution was only a small portion of the total value.

Mainly because of this, private equity does not have the best reputation. Buying companies with debt increases the financial pressure on them and raises the risk of bankruptcy. And yes, there have been cases where this led to serious fallout, including employees losing their jobs and customers losing trusted suppliers. The business model itself is often seen as a pure expression of capitalism. The primary goal of private equity firms is to maximize returns for their investors, which can sometimes lead to decisions that favor the fund over the long-term health of the portfolio company. A commonly criticized example is when margins are weak and cash flow is needed to service the debt. One of the fastest and most effective ways to cut costs is to reduce headcount and lower personnel expenses.

However, as always, these are outlier cases. In reality, most private equity investments create substantial value, not only for shareholders but also for the broader economy. Think about it – If private equity were truly as harmful as some critics claim, why would it consistently generate such strong returns, and why would more and more companies choose to sell to these funds each year? Overall, private equity provides essential capital that fuels economic growth and innovation, contributing to the creation of thousands of jobs. For individual companies, these firms offer expertise and access to a broad network of professionals. So the next time you come across private equity in the news or hear someone mention it, hopefully you will have a clearer picture of what it really involves. Or at least you can educate your uncle, who enjoys engaging in loud debates without having much of a clue what he is actually talking about ;)