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Author: Rianna Ramdharee
Publication date: 20.02.2024
You’ve probably heard the terms “private equity firms” and maybe know about quite a few like Apollo Management or Kohlberg Kravis Roberts but somehow don’t understand what this term mean. Private equity firms have been growing since the 1980s and have now become “seemingly inescapable…”(Morran & Petty, 2022). In this article, I’ll be giving a quick breakdown of these firms.
What Are Private Equity Firms?
Commonly known as PE firms. Private equity firms traditionally consist of an investor or investors that raise private equity funds to successfully acquire majority stakes in companies. They would borrow large amounts of money to fund the purchase. This money would dramatically increase revenue before the investors exit through a private sale.
In more recent times, investors will financially invest minimal to no borrowed money to late-stage private companies. They will then try to profit when these companies are acquired by larger firms or go through an IPO. PE firms have been known to be quite notoriously ruthless, especially during the 1980s. They have rightfully and unrightfully been recently dubbed “vulture capitalists”(Team, 2023).
How Do Private Equity Firms Make A Profit?
PE firms make money through these three strategies:
● Carried interest: Profit paid to general partners. Fund managers will usually receive a percentage(typically 20%) of the portfolio company’s profit. Limited partners will receive what’s called a hurdle rate. Fund managers will only receive profits after limited partners. Carried interest will be deducted as part of capital gains tax.
● Management fee: This is a fee that limited partners will pay to general partners in order for their money to be managed. General partners will wait before calling committed capital. This will then reduce the costs that limited partners will incur. This fee is taxed as income tax and not capital gains.
● Dividend recapitalization: A bit of a more controversial strategy. This strategy involves the PE firm more or less taking out a loan against the company they invested in and paying themselves back. PE firms will almost eliminate downside risk and the portfolio company will have to focus on improving operations. As of 2017, this strategy is banned within the first two years of ownership.
Private Equity Firms And Venture Capital Firms
Venture capital is a form of private equity but there are slight differences between the two. Venture capital involves investors trying to acquire minority stakes in companies. Venture capital is also more tech-focused and will typically invest in startups. Venture capital firms will also invest for much longer periods(typically 10 years or more).
Conclusion
Investors in private equity firms will typically invest in companies to acquire majority stakes. The money used to invest is generally a loan of quite a substantial amount. Nowadays, these firms try not to use large amounts of loaned money to invest in companies. Private equity firms make profits through carried interest, management fees and dividend recapitalization. Venture capital firms although being a form of private equity are slightly different than typical PE firms. Venture capital firms also invest more in the tech industry.
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