You've probably heard of the term private equity (PE). Roughly $3.9 trillion in assets were held by private equity firms as of 2019, and that was up 12.2 percent from the year before.﻿﻿ Investors seek out private equity funds to earn returns that are better than what can achieved in public equity markets. But there may be a few things you don't understand about the industry. Read on to find out more about private equity including how it creates value and some of its key strategies.

Key Takeaways Private equity refers to capital investment made into companies that are not publicly traded.

Most private equity firms are open to accredited investors or those who are deemed high-net-worth, and successful private equity managers can earn millions of dollars a year. ﻿ ﻿﻿ ﻿ ﻿

﻿﻿ ﻿ Leveraged buyouts and venture capital (VC) investments are two key private equity investment sub-fields.

What Is Private Equity?

Private equity is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity comes from high-net-worth individuals and firms that purchase stakes in private companies or acquire control of public companies with plans to take them private, eventually delisting them from stock exchanges. The private equity industry is comprised of institutional investors such as pension funds, and large private equity firms funded by accredited investors.

Because private equity entails direct investment—often to gain influence or control over a company's operations—a significant capital outlay is required, which is why funds with deep pockets dominate the industry. The minimum amount of capital required for accredited investors can vary depending on the firm and fund. Some funds have a $250,000 minimum entry requirement, while others can require millions more.

The underlying motivation for such commitments is the pursuit of achieving a positive return on investment (ROI). Partners at private-equity firms raise funds and manage these monies to yield favorable returns for shareholders, typically with an investment horizon of between four and seven years.

2:10 Private Equity Fundamentals

The Private Equity Profession

The private equity business attracts the best and brightest in corporate America, including top performers from Fortune 500 companies and elite management consulting firms. Law firms can also be recruiting grounds for private equity hires, as accounting and legal skills necessary to complete deals and transactions are highly sought after.

The fee structure for private-equity firms varies but typically consists of a management and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale of the company is common, though incentive structures can vary considerably.﻿﻿

Given that a private-equity firm with $1 billion of assets under management (AUM) might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees, it is easy to see why the industry attracts top talent. At the middle market level—$50 million to $500 million in deal value—associates can earn low six figures in salary and bonuses, while vice presidents can earn approximately half a million dollars. Principals, on the other hand, can earn more than $1 million in (realized and unrealized) compensation per year.﻿﻿

Types of Private-Equity Firms

Private-equity firms have a range of investment preferences. Some are strict financiers or passive investors wholly dependent on management to grow the company and generate returns. Because sellers typically see this as a commoditized approach, other private-equity firms consider themselves active investors. That is, they provide operational support to management to help build and grow a better company.

Active private equity firms may have an extensive contact list and C-level relationships, such as CEOs and CFOs within a given industry, which can help increase revenue. They may also be experts in realizing operational efficiencies and synergies. If an investor can bring in something special to a deal that will enhance the company's value over time, they are more likely to be viewed favorably by sellers.

Investment banks compete with private-equity firms (also known as private equity funds) to buy good companies and to finance nascent ones. It is no surprise that the largest investment-banking entities such as Goldman Sachs (GS), JPMorgan Chase (JPM) and Citigroup (C) often facilitate the largest deals.

In the case of private-equity firms, the funds they offer are only accessible to accredited investors and may only allow a limited number of investors, while the fund's founders will often take a rather large stake in the firm as well. However, some of the largest and most prestigious private equity funds trade their shares publicly. For instance, the Blackstone Group (BX) trades on the New York Stock Exchange (NYSE) and has been involved in the buyouts of companies such as Hilton Hotels and MagicLab.﻿﻿ ﻿﻿

How Private Equity Creates Value

Private-equity firms perform two critical functions:

deal origination/transaction execution

portfolio oversight

Deal origination involves creating, maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks, and similar transaction professionals to secure both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates referred to private-equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that funds raised are successfully deployed and invested.

Additionally, internal sourcing efforts can reduce transaction-related costs by cutting out the investment banking middleman's fees. When financial services professionals represent the seller, they usually run a full auction process that can diminish the buyer's chances of successfully acquiring a particular company. As such, deal origination professionals attempt to establish a strong rapport with transaction professionals to get an early introduction to a deal.

It is important to note that investment banks often raise their own funds, and therefore may not only be a deal referral, but also a competing bidder. In other words, some investment banks compete with private-equity firms in buying up good companies.

