Private equity is essentially a way to invest in some asset that isn't publicly traded, or to invest in a publicly traded asset with the intention of taking it private. Unlike stocks, mutual funds, and bonds, private equity funds usually invest in more illiquid assets, i.e. companies. By purchasing companies, the firms gain access to those companies' assets and revenue sources, which can lead to very high returns on investments. Another feature of these private equity transactions is their extensive use of debt in the form of high-yield bonds. By using debt to finance acquisitions, private equity firms can substantially increase their financial returns. The debt used in buyouts has a relatively fixed cost, so if a private equity fund's return on assets (ROA) is greater than this cost, the fund's return on equity (ROE) is higher than if it hadn't borrowed money. The same principle applies in reverse, however, making these leveraged buyouts potentially very risky; if the acquired company's ROA is lower than the cost of the debt used to buy it, then the private equity fund's ROE is less than if hadn't used debt. The firm would lose money on the investment and still have to pay back the loans, a situation similar to having negative equity in the housing market.
While private equity firms sometimes pay themselves back using the acquired company's profits, this isn't their principal moneymaking area. Actually, clauses in private equity deals known as covenants, which assure such repayment, have become increasingly rare in recent years. Rather than making money from guaranteed minimum dividends, etc., private equity firms have been generating most of their profit from the "exit event", or the time when they either sell the company to another private entity or return it to the public markets, presumably for a higher price than they paid originally. Especially with their heavy use of leverage to acquire companies, private equity firms can make a substantial profit in this way.
One example is the acquisition of Hertz Global Holdings (HTZ), the car rental company. When Ford Motor Company (F) decided to sell the company in 2005, private equity firms Clayton, Dubilier, and Rice, Inc., Carlyle Group, and Merrill Lynch Global Private Equity stepped in to buy the company. When the deal was completed in December of 2005, the firms had put up $2.3 billion in equity, and the acquired Hertz had taken on $12.5 billion in debt. Just eleven months later, Hertz was returned to the public markets with an IPO; even before the exit, Hertz paid $991 million to the firms in special dividends, $25 million to each for "acquisition services", and $2.25 million in other various fees. After the IPO, the three firms received another round of special dividends valued at around $427 million and $15 million to terminate standing agreements. Now, the three firms hold a combined 91.9 million shares of Hertz, valued at almost $2.1 billion (up 43% since the IPO in November of 2006). Merrill Lynch made out particularly well; in addition to its private equity firm doubling its investment in a year, the firm itself collected advisory fees for both the acquisition and the IPO and now holds 75 million shares of Hertz in addition to its private equity division's 32 million.
Raising Capital
Why would a company agree to sell a part of its interests to a private equity firm? There may be several reasons. First, the company may need a large inflow of capital for long-term productivity investments such as research and development. Rather than waiting several quarters (or years) to gather sufficient capital, the company may choose to sell part of its interests in exchange for the ability to pursue development projects sooner. This may be especially true of highly time-sensitive industries such as technology (e.g. software, telecommunications, and Internet services), where a few quarters may make a critical difference in a company’s ability to gain (or maintain) a market advantage.
Increasing Regulation of Public Markets
Second, given the increasing regulation and scrutiny in the public markets over the last several years, some companies may wish to avoid having their destinies controlled—or at least heavily influenced—by public shareholders. In a public company, shareholders have the right to cast votes with regard to any number of issues critical to the company. In a private equity transaction, such rights typically do not exist. Accordingly, a company can raise capital without relinquishing operating control to external shareholders. Nevertheless, a private equity firm does retain some control, such as the ability to influence the composition of management teams. Often, a private equity firm may take an interest in a company on the condition that the company install new management—which ideally will improve operating results and drive profits.
Effect on Public Markets
For stock market investors, the real question is how the private equity market has affected public markets and what its likely effects will be in the future. Many analysts argue that the increase in private equity deals has actually benefited some aspects of the stock market; the reason is that, with so many companies going private, it’s become harder for public investors to gain exposure to industries where private equity has been especially influential. Small- to mid-size firms in the energy and finance industries are prime examples. With the increase in private equity deals, the availability of publicly traded shares of such companies has decreased. This decrease in supply has caused the remaining shares to increase in price; as there are fewer available, each becomes more valuable.
Also, private equity can boost a company's stock price if people think a buyout is likely. Companies that are perceived as likely targets of private equity buyouts have seen their stock prices rise in anticipation of the transaction. Given recent trends in the private equity industry, investors often feel safe in assuming that private equity firms will pay a hefty premium over a company's market value. This drove up the stock prices for companies such as Martha Stewart Living Omnimedia (MSO) and Radioshack (RSH), which were commonly mentioned as buyout targets.
Financing the Private Equity Boom
One beneficiary of private equity's strength is certain: the financial firms who structure the deals. Whether they're lenders or underwriters (such as investment banks), a number of financial firms have used their market savvy and extensive industry contacts to ensure that they're in the middle of what has been one of the most profitable trends over the past market cycle. That said, if long-term interest rates continue to rise over the next one to two years, it could become more difficult for financial firms to find the capital and participants necessary to keep private equity deals moving at the same rapid pace.
