private equity

What is Private Equity?

Companies make a profit in many ways, and private equity is one of the methods businesses employ to get easy gains. Private equity is when investors directly purchase the shares of a business or participate in a buyout of a public company with the intention to sell it later for increased capital. There’s a lot that goes into private equity, but here is a quick overview to help you learn more.

What are private equity firms?

Private equity firms take on clients that want to make a profit by directly investing in a company without having to purchase stock. These firms usually buy entire businesses that have shown high capital gains in the past. Financial statements are used to determine whether a company is worthy of a buyout or if it is a risky investment. Not every private equity firm buys an entire business with its own money. Sometimes, it requires leverage (debt) acquired with the promise that the borrower will pay back the loan and more once the investment is sold. It isn’t unusual for private equity firms to use a high amount of leverage for the purchase price. 

Do private equity firms charge?

Private equity firms charge clients a “two-and-twenty” fee structure, similar to a hedge fund. Two and twenty stands for the 2% charged for as a management fee and another 20% for a performance fee, should the private equity fund perform exceptionally well for investors. 

Are there more fees?

Like with any investment, there can be more costs involved other than the management fees. The IRS also charges private equity executives a special "carried interest" rate that allows them to pay less than the income tax rate. The income tax rate can be as high as 39.6%, but the carried interest rate is often much lower at 20% rate of long-term capital gains. 

What happens to the purchased business?

The acquired company is sold once the private equity firm determines that the profits are at the highest peak, and layoffs may begin after selling. However, private equity doesn’t account for several job losses, and, according to CBS News, only about 6% fewer jobs over five years result from selling the business. Often, employees are absorbed into the investment company for further employment, although this doesn’t happen all at once. The biggest loss is in retail where job loss can be as high as 12%. 

Most often, this situation is referred to in private equity firms as “buy, strip, and flip.” After so many years where the financial status of a company improves, the firm puts the newly-successful business up for an initial public offering—which is when a private company goes public by offering shares for purchase by public investors. The private equity firm sees a return on profit. A buy, strip, and flip can be as short as two years while many other investors can hold onto a company for much longer to increase profit gains. 

Last Updated: December 13, 2018