Transaction execution involves assessing management, the industry, historical financials and forecasts, and conducting valuation analyses. After the investment committee signs off to pursue a target acquisition candidate, the deal professionals submit an offer to the seller. If both parties decide to move forward, the deal professionals work with various transaction advisors to include investment bankers, accountants, lawyers and consultants to execute the due diligence phase. Due diligence includes validating management's stated operational and financial figures. This part of the process is critical, as consultants can uncover deal-killers, such as significant and previously undisclosed liabilities and risks.

Private Equity Investment Strategies

There are plenty of private equity investment strategies. Two of the most common are leveraged buyouts and venture capital investments.

Leveraged buyouts are exactly how they sound. A target firm is bought out by a private equity firm. The purchase is financed through debt, which is collateralized by the target firm's operations and assets. The acquirer (the PE firm) seeks to purchase the target with funds acquired through the use of the target as a sort of collateral. 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.

Venture capital is a more general term, most often used in relation to taking an equity investment in a young firm in a less mature industry (think internet firms in the early to mid-1990s). PE firms will often 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. 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.

Oversight and Management

Oversight and management make up the second important function of PE professionals. Among other support work, they can walk a young company's executive staff through best practices in strategic planning and financial management. Additionally, they can help institutionalize new accounting, procurement, and IT systems to increase the value of their investment.

When it comes to more established companies, PE firms believe they have the ability and expertise to take underperforming businesses and turn them into stronger ones by increasing operational efficiencies, which increases earnings. This is the primary source of value creation in private equity, though PE firms also 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, which then allows the PE firm and the acquired firm's management to take a longer-term approach in bettering the fortunes of the company.

Management compensation is also frequently tied more closely to the firm's performance, thus adding accountability and incentive to management's efforts. This, along with other mechanisms popular in the private equity industry 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's a resale, an initial public offering (IPO), or another option.

Investing in Upside

One popular exit strategy for private equity involves growing and improving a middle-market company and selling it to a large corporation for a hefty profit. The big investment banking professionals cited above typically focus their efforts on deals with enterprise values worth billions of dollars. However, the vast majority of transactions reside in the middle market at the $100 million to $500 million range, and the lower-middle market below $100 million.﻿﻿ Because the best gravitate toward the larger deals, the middle market is a significantly under served market. There are more sellers than there are highly seasoned and positioned finance professionals with extensive buyer networks and resources to manage a deal.

The middle market is a significantly underserved market with more sellers than there are buyers.

Flying below the radar of large multinational corporations, many of these small companies often provide higher-quality customer service, and/or niche products and services that are not being offered by the large conglomerates. Such upsides attract the interest of private-equity firms, as they possess the insights and savvy to exploit such opportunities and take the company to the next level.

For instance, a small company selling products within a particular region may grow significantly by cultivating international sales channels. Or a highly fragmented industry can undergo consolidation to create fewer, larger players. Larger companies typically command higher valuations than smaller companies.

An important company metric for these investors is earnings before interest, taxes, depreciation, and amortization (EBITDA). When a private-equity firm acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

Private-equity investors must have reliable, capable, and dependable management in place. Most managers at portfolio companies are given equity and bonus compensation structures that reward them for hitting their financial targets. Such alignment of goals is typically required before a deal gets done.

Investing in Private Equity

Private equity is often out of the equation for people who can't invest millions of dollars, but it shouldn't be. Though most private equity investment opportunities require steep initial investments, there are still some ways for smaller fries to play.

There are several private equity investment firms—also called business development companies—that offer publicly-traded stock, giving average investors the opportunity to own a slice of the private equity pie. Along with the Blackstone Group there is Apollo Global Management (APO), Carlyle Group (CG), and Kohlberg Kravis Roberts (KKR), best known for its massive leveraged buyout of RJR Nabisco in 1989.﻿﻿

Mutual funds have restrictions in terms of buying private equity due to Securities and Exchange Commission (SEC) rules regarding illiquid securities holdings,﻿﻿ but they can invest indirectly by buying these publicly-listed private equity companies, too. These mutual funds are typically referred to as funds of funds. Average investors can also purchase shares of an exchange-traded fund (ETF) that holds shares of private equity companies, such as ProShares Global Listed Private Equity ETF (PEX).﻿﻿

The Bottom Line

With funds under management already in the trillions, private-equity firms have become attractive investment vehicles for wealthy individuals and institutions. 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 gradually becoming more accessible to individual investors.

As the industry attracts the best and brightest in corporate America, the professionals at private-equity firms are usually successful in deploying investment capital and in increasing the values of their portfolio companies. However, there is also fierce competition in the M&A marketplace for good companies to buy. As such, it is imperative that these firms develop strong relationships with transaction and services professionals to secure a strong deal flow.