by Dave Driscoll
Private equity. You hear it on the radio, read about it in the papers – one of the presidential candidates is connected to private equity. So, what exactly is private equity?
Let’s start by defining a private equity fund, another term you hear all the time. A private equity fund is a fund that is established by a private equity group. A private equity group is a company whose principals and managers have broad experience in managing and operating businesses. This group is charged with investing the money that is contributed to a private equity fund by individual investors seeking a higher return on their investment than they can get through more traditional investment vehicles. Keep in mind that an investor seeking higher returns also must take on higher risk.
Let’s drill into that a bit in order to understand why private equity is so popular in today’s economy. Today, U.S. Treasury investments return very little on your investment. Bonds are paying a little more yet are at risk long term since their value may decrease as inflation results in new bonds with higher interest rates being issued in the future. The stock market is the next step up on the risk/return ladder, offering a greater potential return on investment matched by a greater risk that you will lose that investment à la 2008.
The risk associated with private equity funds is even higher than that of the stock market; high risk equals higher reward but also the higher probability that you could lose your investment. Clearly private equity funds are not the place to invest long-term retirement funds or your milk money. Any funds that you need to support the essentials of your lifestyle should not be invested in private equity funds.
OK, now we understand “who” and “why.” Let’s look at the “what,” as in, What exactly do private equity groups invest in?
Private equity groups use the money received from individual investors to buy privately held companies, companies that are not traded on the stock exchange. These companies are owned by individuals, families, your neighbors, your boss. Privately held companies are, by their very nature, considered high-risk.
Think of it. There are substantially more privately held businesses in this country than publicly held firms. These privately held businesses will most likely end up being sold outright someday if they are not passed on to the owners’ children or key employees of the business. Smart owners know that selling your business to a private equity group is a great way to take some chips off the table and fund your future financial objectives. In many cases, private equity groups will want current management to remain to operate the company, giving them an interest in the future value appreciation of the business.
So the private equity group invests in privately held businesses, thereby capitalizing on the earning and management synergies created by combining similar companies under one ownership group. The earnings, losses, and changes in value of the companies held in the private equity fund by the private equity group flow back through the group to the individual investors after the group collects its management fees. In other words, the balance of the profit, loss or change in value of the companies owned is credited to the investor accounts in the private equity fund.
Private equity plays an important role both for owners of privately held businesses looking to sell and for investors seeking higher returns on their investments.
Dave Driscoll is president of Metro Business Advisors, a business intermediary and mergers and acquisitions firm helping owners sell their most valuable asset. Reach him at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.