Private Equity Firms

Many of you may have a checking account and perhaps a savings account.  Within a savings account, the main objective is to preserve your cash and have it grow a little.  For savings accounts, banks take your money and invest it in investments usually backed by the U.S. government.  Your savings account balance may only increase a few dollars each month but it’s still growing nonetheless.  Tonight, I will talk about private equity, which is a riskier form of investing typically reserved for institutions or very wealthy individuals.  I want to explain how a private equity fund operates and demonstrate why it’s so appealing to investors and finance professionals – even current and former politicians such as Bill Clinton, Mitt Romney, and Illinois’ very own governor Bruce Rauner.  Private equity firms can turn a $2 million initial investment into a $120 million payout at the end of 10 years and I intend to show you how.  I want to give you a heads up that there’s math involved in this speech so put on your grade-school thinking caps.

Private equity, or PE, firms are largely known as leveraged buyout investment firms.  These firms acquire companies using a relatively small portion of equity and a relatively large portion of debt.  It’s like flipping a house after making improvements to the home.  My down payment for my home, or my equity, was approximately 10% of my home’s purchase price and I borrowed the remaining 90%.  If we all chipped in what amounted to 10% of a purchase price and borrowed the rest from a bank to buy investment properties with the goal of flipping them, then we’d be doing the same thing PE firms do.  PE firms get a bunch of investors together to commit some cash, which is the equity.  Next, the PE firm borrows several times that amount from the bank, which is the leverage.  Then, the PE firm acquires a target company or companies, which is the buyout.  At this point, PE firms make certain changes to the target companies to make them more profitable, which in turn make the target companies more valuable.  The PE firm itself would put down 1% of the purchase price and ask investors to contribute money as well.  The PE firm would then borrow the remaining money needed from the bank.  Lastly, the PE firms sell the target companies for a profit.  

The average PE firm has 10 to 20 employees.  A PE firm raises equity through a fund and borrows the rest from banks.  A PE firm can have several funds.  PE firms raise equity from investors such as pension funds or high net worth individuals.  These investors then commit to provide money for investments as well as paying management fees. The PE fund has a fixed life of about 7 to 10 years.  The first five years are used to invest the money by purchasing target companies.  The next 5 or so years are used to return money back to the investors.