Private equity (PE) has gained a great amount of influence in today's financial marketplace, but few people actually understand the ins and outs of the private equity industry. In this article we will break down private equity from the ground up and examine the methods behind private equity transactions, how they generate returns and how investors can gain access to such private equity investments. (For background information, take a look at What Is Private Equity?)
TUTORIAL: Risk and Diversification

What Is Private Equity?
The simplest definition of private equity is that it is equity that is not publicly listed or traded. Private equity actually consists of individuals and firms that invest directly into private firms or perform buyouts of public firms with plans to take those firms private. The underlying motivation for such investments is of course the pursuit of achieving a positive return on investment. Most of the private equity industry is made up of large institutional investors, such as pension funds, and large private equity firms funded by a group of accredited investors. Since the basis of private equity investment is direct investment into a firm, often to gain a significant level of influence over the firm's operations, quite a large capital outlay is required, which is why larger funds with deep pockets dominate the industry.

In the case of private equity funds, more private funds are only accessible to accredited investors and may only have a limited number of investors, while the fund's founders will often have a rather large stake in the firm as well. However, private equity investments are also accessible to the everyday investor as well, with some of the largest and most prestigious private equity funds in the world trading their shares publicly. For instance, The Blackstone Group (NYSE:BX) trades on the NYSE and has been involves in the buyouts of companies such as Hilton Hotels and SunGard. The latter was a deal that was entered into by several PE firms, including another publicly traded PE firm, Kohlberg Kravis Roberts (NYSE:KKR), best known for its massive leveraged buyout of RJR Nabisco in 1989. (Learn more about KKR's famous buyout in Corporate Kleptocracy At RJR Nabisco.)

Private Equity Investments and How They Create Value
Private equity investment strategies are numerous; two of the most common investments are leveraged buyouts and venture capital investments. Venture capital is a general term, most often used in relation to taking an equity investment in a firm in a less mature industry - think of internet firms in the early to mid 1990s. Quite often PE firms will see that potential exists in the industry and more importantly the target firm itself, and often due to the lack of revenues, cash flow and debt financing available to the target, PE firms are able to take significant stakes in such companies in the hopes that the target will evolve into a powerhouse in its growing industry. Additionally, by guiding the target firm's often inexperienced management along the way, private equity firms add value to the firm in a less quantifiable manner as well.

Leveraged buyouts are exactly how they sound: a target firm is purchased by a private equity firm (or as a part of a larger group of firms). However, the purchase is financed through debt which is collateralized by the target firm's operations and assets. The acquirer (PE firm) seeks to purchase the target with funds acquired through the use of the target as a sort of collateral. In essence, in a leveraged buyout, acquiring PE firms are able to purchase companies with only having to put up a fraction of the purchase price. By leveraging the investment PE firms aim to maximize their potential return, always of the utmost importance for firms in the industry.

Additionally, as previously mentioned, in cases where the target firm is publicly traded, the acquirer will transition the firm to a private entity in order to re-engineer the firm and increase operational efficiencies out of the public scope. That is the primary source of value creation in private equity. PE firms believe they have the ability and expertise to take underperforming companies and turn them into stronger ones by eliminating inefficiencies in their operations, which increases earnings. Also, PE firms create value by aiming to align the interests of company management with those of the firm and its investors. By taking public companies private PE firms remove the constant public scrutiny of quarterly earnings and reporting requirements. This allows the PE firm and the target company's management to take a longer term approach in bettering the fortunes of the company. Also, management compensation is frequently tied more closely to the firm's performance, thus adding accountability and incentive to management's performance. This along with other mechanisms popular in the private equity industry (hopefully) eventually lead to the acquired firm's valuation increasing substantially in value from the time it was purchased, creating a profitable exit strategy for the PE firm – whether that be resale, an IPO or other such options.

The Bottom Line
The private equity industry will only continue to grow as we move on, with private equity funds under management already in the trillions, fundraising will continue to increase. Understanding what private equity exactly entails and how its value is created in such investments are the first steps in entering an asset class that is only becoming more accessible to individual investors. (For additional reading, also see Learn The Lingo Of Private Equity Investing.)

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