Private equity funds have a poor reputation but far from everyone knows what they are actually doing. Here is a short overview of private equity funds.
First a few definitions, private equity funds are run by private equity firms. Private equity firms are simply investment companies that are funded by private sources. This includes rich individuals but also cash-rich institutional investors, such as pension funds and insurance companies. Private equity funds are typically set up as partnerships, with the investors as limited partners and professionals from the private equity firm as the general partners.
Private equity is often confused with venture capital. But venture capitalists don’t have anything to do with private equity. Venture capitalists invest in small young companies without taking control of them. They hope that the small company will become the next Microsoft or Google. Venture capitalists will most likely make many more failed investments than successes. But they hope that their gains on the successes will outweigh their losses. Private equity funds on the other hand, want to gain full control of the companies they invest in. They are not interested in small companies with growth potential. They are looking for large companies which they hope to make more efficient. In order to gain control, they often borrow a lot of money. The leverage makes private equity funds vulnerable for failures.
Sometimes you hear hedge funds and private equity funds being mentioned together. But they don’t have much in common, except for that they are often criticized by the same people. Both are often accused of being extremely short-sighted in order to try to make a quick profit, without any concern about the long-term outcome.
Private equity funds are often seen as successors to the leveraged buyouts (LBO). This because they very often fund their purchases with a lot of debt. Using debt can increase the ROI but also the risks. In order to be able to pay the interest, private equity funds typically look for companies with strong cashflow and plenty of assets. The cashflow can be used to meet the interest payments and assets can be sold to pay down the debt.
Since the aim of private equity funds is to sell the company at a profit, they often cut costs drastically. This is something that caused a lot of criticism, private equity funds are often accused of being only interested in short term results, sacking staff and cutting down on research and development.
Two other things that private equity groups have been criticized for are lack of transparency and tax. Since the companies are typically taken over completely by the private equity funds, they can make decisions behind closed doors without any accountability. Since debt is tax deductible, leveraged buyouts automatically receive a tax advantage. In the US and the UK, private equity has also been given additional tax breaks. Many are complaining that private equity has a significant tax advantage which makes it difficult to compete with them.
While private equity funds have a lot of supporters in the English speaking world, in many parts of Europe and Asia they are seen as pariah. Numerous studies of private equity takeovers have been done but many of them have been sponsored by groups that have a clear interest in making private equity either look good or bad. Let’s just say that private equity funds are controversial, trying to sort out if they make the world a better place would require a lot of time.