1.1 Defining private equity

Private equity owns a large and growing number of companies. The firm that makes your coffee machine, runs your local veterinary clinic or writes your payroll software may well be owned by a private equity fund. If you work in fund accounting, investor relations, or at a firm that services these funds, private equity will shape much of your day. The term is used loosely, so it helps to start with a clear definition.

This lesson explains what private equity is, how the firms that practice it are organized, and how owning a private company differs from owning shares on a stock exchange. The rest of the course builds on these ideas.

What private equity is

Private equity is investment in the equity of companies that are not listed on a stock exchange. Equity means ownership: a share in the company's profits and in its value when it is sold. Private equity investors typically hold each investment for several years and take an active part in running it.

Three features set private equity apart:

• Unlisted companies. The shares are not traded on a public market. There is no daily share price, and the investment is bought and sold through private negotiation.
• A long holding period. Investors commonly hold a company for three to seven years, though this varies widely. They aim to make money when they sell, not from short-term price moves.
• Active, hands-on ownership. Private equity owners do not just wait. They work with management to grow sales, cut costs, make acquisitions and improve how the company is run.

The companies that receive private equity money vary a lot. They include:

• young companies at an early stage of development
• mature, profitable, privately owned companies, often founder- or family-owned
• divisions that a large corporation no longer wants, sold off in what is called a carve-out
• listed companies that are bought out and removed from the stock exchange, known as take-privates

Each of these calls for a different approach. Lesson 1.3 covers the main strategies, from venture capital to buyouts.

How private equity firms work

Most private equity is done through funds. A private equity firm acts as the general partner (GP) of a fund. The GP finds the investments, manages them and decides when to sell. The investors in the fund are limited partners (LPs). They provide most of the money but take no part in day-to-day decisions. LPs are mostly institutions, such as pension funds, endowments, insurers and sovereign wealth funds, along with wealthy individuals and family offices.

A typical private equity fund is closed-end. It raises money once, during a fundraising period, and then closes to new investors. Investors cannot take their money out when they choose. Funds commonly have a life of about ten years, and extensions are sometimes agreed with investors.

Investors do not hand over all their money at the start. Instead, each LP makes a capital commitment: a binding promise to provide up to a set amount. The GP draws on that promise, through capital calls, as it finds companies to buy. Because investors commit before most of the investments are known, this is called blind pool investing. The LP is backing the GP's skill and judgement, not a list of companies.

To show they share the investors' interests, senior people at the GP usually commit some of their own money to the fund as well.

The GP is paid in two main ways. It charges a management fee to cover running costs such as salaries, offices and due diligence. It also receives carried interest, a share of the fund's profits, which usually only pays out once investors have earned a minimum return. Lesson 2.3 covers both in detail.

Money comes back to investors when the fund sells or refinances its companies. This usually happens in the second half of the fund's life. Common exit routes include:

• a sale to a strategic buyer, such as a larger company in the same industry
• a sale to another private equity firm, called a secondary buyout
• an initial public offering (IPO), where the company lists its shares on a stock exchange
• a dividend recapitalization, where the company borrows money to pay a dividend to its owners

Lesson 4.1 looks at exits more closely.

How private equity differs from buying public shares

Owning shares in a listed company and owning a private company are both equity investments. But the experience is very different.

The central trade-off is this. Private equity investors give up liquidity, the ability to turn an investment into cash quickly. In return, they get control, better information and time to change a business. They expect to earn a higher return for accepting that illiquidity and for the work they put in.

An example

The following example is illustrative.

Northfield Components is a mid-sized manufacturer of industrial parts, owned by its founding family. The family wants to retire, but no one in the next generation wants to run the business.

Ashcombe Capital, a private equity firm, is investing its fund, Ashcombe Capital Fund I. It agrees to buy a majority of Northfield. To pay for the deal, Ashcombe calls capital from the fund's LPs and borrows part of the price.

After the deal closes, Ashcombe appoints most of Northfield's board. It hires a new finance director, invests in a new factory line and buys a smaller competitor. It receives monthly management accounts and meets the management team often.

Several years later, Ashcombe sells Northfield to a larger industrial group. The fund distributes the proceeds to its LPs, and Ashcombe earns carried interest on the profit. That is private equity in a nutshell: buy a stake in a private company, improve it over several years, then sell.

Key terms

• Private equity: Investment in the equity of unlisted companies, typically held for several years with active ownership.
• Equity: Ownership of a company, giving a share of its profits and its value.
• General partner (GP): The firm that manages a private equity fund and makes its investment decisions.
• Limited partner (LP): An investor in a private equity fund who provides capital but does not manage the fund.
• Closed-end fund: A fund that raises money once and does not let investors withdraw it on demand.
• Capital commitment: An investor's binding promise to provide up to a set amount to a fund when called.
• Blind pool: A fund whose investments are mostly unknown when investors commit to it.
• Carried interest: The GP's share of a fund's profits, usually paid once investors reach a minimum return.
• Liquidity: How quickly and easily an investment can be turned into cash.

Key takeaways

• Private equity is long-term, hands-on investment in the equity of unlisted companies.
• Most private equity is done through closed-end funds, where a GP invests money committed by LPs.
• LPs commit before the investments are known, so they are backing the GP's skill.
• Compared with public shares, private equity offers control, information and time, but gives up liquidity.
• Investors are repaid mainly when the fund exits its companies, through sales, IPOs or recapitalizations.