Most conversations start out innocently enough. “Hi, what’s your name?” “Where are you from?” “Check out these pictures of my dog.” But then it always happens… You hear it… The four most dreaded words known to anyone who works in private equity. “What do you do?”
Unlike the teaching and medical professions, the average person has very limited exposure to the private equity industry. To make matters worse, the few references to private equity in the media and movies tend to portray our industry in a negative light. Some of which are well deserved… I won’t name any names. Private equity is viewed as a rich man’s industry. It’s seen as an industry that normal people don’t have a stake in. I completely disagree with that perspective and here’s why: If you have a pension, are invested in a mutual fund, or have life insurance, I can almost guarantee that you have an indirect investment in a private equity fund. It’s the “Average Joes” that fuel the private equity industry and they don’t even realize it.
Have I piqued your interest enough to learn more about what we do? If so, I hope that this post will help shed light on our industry and answer the question that I get asked at every social gathering or family event, “What the Heck is Private Equity?”
Why Do Private Equity Firms Exist?
Did you know that there are thousands of great investment opportunities that will deliver higher returns than the stock market? If you want access to these investments, don’t bother calling your stock broker or going to E*TRADE. You won’t find them there. None of these companies are listed on exchanges because they are all private companies. If you want access to these investments, you have to go directly to the company’s owner and ask to buy some of their stock.
Are you going to call the CEO of Uber and say, “Hey, Travis! My man! I really like your app. Can I invest my $1,000 tax return in your business?” I’m going to guess, probably not. Entrepreneurs are busy. If you own a business, you aren’t going to deal with the hassle of selling a few shares at a time to random people. There are also laws that prohibit this. The only way to get the attention of these companies is to have a lot of capital (i.e money). Let’s say you do have a lot of capital, there are still so many hurdles that prevent you from investing in private companies. It’s time-consuming and it takes meaningful resources and expertise to find, evaluate, negotiate, and manage investments in private companies. If only there was a solution to this problem…
Enter private equity. Private equity firms make it easier for investors to access private companies and make it easier for entrepreneurs to access capital. They do this by pooling the capital from many different investors into a “fund” and then make investments out of that fund.
What is a Private Equity Firm?
A private equity firm is a company that uses private investor capital to directly buy equity ownership in companies. “Private investors” can be individuals or institutions. When we think of “institutions”, think of pension funds, insurance companies, or endowments. Private equity firms invest in companies, hold the investment for several years, and then sell the companies for a profit (hopefully).
How do Private Equity Firms Make Money?
Private equity firms make money in two ways. The first is by charging annual management fees. Management fees are typically a small percentage of the total “fund” size (2% on average) and are used to pay salaries and keep the lights on. The second is earned only when the private equity firm sells one of its investments at a gain. This is where private equity makes most of its money. Upon the sale of a company, a private equity firm earns a “carried interest” payment. Carried interest is calculated as a percentage of the total gain from the investment, typically 20%. Here is the math: A private equity firm buys a company for $10M. Five years later, the same company sells for $100M dollars. That creates a $90M gain. The private equity firm would get 20% of that gain or $18M and the remaining $82M is distributed to the original investors who put their capital into the PE fund. (FYI – that would be a slam dunk return and almost never happens.)
What Do Private Equity Firms Actually Do?
Contrary to what you see on Shark Tank, we don’t get to sit in tufted leather chairs all day while raining judgment down on entrepreneurs. That’s just a small piece of what we do (insert emoji that lets you know I’m being sarcastic). Below is the high-level detail of where we spend most of our time. See this post for more information on a typical private equity process.
- Fundraising: Private equity firms can’t make investments unless they have capital to invest. We spend a lot of time and resources getting in front of high net worth individuals and institutional investors to convince them to invest in our funds.
- Sourcing investments: Once we have the capital lined up, we need to find companies to invest in. Private equity firms look at hundreds of deals a year and make only a few investments each year. To find the perfect “needle in the haystack” investment, we have to network like crazy. Some firms have teams who do nothing but call companies all day long.
- Forming relationships with management teams: This is probably one of the most important elements of being successful at private equity. Developing strong working relationships with management teams help us win deals and better manage investments.
- Evaluating investment opportunities: The pitch you see on Shark Tank is the beginning stage of evaluating a business. Our job is to become a quasi-expert on a business in a very short period of time. We sift through hundreds of Excel files, legal documents and conduct countless hours of research to make sure we fully understand the business before making an investment. For more detail, see this post on what makes an attractive private equity investment?
- Negotiating deals: Valuation and ownership percentages are the tip of the iceberg when negotiating deals. Negotiating a deal requires countless pages of legal documentation with each and every sentence being a potential point of negotiation. If this sounds more boring than Shark Tank, that’s because it is.
- Managing investments: In general, a private equity firm’s goal is to help grow the business and improve operational efficiency. Some private equity firms are fairly hands off. Other firms are operationally intensive and will drop in their own team members to work day-to-day with the management teams. The best firms offer strategic advice, support and connections to help improve the business.
- Selling investments: We make most of our money by selling our investments, so we spend a lot of time making sure the businesses are best positioned to get the highest price.
What are the Different Types of Private Equity Firms?
Private equity firms vary greatly firm to firm. Each firm has a different target customer, product offering and culture. Private equity is a broad category that covers everything from venture capital through mega buyouts. We’ve compiled a summary of the different types of investors as a reference here. At a high-level, all private equity firms provide company owners with cash in exchange for equity. What differentiates firms is what that cash is used for (liquidity or growth), the stage of the company they invest in, the types of transactions they do, industry focus, and management style. As an example, you can check out ROND’s investment strategy here.
Does Private Equity Make Sense For My Business?
I dive into whether private equity makes sense in more detail here, but here is my initial advice: Selling a piece of your business to a private equity firm is a complicated and personal decision. At the very least, you are bringing on a partner who will have some decision making power and at the extreme end, you’re handing over the keys to the kingdom you spent years building. If you aren’t ready to give up any control, private equity is probably not the right path for you. If you are willing to share some of the reigns, see value in diversifying your net worth and are looking for a partner who can provide capital and resources to pursue growth initiatives, private equity may make sense for you.